In the United States, it is better to be an owner than an employee. Use these ownership strategies to build wealth through non-taxable income.
PIMD welcomes the white-coated investor. WCI is a personal finance and investing website specifically for physicians. White Coat Investor can help you become financially disciplined and educated, allowing you to dedicate your time and effort to your patients, your family, and your own well-being. WCI truly believes that a financially secure physician is a better partner, parent, and professional. White Coat Investor is an affiliate partner of PIMD.
There are many ways for homeowners to increase their wealth that avoid generating any type of taxable income, qualify the generated income for a lower tax rate, or at least delay that taxable income for later years. This allows homeowners to drastically reduce the biggest obstacle to wealth accumulation, taxes, and thus accumulate wealth at a much faster rate.
I have written before about how property has its privileges and about how you really want become capitalist as fast as possible. While not risk free, ownership is great because when a business is successful, the vast majority of the profits accrue to the owners, not the employees. In a capitalist system, capital is king, so you want to do everything you can to go from having to depend on your personal labor to being able to depend on your personal capital. Capital, like debt, works all hours of the day and night, 24/7/365. If you change “principal” to “interest” in the famous quote by J. Reuben Clark, you’ll see what I mean:
“[Capital] he never sleeps or gets sick or dies; never goes to the hospital; it works on Sundays and holidays; he never takes a vacation; he never visits or travels; does not take pleasure; you are never fired from work or fired from employment; never works reduced hours; it never has short harvests or droughts; never pay taxes; does not buy food; does not wear clothes; is homeless and homeless and therefore has no repairs, replacements, shingles, plumbing, painting, or whitewashing; he has no wife, children, father, mother or relatives to take care of and take care of; has no living expenses; it has no weddings or births or deaths; it has no love, no sympathy; it is as hard and soulless as a granite cliff. Once [invested], [capital] It is your companion every minute of the day and night. . .”
It’s nice to come home after a vacation richer than you were when you left.
Not here to judge the fairness of the rules
First, a warning. Many people think that “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 over the rules of 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-income professional and it mainly discusses “first world problems”. I fully expect the vast majority of my readers to eventually be billionaires. If you’re offended by learning the rules, following the rules, paying every dollar you owe in taxes but not tipping, and building up wealth, this blog is probably not a good place 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 is not taxable income, you do not pay income tax. Only income is subject to income tax. Let’s talk about examples of nontaxable income.
Become a homeowner
Perhaps the easiest to understand is home ownership. A house is often ridiculed as a liability rather than an asset. I completely understand that idea, and have written about it many times before. Yet somehow, your home actually is an active. If you house is an investment. It can appreciate in value and pays “dividends” in the form of rent saved. 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’re not 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 married filing jointly in 2023), most homeowners no longer itemize. Also, even for those who do, only the amount above the standard deduction is truly deductible. Also, the property tax deduction doesn’t really exist for high income earners who already pay more than $10,000 in state taxes. Also, the mortgage interest deduction disappears when you pay off the mortgage. No, my friends, Schedule A is NOT where the main tax benefit of owning a home is.
The main tax benefit of owning a home is that you do not pay taxes when the value of your home increases. Let’s say you bought your house 10 years ago for $400,000. Now, maybe it’s worth $700,000. His net worth is $300,000 higher than it used to be. You never paid a dime in taxes on that $300,000 though, did you? No capital gains tax is due until you actually sell the asset. But wait, there is more. Even when you sell, the first $250,000 ($500,000 if married) in gains from a residence you’ve lived in for two of the past five years is not taxable at all. A married couple can trade houses every time the house appreciates $500,000 and never pay taxes on all that increased wealth!
Guess what? Business ownership works the same way to reduce taxable income. Most of our personal wealth resides in the value of The White Coat Investor. Yes, we’re trying to diversify that as fast as we can, but that’s the life of many successful entrepreneurs. When I started blogging in 2011, The White Coat Investor was worth $0. Now its value is much more than that. None of that increase in value has ever been subject to income tax, and if I leave it to my heirs (thanks to the intensify based on death) or leave it to charity, it never will be.
Since most companies sell at a multiple of earnings, this increase in net worth can happen very quickly. Consider a business that makes $1 million a year and is valued at 10X profit, or $10 million. That million dollars is taxed every year, of course. However, if business owners and managers find a way to earn $1.5 million a year, they will have created another $5 million in wealth (plus the additional $500,000 in profit, for a total of $5.5 million). However, they would only pay tax on $500,000 of that $5 million. That beats the effects of quite significant leverage.
No, you probably don’t own any business similar to WCI, but the same concept applies to every other business out there. And even if you don’t start or own an entire business, that doesn’t mean you can’t buy parts of other successful businesses. Many of the world’s largest and most successful companies are publicly traded, and you can buy your shares on the stock markets either directly or through mutual funds (especially low-cost, broadly diversified index funds, my favorite way to own them). Many of these companies will continue to appreciate in value as they develop new products and services, raise prices, and enter new markets. As long as you don’t sell your shares in these businesses, that increase in your net worth isn’t taxable. And if you leave them to heirs or charity, they will never be taxed.
Tax Benefits of Investing in Real Estate
investment real estate does not qualify for the $250,000/$500,000 capital gains exclusion for which owner-occupied real property qualifies. But the rest of this all applies AND you get the added benefit of deducting or depreciating all 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 bonus depreciation rules in effect at the time of this writing, you could take more than 60% of the value of your investment as depreciation in the year of the investment. Depreciation can “cap” a large portion 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 recovered at a rate of up to 25%, but there’s probably an arbitrage between your marginal tax rate and 25%. In addition, you have three other options to prevent depreciation recapture from occurring:
- Die (and pass it on to your heirs tax-free thanks to the increase in the basis on death)
- Give it to a charity (you get a full value deduction and neither you nor the charity pay capital gains tax or recover depreciation)
- Trade it in for another property (1031 exchange), further delaying recovery until the second property is sold
Depreciate, trade, depreciate, trade, 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.