There may not be a single person, investor or not, who doesn’t want to learn how to pay less taxes. If for nothing else, the less someone pays in taxes, the more they are able to pocket for themselves. Whether they want to remain more liquid or invest the money they save, understanding how to pay less taxes each year can help the average person exercise more financial freedom. After all, the fewer dollars spent on taxes, the more someone will be able to spend on the things they truly love.
It is worth noting, however, that the Internal Revenue Service (IRS) isn’t going to simply let someone pay less taxes because they want to; they will absolutely collect the money they are owed. Instead, tax paying citizens of the United States will need to familiarize themselves with the tax code in order to learn how to pay less taxes; that, or they can learn how to pay less taxes with the following IRS-approved tax strategies.
To be perfectly clear, the following content is not intended to serve as individual tax advice, but instead highlights some of the ways the IRS may allow qualifying individuals to shelter income. Before making any tax decisions on your own, please consult a professional who is well versed in the current tax code.
10 Ways To Pay Less Taxes
Nobody likes paying taxes. People work too hard for their money to simply return a large portion of it back to a government who has other plans for the capital. Unfortunately, there’s no way to stop paying taxes entirely. The government will always get what it is owed. However, there are strategies which enable people to shelter some of their cash. Using some of the following tax saving strategies and a lot of due diligence, the average person may be able to legally reduce their taxable income and how much they owe the government:
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Invest In Municipal Bonds
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Adjust Your W-4
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Long-Term Capital Gains
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Contribute To Your 401(k)
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Open An IRA
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Start A Business
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Use A Health Savings Account (HSA)
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Create A College Fund
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Claim Tax Credits
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Sell Under-Performing Stocks
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1. Invest In Municipal Bonds
Municipal bonds are issued on behalf of states, municipalities, or counties in an attempt to raise capital for community projects. In doing so, each government entity may issue a bond on the bond market. By issuing a new bond, the government entity is essentially asking for a loan funded by an individual investor.
In the event a bond is purchased, the government receives the funds for their respective project. The investor who purchased the bond, on the other hand, can expect to receive their initial investment (the face value of the issue) plus interest (also known as the coupon rate) once the bond matures.
Municipal bonds enable individual investors to act as the bank for local government projects, which begs the question: How is investing in municipal bonds one of the ways to reduce taxable income?
Since many states, municipalities and counties are exempt from paying federal taxes, the interest they pay out to investors who buy their bonds may also be tax exempt. As a result, the money investors collect at the time a bond matures does not count as taxable income. That said, investing in municipal bonds is traditionally reserved for income investors, and not those looking for a lot of growth in their invested dollars.
2. Adjust Your W-4
As an IRS tax form, Form W-4 allows employees to indicate their individual tax situation to the employer. Simply put, Form W-4 is how the employer knows exactly how much federal tax to withhold from an employee’s paycheck. Unfortunately, far too many new employees don’t realize the implications of signing a W-4 without understanding how much to claim. Those who claim too little may find the government taking too much out of their paychecks. Those who claim too much may wind up owing a lot of money each year.
Instead of simply claiming an arbitrary number, new employees should use the W-4 as a tax saving strategy. Those who reduce their withholdings may find that they get more money back at tax time. Of course, there is a tradeoff: by reducing one’s holding, the government will take more out of each paycheck. Increasing withholdings, on the other hand, will lower the amount the government takes out of each check.
When all is said and done, adjusting W-4 withholdings will determine how much the government takes out of each paycheck; if they take too much, employees can expect to receive money when they do their taxes. However, if employees don’t allow the government to take enough up front, they will pay more come tax time. Therefore, if employees want to learn how to pay less taxes in April, they should reduce their withholdings. Unfortunately, more money will come out of each paycheck, but employees won’t be stuck with an even bigger tax bill than they expected.
3. Long-Term Capital Gains
Anyone who wants to learn how to pay less taxes should take a closer look at their personal assets. Whether it is a house or stocks, anything that appreciates in value will result in a capital gain for the owner of the asset. Consequently, the government will tax the owner on any of the capital gains acquired when the time comes to sell the asset; that means any of the money someone makes on the sale of said asset will be taxed.
