Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax

Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax

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by Diane Kennedy

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Loopholes of the Rich helps Americans from all walks of life use the same tax loopholes that the wealthy use to lower their tax bill. With this handy guide, you won't need an accountant to find quick and easy ways to pay less. And there's nothing unethical about these tax loopholes. In fact, the government wants you to take advantage of them! These tax-reducing


Loopholes of the Rich helps Americans from all walks of life use the same tax loopholes that the wealthy use to lower their tax bill. With this handy guide, you won't need an accountant to find quick and easy ways to pay less. And there's nothing unethical about these tax loopholes. In fact, the government wants you to take advantage of them! These tax-reducing tactics and strategies can give you the freedom to save for your family's future or for your own financial independence. Plus, you'll find a handy checklist of more than 300 business deductions, real-life tax strategy examples, useful sample forms, explanations of IRS codes and rules, and much more.

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Loopholes of the Rich

By Diane Kennedy

John Wiley & Sons

ISBN: 0-471-71178-0

Chapter One


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.

Income Statement

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.

Like-Kind Exchange

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.

401(k) Plans

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.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Meet the Author

DIANE KENNEDY, CPA, is a top real estate author and investing expert. She holds seminars across the country on how to legally and ethically minimize tax obligations. She is the founder and owner of DKA, a leading tax strategy and accounting firm. She is also the coauthor of The Insider's Guide to Real Estate Investing Loopholes and The Insider's Guide to Making Money in Real Estate, both from Wiley.

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Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax 3.7 out of 5 based on 0 ratings. 9 reviews.
Guest More than 1 year ago
The authors of the eBook version do not allow loaning, giving, printing, copying or 'reading aloud'. Nor do they make the buyer aware of this prior to purchase. By not providing the 'giving' option, you can not move this book to a different computer. So, if your computer dies, so does the book. Without the 'reading aloud' capability, the visually impaired will have a difficult time reading this book. Do not purchase the Adobe eBook version of this book!
Anonymous More than 1 year ago
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Guest More than 1 year ago
This clearly written book offers a handy guide to tax strategy for the rich and for those who hope to be rich. Author Diane Kennedy, a certified public accountant, provides basic information on common tax risks and opportunities. Without using burdensome jargon, she explains the fundamentals of financial reports and record keeping. Her approach is commonsense and straightforward she doesn¿t make outrageous promises or exotic, inapplicable recommendations. The title is slightly misleading. This book is not really about loopholes, but rather about sound planning and management - especially for business owners. It does get into the minutiae of tax law, which is subject to change, so some of the details may have a short shelf life, and much of the advice will have little applicability outside of the United States. Nonetheless, we recommend this basic guide to anyone who needs a fundamental introduction to personal financial and tax management in the U.S.
Guest More than 1 year ago
Diane truly covered the necessary tips of learning how to make your money work for you.
Guest More than 1 year ago
Guest More than 1 year ago
Think only the rich get money off on their taxes? Perhaps you don't even know what a loophole really is! Well if you pay taxes at all, you must read this book. Taxes are the single largest expense that you have (add them all up for yourself and see) and this book clearly explains what you can do to reduce that burden. All those money saving things that you have been doing (from clipping coupons, driving farther to get cheaper gas, finding the best deals on business supplies, etc., etc., etc.) will be unneccesary once you've read this book. It's not just about how much you make, it's about how much you actually get to keep. I highly recommend this book. It will really open your eyes to taxes, how they work, and what you can legally do about them. It will really change your mind about where your money saving priorities should REALLY lie. I only wish I had read it 10 years ago!
Guest More than 1 year ago
All of Robert's books are great!!! He really gets into details and explains himself clearly.
Guest More than 1 year ago
Review Summary: The hardest thing for you to find is simple advice about which financial structure to use for self-employment and small business activities and how to balance cutting taxes, having flexibility, and avoiding asset exposure. This book is the best simple version of how to do all of this I have seen. You will obviously need experts to help you do your planning to match your needs, but this book will prepare you to work knowledgeably with those experts. Over a career as a small business owner, this book may be the most valuable one you will ever read. Review: I am a big fan of Rich Dad, Poor Dad and wrote a review of that book that caused me to get a lot of e-mails asking tax-related questions. I am delighted to see this book because it means that those who wonder how developing passive income can cut taxes can start to understand why that occurs. 'Loopholes . . . are government incentives.' For many years, Congress has provided tax incentives to encourage certain kinds of business development and investing. As a small business owner, you have the opportunity to benefit from some of those incentives, legally and morally. This book will be most valuable for those who know little about the structure of the income-tax code and regulations, how property is protected against legal suits, and ways of creating financial flexibility. The tools you can use differ from year to year, as the rules change. This book is good for explaining the general concept of how these rules usually work. It also tells you what kinds of advice and expertise you need from others. Most people don't know where to start, and this book gives you a step-by-step process to assess where you are today, get the resources you need to help, evaluate a potential strategy, create a plan to implement a strategy, and monitor how well your strategy is working and whether you need to make any changes or not. There is a tendency for popular books about business and investing to overpromise what can be accomplished. I thought that Ms. Kennedy avoided that problem. Based on my understanding of these issues, she describes things accurately and appropriately. When she gets into more problematical areas like VEBA, her cautions are well-stated and complete. I have heard many people try to explain these concepts simply, and her explanation is the briefest, accurate one it has been my pleasure to read. Knowing more detail will not help you all that much. The main drawback of the book is that it doesn't go into enough detail about the advantages of real estate investing. Rich Dad, Poor Dad makes quite a point about how taxes paid can be low on such businesses. Basically, the answer is that you get to charge off part of your investment as an expense (depreciation) and that there are special incentives for specific classes of real estate that reduce tax bills even more. So I expect that I will still get e-mails about why Mr. Kiyosaki is so positive on real estate businesses. After you finish reading and applying this book, I suggest that you think about how your family life should be structured for optimum happiness. If you think about that subject as much as you do the structure of your finances, you will truly be wealthy in all the ways that count. Live life with rich spirituality! Donald Mitchell, co-author of The Irresistible Growth Enterprise and The 2,000 Percent Solution