Read an Excerpt
Loopholes of the Rich
By Diane Kennedy
John Wiley & SonsISBN: 0-471-71178-0
Chapter OneSTARTING POINT-UNDERSTANDING YOUR FINANCIAL STORY
Five STEPS to Financial Freedom through Loopholes
Success leaves a trail. One of the easiest ways to have your own success is to follow where others have gone before. We all have different goals and come from different circumstances, but there are five basic steps that will ensure the best possible results for everyone, no matter where you are now. These five STEPS are:
S Starting point. T Team. E Evaluation strategy. P Plan and path. S Starting point (reevaluation).
S Is for Starting Point
First, you need to know where you are. It's like having to get on the scales before you start a new diet-you might not want to really know what the numbers say, but you do need to know your starting point.
That's just how it is for your financial plan. Your best results will come when you can take a realistic look at where you are financially-without excuses, blame, or justifications. Find out where you are, so you can plot an accurate course to where you want to be!
T Is for Team
After you have a good idea of where you are, you will need to start to think about the members you need for your financial team. Most likely, the main members of your team initially will be advisors, educators, and mentors. But your team can also include customers, clients,vendors, business alliances, and friends, among others. You can make conscious choices about the members of your team. You can learn how to evaluate what you need and how these people will fit into your plan. Finally, you can recognize the hidden influences they have on decisions you have made and will make in the future.
E Is for Evaluation/Strategy
After you know where you are and begin to assemble your team, it is time to call on your advisors to help you evaluate your situation and design a personalized strategy for you to achieve your goals. No one team member-your tax strategist, bookkeeper, legal counsel, or financial planner-will make all of the decisions. It is through the cooperative work of your whole team that you will receive the best advice and plan creation.
P Is for Plan and Path
After S, T, and E, you now need to move forward on the path and implement the strategy designed. This can be the hardest part as you move into previously unknown financial waters. You will want to make sure that the team you have in place has experience in the necessary areas and can give you good advice based on their own personal education, experience, and special skills.
S Is for Starting Point (Reevaluation)
You've taken the first four steps and now you need to again evaluate where you are. Just like a rocket going to the moon needs continual calculations to keep it on its path, you must constantly evaluate where you are and where you are going to ensure that you reach your goals.
By taking the time to thoughtfully consider where you are and where you've come from, you put yourself in a position to achieve the optimum results.
These five STEPS to financial freedom can start you and your family on the path to financial freedom today.
Where Are You Now?
Why is it so hard for many people to look at their financial information?
In school, you received a report card to tell your parents and institutions of higher learning how well you did. In life, your financial statements are the report cards that tell investors and financiers how well you are doing. The financial statement, unlike the report cards of old, is something you volunteer to get. And, most people choose to just not look at the data. Sometimes the truth is just too painful.
Traditional education has a part to play here. People are taught more about the technical aspects of their chosen field than they are taught about the practical aspects of running a business in that field. Doctors are taught medical techniques, but are not taught how to run a business so they can grow wealthy without having to give up all their free time. An architect is taught design, but is never told how to set up a profitable architecture firm.
How to Find Out Where You Are
Your financial statements tell a story. And your financial statements are often the best crystal ball when it comes to predicting what your future is going to be.
First, understand what a financial statement is. No, we're not going to turn you into an accountant, but there are basics of how financial statements work that you need to learn so you can immediately spot the financial story of every statement. Can you imagine being able to look at a financial statement and instantly know what the future of that company is going to be? Even better, imagine looking at your own monthly financial statements to identify what is working, so you can do more of it, and what isn't working, so you can change it! How could that change your life?
Second, utilize the simplified forms in this book so you can start to see where your money is going and identify the cash flow patterns in your own life.
Finally (my favorite step), design your ideal financial statement. How much cash do you want flowing into your pocket each month? How much money do you need in order to create the dreams of you and your family? Put your goals in writing with financial statements and they become a measurable tool that you can use to guide your investment and business decisions. But if you never write them down, they will never happen.
Know Where Your Money Goes
As can be seen in the story about Jean, I do not advise my clients to create additional expenses just for the tax write-off. Instead, I advise them to first look at where they already spend money. They usually will look at the past three months' spending and take an average of their expenses to use as the monthly numbers. This can be a painful experience, as some of my clients have to come face-to-face for the first time with where their money really goes. Don't cheat yourself! Do this exercise accurately and with as much detail as you can. The more care you take, the better the results.
Your business must track income and expenses so your CPA can accurately prepare your tax return. But what do you do about your personal expenses? Our clients find more tax deductions and have better financial planning tools when they track their personal expenses as well as their business expenses. You can do this by using a bookkeeper or through a personal money-management software program.
I have discovered that clients who do not accurately track their personal expenses always and without exception shortchange themselves. They can't substantiate the deductions they can take and they simply don't remember many of them.
Take advantage of every deduction by knowing where all your money goes. See Chapter 3 for a form you can use to determine where you spend your income.
Financial Statements Made Easy
There are three financial statements that every business should use. Each of these serves a different purpose. Unfortunately, many people stop at one or maybe two statements when they look at a business.
Don't skip this section even if you don't have a business. A household is really a business. You want to know how your assets and liabilities look (balance sheet), how much income and expenses you have (income statement), and which way your cash is flowing (statement of cash flows).
Follow along on Figure 1.1 as we consider the elements of financial statements.
In some cases when reviewing an investment you might be presented with an income statement only. The income statement is only one part of the financial statements. You must see all statements in order to get a full sense of the investment potential. The income statement is a great place to start, though!
The income statement shows the income and expense items for a specific period of time, whereas the balance sheet is a snapshot as of a certain date. The first thing to note on the income statement is the time period. Is it for a month, a year, or some other period? The income statement tells you the income that came in and the expenses that went out during this particular time.