A capital gain is essentially the profit someone makes on the sale of an asset that has appreciated in value. Assets can range from physical real estate to cars, and even businesses. Regardless of the asset, the government will tax the money the seller makes on the transaction (minus the original purchase price). That said, the amount the government will tax capital gains depends on the amount of time the asset is held.
If someone wants to lower their taxable income, they should consider holding assets for longer than a year. Capital gains are taxed less if they are held for more than a year; somewhere in the neighborhood of 0% to 20%, depending on the individual’s income status. Conversely, capital gains on assets held less than a year will be taxed at a higher rate. Therefore, those learning how to pay less taxes should look at the timetable they intend to hold their assets.
4. Contribute To Your 401(k)
One of the best ways someone with a job can pay fewer taxes in a given year is to reduce their taxable income; that is to say, lower the amount the government is entitled to. In contributing to a 401(k), employees may reduce their taxable income for the year. Instead of a portion of the paycheck going straight into the employee’s bank account and increasing their income, contributions made to a 401(k) will be taken “off the top” and not be added to the annual income statement.
When money is contributed to a 401(k), the IRS doesn’t count it as income, and is instead willing to defer any taxable implications to when the money is withdrawn from the account. As a result, 401(k) contributions won’t count towards an individual’s taxable income the year they are made. Instead, the money will be taxed as ordinary income at the rate of the person’s tax bracket in the year they make the withdrawal.
While the money will be taxed upon withdrawal, individuals may qualify for special tax treatment with regard to their personal financial situations at the time they decide to take the money out. Qualifying individuals may receive a better tax rate at the time of withdrawal than the initial deposit.
5. Open An IRA
Similar to making 401(k) contributions, opening an Individual Retirement Account (IRA) can help people reduce their taxable income. Unlike 401(k)s, however, IRAs can be opened by an individual without needing to be employed. When someone opens a traditional IRA, contributions are considered pre-tax dollars and any resulting taxes are deferred until the money is withdrawn from the retirement account.
Like their 401(k) counterparts, traditional IRAs reduce an individual’s taxable income; that means less income is reported at tax time because contributions went into a retirement account instead of a bank account. As a result, the individual’s income tax is lessened.
That said, not all IRAs are created equal. Taxes on Roth IRAs work differently. Instead of using pre-taxed money, Roth IRAs tax the contributions at the time they are made. Any contributions made to a Roth IRA won’t actually reduce someone’s income tax on the year they are made, but qualifying distributions won’t be taxed (with some exceptions). Those who want to learn how to pay less taxes in the current year should, therefore, look into contributing to a traditional IRA instead of a Roth IRA.
6. Start A Business
While not as simple as some of the other options on our “tips for taxes 2022” list, starting a business may award entrepreneurs with the opportunity to take advantage of several tax advantages. In particular, business owners may deduct many qualifying expenses from their income the year they were incurred. In deducting business expenses, entrepreneurs may reduce their total taxable obligations by simply making the purchases they need to keep their companies thriving.
Self-employed tax deductions may include, but are not limited to:
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Home-Office Deductions
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Continuing Education
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Vehicle For Business Use
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Health Insurance
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Social Security Taxes
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Retirement
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Covid-Related Sick & Family Leave Credits
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Start-Up Costs
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Equipment & Supplies
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Qualified Business Income Deduction
Starting a business will require entrepreneurs to spend money to reduce their taxable income. However, many of the expenses are necessary, which means the tax break is an added advantage.
7. Use A Health Savings Account (HSA)
A health savings account is exactly what it sounds like: an account which lets someone set aside money to be used specifically for medical expenses. Similar to that of the previously discussed retirement accounts, an HSA allows contributors to place money in the account without being taxed. As a result, each contribution lowers the HSA owner’s taxable income.
Contributing to a Health Savings Account is one of the more unique ways to lessen one’s taxable obligations in a given year. Consequently, withdrawals won’t be taxed as long as the money goes towards a qualifying medical expense.
Health savings accounts are generally preferred to insurance plans which have high deductibles. Over the course of this year, the maximum deductible contribution level for an HSA account is $3,650 for individuals and $7,300 for families, according to the IRS.
8. Create A College Fund
Learning how to pay less taxes may be as simple as saving for a child’s future education. In fact, there’s a fund which provides parents unique tax advantages: a 529 plan. Though its name reveals next to nothing, a 529 plan may simultaneously help parents save for their kids’ education and lower taxable obligations.
