In the US, it’s better to be an owner than an employee. Utilize these ownership strategies to accumulate wealth through non-taxable income.
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There are many ways for owners to increase their wealth so as to avoid generating any kind of taxable income, which qualify generated income for a lower tax rate, or that at least delay that taxable income to later years. This allows for owners to dramatically decrease the greatest obstacle to wealth accumulation—taxes—and thus build wealth at a much faster rate.
I have written before about how ownership has its privileges and about how you actually want to become a capitalist as quickly as possible. While hardly risk-free, ownership is great in that when a business is successful, the vast majority of the profit accrues to the owners, not the employees. In a capitalist system, capital is king, so you want to do as much as you can to move from having to rely on your personal labor to being able to rely on your personal capital. Capital, like debt, works every hour of the day and night, 24/7/365. If you swap out “capital” for “interest” in the famous J. Reuben Clark quote you’ll see what I mean:
“[Capital] never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels; it takes no pleasure; it is never laid off work nor discharged from employment; it never works on reduced hours; it never has short crops nor droughts; it never pays taxes; it buys no food; it wears no clothes; it is unhoused and without a home and so has no repairs, no replacements, no shingling, plumbing, painting, or whitewashing; it has neither wife, children, father, mother, nor kinfolk to watch over and care for; it has no expense of living; it has neither weddings nor births nor deaths; it has no love, no sympathy; it is as hard and soulless as a granite cliff. once [invested], [capital] is your companion every minute of the day and night. . .”
It’s a beautiful thing to come home from a vacation richer than you were when you left.
Not Here to Judge the Fairness of the Rules
First, a caveat. Lots of people think “the rich” don’t pay their fair share. Warren Buffett famously talks about how his secretary has a higher marginal tax rate than he does. I’m not here to play judge, jury, and executioner about the rules in our tax code. I’m just here to tell you what they are. You can decide what you want to do with them, both in your personal financial life and in the voting booth. But this is a blog aimed at the high-earning professional and discusses mostly “first-world problems.” I fully expect the vast majority of my readers to eventually become multimillionaires. If you’re offended to learn the rules, play by the rules, pay every dollar you owe in taxes but don’t leave a tip, and build wealth, this blog is probably not a good place for you to hang out.
The Key Concept: Earn Non-Taxable Income
The main idea I want you to take away from this post is that there are some things that increase your net worth that are not taxable income. If it isn’t taxable income, you don’t pay income taxes on it. Only income is subject to income tax. Let’s talk about examples of non-taxable income.
Become a Homeowner
Perhaps the easiest one to understand is home ownership. A home is frequently derived as a liability and not an asset. I completely understand that idea, and I have written about it many times before. However, in some way, your home actually is an asset. Yes, your home is an investment. It can appreciate in value, and it pays “dividends” in the form of saved rent. However, today we are talking about taxes. So, what are the tax benefits of home ownership?
What Are the Tax Benefits of Owning a Home?
Well, they aren’t what most people think. Most people think the big tax benefit is deducting your mortgage interest and property taxes on Schedule A. Well, with the new higher standard deduction ($27,700 for those married filing together in 2023), most homeowners are no longer itemizing. Plus, even for those who do, only the amount above the standard deduction is really deductible. Besides, the property tax deduction doesn’t really exist for high earners who are paying more than $10,000 in state taxes already. Also, the mortgage interest deduction goes away when you pay off the mortgage. No, my friends, Schedule A is NOT where you find the main tax benefit of home ownership.
The main tax benefit of home ownership is that you do not pay taxes when the value of your home increases. Let’s say you bought your home 10 years ago for $400,000. Now, maybe it’s worth $700,000. Your net worth is $300,000 higher than it used to be. Yet you never paid a dime in taxes on that $300,000, did you? No capital gains taxes are due until you actually sell the asset. But wait, there’s more. Even when you do sell, the first $250,000 ($500,000 if married) in gains of a residence you have lived in for two of the last five years is not taxable at all. A married couple can swap houses every time the house appreciates $500,000 and never pay taxes on all that increases in wealth!
Business Ownership
Guess what? Business ownership works the same way to reduce taxable income. The lion’s share of our personal wealth lies in the value of The White Coat Investor. Yes, we’re trying to diversify as quickly as we can, but that’s the way of life is for many successful entrepreneurs. When I started blogging back in 2011, The White Coat Investor had a value of $0. Now its value is much more than that. None of that increase in value has ever been subject to tax income, and if I leave it to my heirs (thanks to the step up on a basis at death) or leave it to charity, it will never be.
Since most businesses are sold at a multiple of profits, this increase in net worth can happen very quickly. Consider a business that makes $1 million a year and is valued at 10X earnings, or $10 million. That $1 million is taxed annually, of course. However, if the business owners and managers figure out a way to make $1.5 million a year, they will have created another $5 million in wealth (plus the $500,000 in additional earnings, for $5.5 million total). They would only pay taxes on $500,000 of that $5 million though. That’s better than the effects of pretty significant leverage.
Buying Stocks
No, you probably don’t own any WCI-like businesses, but the same concept applies to every other business out there. And even if you don’t start or completely own an entire business, it doesn’t mean you cannot purchase parts of other successful businesses. Many of the world’s largest and most successful businesses are publicly traded, and you can buy their shares in the stock markets either directly or via mutual funds (especially low-cost, broadly diversified index funds, my favorite way to own them). Many of these businesses will continue to appreciate in value as they develop new products and services, raise prices on them, and reach out to new markets. As long as you do not sell your shares in these businesses, that increase in your net worth is not taxed. And if you leave them to heirs or charity, they will never be taxed.
Tax Benefits of Real Estate Investing
Investment real estate does not qualify for the $250,000/$500,000 exclusion of capital gains for which owner-occupied real estate qualifies. But the rest of this all applies AND you get the added benefit of deducting or depreciating all of your expenses on the property against the income from that property (and if you qualify for Real Estate Professional Status (REPS), against your ordinary income). Under the current bonus depreciation rules at the time of this writing, you could take over 60% of the value of your investment as depreciation in the year of the investment. The depreciation can “cover” a great deal of real estate income—income that would normally be subject to ordinary income tax rates—allowing that income to come to you tax-free. Yes, when you sell, that depreciation is recaptured at a rate of up to 25%, but there is probably an arbitrage between your marginal tax rate and 25%. Plus, you have three other options to avoid having that depreciation recapture occur:
- Die (and pass it to your heirs income tax-free thanks to the step up in basis at death)
- Give it to charity (you get a deduction for the full value and neither you nor the charity pay capital gains taxes or depreciation recapture)
- Exchange it into another property (1031 exchange), further delaying the recapture until the second property is sold
Depreciate, exchange, depreciate, exchange, depreciate, die is the mantra of many successful real estate investors. If you don’t sell, you get the appreciation (including the recapture of any depreciation) tax-free.