June 20, 2022

Everyone pays tax one way or another, but there has been a kind of controversy surrounding how the extremely wealthy are taxed. People have been discussing how the Bill Gates, Jeff Bezos, and Elon Musks of the world have huge jumps in their wealth without paying an equivalent jump in their taxes.

If you’ve heard the saying that Warren Buffet pays less tax than his secretary, this isn’t true. It’s not that he pays less tax; he just pays a less EFFECTIVE tax rate. Many wealthy people have mastered the use of equity over active income, so they get as little tax as possible. In this article, we discuss how their net worth can go up so much without them having to foot an income tax bill. We discuss taxing, tax bracket, income, capital gains, and tax rates.

Taxation

According to Britannica, taxation is the "imposition of compulsory levies on individuals or entities by governments." In the United States, what we have is an income tax, not a wealth tax. This means that you are taxed on income as you earn it and not on your entire net worth. If your net worth gets higher, it doesn't automatically constitute a taxable event.

W2 and 1099 are examples of earned or active income. W2 includes income from being employed, while 1099 consists of the income you get as an independent contractor or being self-employed. If you earn W2 income, you are taxed every year. If your active income increases, you’ll pay more in tax.

However, this is different if you own stocks because if you own stocks and the value rises, you will not pay taxes for the increase in value. For example, if you have investment equity, perhaps through shares in a company, the shares can increase in value, which technically means that your worth has increased. But it’s not automatically taxed until you sell those shares and convert them to income, and earned and active income is taxed more than income acquired through equity.

This is why the wealthiest people's tax returns hardly ever have any money earned through active income. It is either passive or portfolio income which is taxed at a much lower rate.

Tax Rates

The tax rate is the ratio or percentage of a person or corporation’s income that is taxed. There are a lot of things that affect your tax rates, such as your filing status. The taxable income you present in a year also dictates your tax bracket, which consequently affects your tax rate.

Income tax rates for W2, 1099, and dividends are considered ordinary income and are taxed up to 37%. However, capital gains tax, which refers to the tax you pay if you sell stocks or real estate, is either 0%, 15%, or 20%, depending on the income level. This is considerably lower than income tax; thus, selling equity is more favorable from a tax perspective.

Income Tax

As mentioned earlier, your tax rate depends on your tax bracket, which is a function of how much you make in a year. Your income tax is also affected by your marital status, the job you do, and the type of transactions your make.

The United States has a tax system that is quite progressive because the more income you make, the more you are taxed.

Capital gains tax

You can sell capital assets such as bonds, real estate, and stocks at higher prices than you bought them and make a profit. The profit you make is called a capital gain.

The capital gain can be divided into either:

●     Long-term capital gain

●     Short-term capital gain

The main difference between these two here is the length of time the seller owned or held an asset before selling. If the asset was held for less than a year, it is a short-term capital, and you will be taxed at the ordinary income tax rate. However, if the asset was held for way more than a year, the rates are the standard 0%, 15%, or 20%.

Note that the short-term capital gain tax will be subject to the same progressive tax rate tier in income tax. This means that if the short-term capital gain is $10,000, the tax will be 12%, but if it is $50,000, the tax will be 22%.

Case Study

Imagine two people, Person A and Person B. They both chose to buy real estate, but Person A chose the fixing and flipping strategy while person B buys and holds.

The property's purchase price is $150,000, the rehabilitation of the building costs $50,000, and the fair market value of the property is $300,000. The person fixing can do all of these in a year. Say he sells the property at the end of the year for a $100,000 gain, he still has to pay ordinary income taxes plus self-employment taxes, which could reach up to $40,000.

Person B, who is buying and holding, finds a tenant to rent the property. Then they go to the bank and refinance for up to 80% of the fair market value. This will allow them to pay off their old loan and still receive a check at closing without incurring any tax.

When Person B finally sells the property, they'll pay taxes at favorable long-term capital gains rates of either 0%, 15%, or 20% instead of 40%, as in the first case of Person A.

As you can see, both individuals had their wealth increase. However, Person B didn’t immediately cause a taxable event like Person A did. Thus, with this, you can conceptualize the mindset of wealthy people and understand why they choose to go with equity over income.

Other examples of non-taxable events:

●     Welfare payments

●     Selling a property that you live in 2-5 years

●     Payments of child support

●     Refinance loans

●     Cash rebates

●     Inheritances (apart from traditional IRA/401k proceeds)

●     Gift from a family member

●     Child Support

●     1031 exchange from rental real estate properties

It is pretty clear that equity is taxed more favorably than income. So, whenever you have the opportunity, always choose equity over income. It’s a way to build wealth without paying so much in taxes.