529 savings plans allow parents to make contributions to a tax-advantaged savings plan dedicated to paying for education. While the 529 plan was originally intended to pay for college, it was recently extended to conclude K-12 education.
In its simplest form, 529 plans allow parents to pay for tuition in advance. However, instead of giving money to a school, the money goes into an account without being taxed. These particular plans allow money to grow tax-deferred and ultimately subtract from taxable income. Perhaps even more importantly, qualifying withdrawals aren’t taxed.
9. Claim Tax Credits
The IRS offers a number of tax breaks for qualifying individuals, not the least of which is the Earned Income Tax Credit (EITC). As its name suggests, the EITC is a tax credit designed to help low- to moderate-income workers and families. In order to qualify for the EITC, applicants must:
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Have worked and earned income under $57,414
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Have investment income below $10,000 in the tax year
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Have a valid Social Security number by the due date of your 2021 return (including extensions)
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Be a U.S. citizen or a resident alien all year
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Not file Form 2555 (related to foreign earned income)
Special qualifying rules may be extended to military members, clergy members, and taxpayers and their relatives with disabilities.
Those who qualify may be entitled to a tax credit which can reduce their taxable income. Those who don’t qualify, however, may have better luck with a number of other tax credits offered by the IRS:
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Advance Child Tax Credit Payments
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Child Tax Credit and the Credit for Other Dependents
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Child and Dependent Care Credit
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Education Credits
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Recovery Rebate Credit
10. Sell Under-Performing Stocks
Anyone trying to learn how to pay less taxes may not want to look past their current investment portfolio. In particular, the stock market holds the key to some great tax advantages. While capital gains may work against investors at tax time, documented losses can actually help offset taxable income. Selling stocks at a loss, for example, can result in a tax deduction.
Otherwise known as tax-loss harvesting, selling stocks which have depreciated can actually help investors pay less at tax time. It is worth noting that stock losses need to outweigh gains over the course of a tax year. Investors can’t simply sell an underperforming stock and expect a tax deduction if capital gains in the same portfolio are greater than the documented loss.
10 Ways to Pay Less Taxes on Real Estate
There are a number of ways for the average person to help themselves at tax time. That said, some professions offer the ability to shelter more taxes than others. Real estate, in particular, happens to offer significant tax advantages. Most notably, there are 10 ways to can pay less taxes on real estate:
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Own Properties in a Self-Directed IRA
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Hold Properties Over a Year
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Avoid FICA Taxes
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Defer Taxes with 1031 Exchange
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Use Installment Sales
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Deduct Mortgage Interest
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Use the 20% Pass-Through Deduction
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Claim Depreciation Deduction
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Borrow Against Home Equity
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Tally Every Expense
1. Own Properties in Self-Directed IRA
You’ve probably heard of an IRA. An IRA is a popular retirement fund in which you steadily contribute money to an investment that will ultimately fund your retirement. When you open an IRA, you get to choose which investment your money will go into. The best part about an IRA is that you don’t have to pay taxes on your contributions right away. Instead, you only pay taxes when you withdraw money from your IRA after you’ve retired (unless you opened a Roth IRA—which works in the opposite way).
You can use an IRA account to fund real estate investments without paying immediate taxes on the sale. This is known as a “self-directed IRA.” This method of real estate investment works best when you’re paying for a property in cash.
Let’s say that you want to purchase a property. First, you’ll need to create a legal entity that will buy, own, and sell rental properties. Many real estate investors choose an LLC.
Then, you’ll pay a custodian or trust to open an IRA account for you, and you’ll choose your LLC as your chosen investment fund.
When you’re ready to buy a property, you’ll transfer the funds into your IRA. Then your LLC can use those funds to complete the transaction. Since you’re technically contributing money to a retirement fund, you don’t have to pay taxes on the purchase—until you retire.
This method is harder to do if you need to finance a property. Your loan must be a “non-recourse” loan, which means you won’t be liable if the loan defaults. But many lenders will refuse to grant those types of loans.
If you’re able to secure financing, only your down payment and principal are sheltered from taxes. The financed portion of the property is still subject to taxes.
