The Government Wants to Help You Make Money – You Just Need to Let It!

The US tax code at last count has supposedly more than 2600 pages. Most people know about forms that need to be filled out, a basic deduction each person or family gets, and a few things we can use to reduce our tax burden under certain circumstances.

Then how can it be that a residential real estate investor who has a lot of assets and value pays relatively few taxes?

How come a regular worker has almost no assets and pays considerable parts of the income in taxes?

If we take it to the extreme, we find that residential real estate investors are small fish, and organizations like Amazon or GE and similar others are the big fish who can make billions in revenue and profit but not pay any taxes?

How is that possible?

The residential real estate investors and professional organizations look at taxes, not as a burden or curse but as a challenge.

It’s similar to a keyboard. W2 workers only know the on/off switch and play with 3 keys.

The professionals know how to play all the keys and what each of the little buttons on the instrument away from the keys can do.

They can play a symphony just with one keyboard, some looping and great utilization of all the features the instrument has to offer.

If you translate that to the application of tax code and laws, that great utilization leads to written confirmation by the IRS that they don’t owe anything.

If you only play music with three keys you leave large parts of your income at the IRS, lost forever.

Residential real estate investors use the full keyboard to find the IDEAL approach to economic independence.

What’s going on in more detail:

Most people look at taxes as a necessary evil that comes with living in a society or democracy. The history of income tax is pretty interesting:

Tax rates have varied widely over the years, especially for the nation’s highest earners, ranging from an initial low of around 7 percent in 1913 to a top rate of 91 percent in the early 1960s. In 2016, taxpayers in the top tax bracket (income level) paid a tax rate of 39.6 percent, according to the Tax Policy Center; they included some 860,000, or 0.5 percent of the total number of U.S. households. Nearly 80 percent of U.S. households were in the 15 percent bracket or lower, including those Americans with no taxable income and those who don’t file tax returns.

It has become normal to see the collection of income tax as a way for the government to collect money and then send it back out to people with certain needs ( i.e. social security) it’s for programs that the government supports (i.e. Housing and Urban Development rent support, also called “Section 8 HUD rent”). A large portion goes to the military — about 50% of the money the government can decide to allocate. About 10% of the total goes to pay interest on the national debt. That part will probably increase a lot in the future due to all the money that has been printed in the last 2 years.

How come then that some people and organizations pay little to nothing while others pay a lot?

Well, the 2600 pages are not all about the rules and laws we have to follow. Actually, the vast majority is the interpretation of the rules.

Here is a quick example to illustrate. You may have actually heard about the applicable rule recently in the media:

Let’s assume investor #1 buys a house for $100,000.00 and investor #2 buys shares of an electric car maker from the stock exchange, also for $100,000.00.

Both were really good at selecting the assets.

The residential real estate investor (#1) had heard a rumor that the town he was buying the house in might soon get an Amazon distribution center that would bring a lot of new jobs, shopping, etc. to the area. Nobody could guarantee if it would happen, but if it did, it would be great for property values. The cash flow for the house was only about $100/month after all expenses, etc.

The stock market investor (#2) believed that we will soon get more concerned about the environment and would want to be able to drive cars that don’t pollute the air anymore, and if that’s ere to happen the stock for the car manufacturer would go through the roof.

2 years later it turns out both investor #1 and investor #2 were right.

Amazon came, jobs came, house prices increased. Investor #1 put the house on the market and was able to sell it for $150,000.00.

The electric car company also did very well and the stock investor was happy about the price increase and sold his shares for $150,000.00.

Both investors made $50,000.00 in profit.

The stock investor (#2) has to pay 15% capital gains tax on this money. After that, the rest is available for consumption or reinvestment.

Investor #1 who bought and sold the real estate can also reinvest the money but the government provides a rule in the tax code called §1031. This rule says that investor #1 has 45 days to find another investment property and complete the purchase in 6 months (180 days). If he does that he can keep the full $50,000.00 in profit without any taxes due.

Photo by Chronis Yan on Unsplash

Why the difference?

The government likes the public to be directly involved in things. If you buy a house and rent it to a tenant you are providing shelter to that tenant and his/her family. If you would not do that, the government through the department of housing and urban development (HUD) would have to do it using tax dollars from the public. Basically, you as investor #1 are doing the government favor and as long as you keep doing that, you are not asked to pay taxes on your profit. If investor #1 buys another great property, makes new profits in a few years, and uses the 1031 exchange again, there are again no taxes on the gains.

Investor #2, on the other hand, is indirectly participating in the economy. The government would much rather see you become a business owner and assume the risk than speculation in the stock market. That’s why those profits are taxed (there are a few there reasons too).

Want to know the real kicker of this story?

Yes, there is one more thing that is going to blow your mind (assuming you are not already blown away):

When investor #2 decided to buy the stocks at the stock exchange he/she needed to put the full $100,000.00 on the table and receive the stocks in return.

When investor #1 decided to buy the house, he/she only needed to put $20,000.00 on the table. The bank gave the other $80,000.00. The tenant paid the rent + insurance + reserves + maintenance reserves +$100/month to investor #1 as positive cash flow.

When the house was sold and investor #1 got the $50,000.00 in profit, he/she made 250% on their initial investment and don’t have to pay taxes.

Let me know, which would you rather do?

I’ll go for tax-free and 250% returns any day of the week…

That’s how the tax code can put money into your pocket.

Photo by Terrah Holly on Unsplash

Best of all: you are doing a great thing because you are providing a good quality house to a family at a fair price. You help the government provide shelter for the population. And you’re using the rules put in place to incentivize you to use your money together with the bank’s money to make it happen.

Everybody wins!