Types of Income
Since the 1986 Tax Reform Act, the IRS has defined three different "buckets" of income. These three different buckets are taxed differently. There are also restrictions on losses and expenses that are incurred within those three categories. For example, in general, the amount of passive loss that you can take against earned income is limited.
The three types of income are: (1) earned, (2) portfolio, and (3) passive.
Earned income is the money you work for. It includes the wages from a job (even if the employer is your own company), net income from your sole proprietorship (not incorporated business), and income from your active involvement in a partnership.
Portfolio income is the money your money makes for you. This includes interest, dividends, and capital gains. There are both short-term and long-term capital gains, but both refer to the gain that your money makes for you. Short-term means you held the asset for less than one year. Long-term means you've held it longer.
Passive income is the income your investments make for you. The most common source of passive income is from real estate investments.
Earned income is the highest-taxed income there is. In 2004, the highest federal tax rate for earned income was 35 percent. But add in payroll taxes (or self-employment taxes, if you're in the wrong business structure) and you are looking at a tax rate of more than 40 percent!
Now, contrast that with the tax rate for portfolio income. Interest and short-term capital gains are taxed at the earned income tax rate, but without self-employment or payroll tax. The current highest federal tax rate for the majority of portfolio income-dividends and long-term capital gains-is 15 percent.
Passive income is the best kind of all! If you take advantage of all the real estate loopholes, such as maximizing depreciation, you can pay at 0 percent tax rate.
Where does your income currently come from? Which tax rate are you paying at? If you're like most Americans, most of your income is coming from earned income. That means you work hard for the money and you pay the highest possible tax rate.
Since 1986, U.S. tax laws have stated that losses can be claimed only against income in the same category. For example, passive losses can generally be used only against passive income. Investment expenses, such as for margin interest or investment education, can go only against portfolio income. Of course, this is a simplified version of a more complicated piece of tax law. For example, you are allowed up to $25,000 in real estate losses against other forms of income as long as your income does not exceed $100,000 per year. If your income is over $150,000 and unless you can qualify as a real estate professional, you will not be able to deduct your real estate losses against other income. The allowable real estate loss phases out when your income reaches an amount between $100,000 and $150,000.
Tax-Deferred and Tax-Free Income
As mentioned, the three types of taxable income are earned, portfolio, and passive. However, there are also two other types of incomes that you don't currently pay tax on. Tax-deferred tax means "tax later," while tax-free means "tax never." Sometimes, if you've set up your strategy right, tax-deferred can mean tax never. But remember, there is generally a day of tax reckoning on tax-deferred income.
Two common types of tax-deferred income are (1) like-kind exchange and (2) 401(k) plans.
A like-kind exchange allows you to exchange one investment for another investment, under certain circumstances. There are like-kind provisions for life insurance policies, cars, equipment, and real estate. The real estate like-kind exchange, also known as a 1031 exchange or a Starker exchange, is probably the most common.
The like-kind exchange is described in Section 1031 of the Internal Revenue Code and is further defined in a court ruling, Starker v. Commissioner-hence the other names. This is a specific exchange of real estate that has been held for business or investment. You cannot do a Section 1031 like-kind exchange on your personal residence or on non-real estate items. A like-kind exchange allows you to sell a piece of property that is highly appreciated and roll over the gain into another piece of property. You don't pay tax on the sale now.
The second piece of property merely has to be another piece of investment real estate property. It does not need to be exactly the same kind of property. For example, you could exchange a single-family residential rental for a piece of commercial land. Or you could exchange an apartment building for a shopping center.
There are some rules for the like-kind exchange that must be closely followed. We strongly recommend that you have an exchange accommodator help you with the details of the exchange. An exchange accommodator is someone who comes from a specialized profession that only handles property exchanges. Neither your accountant nor your lawyer can fill this position for you. In general, you must declare three possible choices for the exchange within 45 days and you must close on the replacement property within 180 days. You need to invest all of the cash from the sale into the next property, and the next property must be purchased for at least as much as the sale price of the first property.
Recent tax law has given us a few more opportunities. For example, there is a method of holding title to property called "tenants-in-common" in which there is more than one owner. While you can't exchange an investment property for an interest in a partnership even if the partnership owns real estate, you can exchange an investment property for a group ownership property if the property is held as tenants-in-common.
Another form of tax-deferred income is a 401(k) plan. (Most forms of pension plans are tax-deferred.) A deduction is made currently from your income for the contribution and then later you pay tax. That's what tax-deferred means-tax later.
I like the like-kind exchange plan for tax deferral in the right circumstances, but I'm not such a fan of the 401(k) plan. Here are the three reasons why I hesitate before recommending such a strategy for wealth building.
1. A 401(k) plan generally assumes that the values of the underlying mutual funds will go up. Well, we all know these funds don't always go up. In fact, the stock market moves up, it moves down, and it moves sideways. If you're a day trader, watching your stocks on a minute-byminute basis, then you know you can make money, in fact a lot of money, when the stock market moves down. But most people in 401(k) plans are stuck with watching their funds lose money as they spiral down.
2. The typical reason given for using a pension plan is that you're going to make less money in the future. Well, the average American is likely to be making considerably less money in the future. I like to say that there are three financial plans that you can have for your future: a plan to be poor, a plan to be middle-class, or a plan to be rich. If you are looking at receiving less money in the future, you have a plan to be poor. My clients have a plan to be rich. So, an automatic deferral of income might not be the smartest thing. In fact, by the time we're done with all of the loopholes we discuss in this book you might be like my clients and find that you can pay a whole lot less tax right now. It doesn't make sense to defer income to the future when we don't know for sure what the tax loopholes will be.
Excerpted from Loopholes of the Rich by Diane Kennedy Excerpted by permission.
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