With a self-directed IRA, the same rules apply as with a traditional IRA. You can’t withdraw money until you’re 59 1/2, and you must start withdrawing when you’re 70 1/2.
2. Hold Properties Over a Year
One of the easiest ways to reduce your tax burden is to hold a property for at least one year.
If you’re a house flipper, you might want to buy and sell properties as fast as possible. But it can actually be more profitable to hold your properties for at least a year before selling.
When you own an asset for less than a year and sell for profit, the IRS considers you a “dealer.” Short-term buying and selling is considered a business. And since you’re a business, you must pay FICA taxes—taxes set aside for Medicare and Social Security.
Furthermore, the sale of the property will be taxed as personal income instead of capital gains—which is far higher.
It’s okay to sell one short-term property per year, but if you’re going to sell two or more, then you’ll almost certainly be classified as a “dealer” for tax purposes, and you’ll also incur the higher personal income tax rate.
All you have to do to avoid these taxes is to hold your properties for more than a year before you sell. If you are house flipping, you should be able to find hard money loans that don’t need to be repaid for 1-2 years.
If you’re in a financial crunch, you can always rent out your fix-and-flip before you sell. Rent it out to tenants and use the money to start paying off your hard money loan. Make sure you only offer a short-term lease so you can sell the property within two years.
As long as you hold a property for a year or more, you can avoid FICA taxes and ensure the sale is taxed at the lower capital gains tax rate.
3. Avoid FICA Taxes
Are you a part-time real estate investor? You may have an opportunity to avoid paying FICA taxes on your investments.
As mentioned in the last section, the IRS will make you pay FICA taxes if they consider you a self-employed real estate investor. However, you can avoid these taxes if you demonstrate “investment intent.” In other words, you’re showing the IRS that you’re only trying to generate capital for other investment projects and that it’s not a standard business practice for you.
These investment projects may include:
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Making renovations on a property
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Making a down payment on a long-term rental
These types of projects show the IRS that you’re focused on doing long-term investing and that you’re not trying to do short-term investing for immediate business revenue.
It can be difficult to prove “investment intent,” so it’s always best to consult with a tax attorney before using this strategy.
4. Defer Taxes with 1031 Exchange
Section 1031 of the tax code allows for a “like-kind exchange,” in which you can defer paying taxes on a property sale for an indefinite period. All you have to do is buy a similar property with proceeds from the sale.
If you sell a property and make a profit of $100,000, you can defer paying capital gains if you use the $100,000 to purchase another property (the $100,000 will be used for the down payment).
There are some rules that govern 1031 exchanges:
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You need to hire a qualified intermediary to facilitate the transaction
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You must provide the intermediary with a list of possible properties for the replacement property no later than 45 days after the sale of the original property
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You must purchase a qualifying replacement property within 180 days of selling the original
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Value of replacement property must be equal to or greater than your original property
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The original and replacement properties must be investment properties—neither can be your primary residence
This is an excellent strategy if you don’t plan on selling the replacement property. Hypothetically, you could keep the replacement property your entire life and generate profit by renting it out to tenants. You’d never have to pay capital gains tax.
5. Installment Sale
What if you earn a profit on a sale, but you don’t want to use the proceeds to buy a new property? In that scenario, you’d have to pay capital gains tax, and you could potentially be faced with higher income tax.
Some investors prefer to sell a property using seller financing. With seller financing, you’re providing a loan to the person that’s buying your property.
You’ll only have to pay taxes on the buyer’s down payment and principal (closing costs), but you don’t have to pay capital gains tax because you didn’t receive all the money upfront. Instead, the buyer is paying you the outstanding balance over time. You also get to earn interest from the buyer, so seller financing can be hugely profitable.
Of course, seller financing is very risky. If the buyer defaults, the foreclosure will fall on you because you still have some—if not most—of the equity in the property.
Make sure you thoroughly bet the buyer before you offer them seller financing. It’s also a good idea to start with a lease-purchase agreement. Under this type of agreement, the buyer starts as a renter and part of their rent goes toward a down payment on the home. After the buyer has paid a stipulated amount toward the down payment, you can transfer the property and sign a mortgage note.
6. Deduct Mortgage Interest
Many expenses in real estate are tax-deductible. Here are some of the tax deductions you can claim in real estate:
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Mortgage insurance
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Home insurance
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Property taxes
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Property management fees
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Advertising expenses
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Legal fees
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Maintenance costs
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Home office expenses
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Travel expenses for business
What’s great about these tax deductions is that you don’t necessarily have to itemize your deductions to claim them. You can claim the standard deduction and also claim deductions for many of the expenses listed above. Claiming these deductions can significantly reduce your tax bill.
A word of advice: Be honest and don’t push it. If you’re going to buy a personal laptop, don’t try to write it off as a business laptop. The IRS may get suspicious if there are too many questionable expenses, which might prompt them to run an audit.
7. 20% Pass-Through Deduction
Small business owners can deduct an extra 20% of their net business income. This is known as the 20% pass-through deduction.
This tax deduction is meant for small businesses, so there are income limitations: $315,000 for married couples and $157,000 for single filers.
It may be helpful to consult a tax expert if you’re not sure whether or not you can claim this deduction.
8. Use Depreciation Deduction
Properties tend to depreciate because of natural deterioration and wear and tear. Therefore, the IRS allows you to claim depreciation for each of your investment properties.
The IRS sets the lifespan of a residential building at 27.5 years so that you can deduct 1/27.5th of a property value each year for the first 27.5 years of a property.
For example, if your property is valued at $500,000, then you can claim a tax deduction of $18,181 for the first 27.5 years you own the property (500,000 / 27.5).
You can also depreciate appliances and fixtures over 15 years, and also property improvements. So if you spend $5,000 on renovations, you can deduct $181 per year for 27.5 years (5,000 / 27.5).
There’s a major caveat: if you claim depreciation, you may also owe taxes on depreciation recapture if you sell the property for a profit. This is because the IRS wants you to pay back the taxes you avoided from depreciation claims.
You can avoid depreciation recapture if you sell the property for a loss, or if you don’t sell the property at all.
For that reason, you might only want to claim depreciation on a property that you’re going to hold long-term.
9. Borrow Against Home Equity
Acquired lots of equity in a property? You can pull out equity from your property and use the money to finance another real estate investment.
Some investors might choose to sell the property and use the proceeds to finance a new investment—but this may incur capital gains tax. When you borrow against home equity, you can keep your property, avoid paying capital gains and gain income to finance a new investment.
Most lenders will allow you to extract 80% to 85% of your home equity. There’s some risk involved because you’re losing equity in the property and accruing more debt, but you can mitigate this risk by renting out your property to tenants. You can use the rent income to pay back the equity you’re borrowing from the property.
10. Tally Every Expense
As you might have realized, it’s harder to develop a tax strategy when you’re not keeping track of all your real estate expenses. Keep thorough records of all your expenses, especially if you want to claim tax deductions.
Many real estate apps that can help you keep track of your expenses and even help you prepare for your annual tax filing. Be sure to add one or two of these apps to your real estate investment toolbox.
Passing Away With Real Estate
For tax purposes, what happens if you pass away when you own real estate?
If you own property when you pass away, your “original basis” on the property disappears. In other words, the original price you paid on the property is no longer a factor. Additionally, your heirs do not have to pay capital gains on the property.
Soon after you die, your properties will be reassessed and given a new market value. If your heirs decide to sell the property, they don’t have to pay capital gains on any profit made from the sale.
Let’s say you originally paid $300,000 for the property. When you die, the property is assessed and given a value of $500,000. Your heirs sell the property for $550,000.
Under normal circumstances, there would be a capital gains tax on $250,000. But not if you died. Your heirs can keep the $550,000 profit without having to pay any capital gains.
Your heirs may have to pay estate tax if you’re wealthy—only the first $11.8 million of your estate is tax-free. Otherwise, your heirs will have little tax obligation, especially if you’ve acquired full equity in your properties.
Summary
Learning how to pay less taxes has more to do with working what the IRS gives you and less to do with making significant changes. If for nothing else, reducing your taxable income is as simple as understanding the parameters to work within. Many people may already qualify for tax advantages, but it’s up to them to learn what they are. Unfortunately, the IRS isn’t going to hold anyone’s hand through the process, so it is up to all of us to learn what we can, mind due diligence, and chip away at our taxable obligations.
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