The wealthiest people in America are taxed at a 37% marginal rate, according to the IRS. For individual taxpayers, that’s anyone earning $626,350 or more annually (or $751,600 for married couples filing jointly).
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Despite high taxes, these wealthy individuals often find ways to pay less due to certain tax laws and loopholes. Here are the main laws keeping the rich wealthy. Notably, these strategies are considered legal — they’re just more likely to benefit high-income individuals.
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Capital Gains Tax Law
For wealthy individuals, it’s less about how much money they make and more about how they make it. Most earned income is taxed as ordinary income. Capital gains, however — which are the profits from selling things like real estate, businesses or stocks — are taxed at lower rates.
“Wealthy individuals often structure income to be from investments, not salary, reducing their effective tax rate,” said Chris Rivera, CPA and founder of The Ecommerce Accountants. “Long-term capital gains max out at 20%, while wages can be taxed at 37%.”
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Real Estate Depreciation
Many high-net-worth-individuals in America build their wealth through a combination of investments, including real estate. While earnings are still taxable, there are several ways these individuals can keep more money in their pocket — so to speak.
“Real estate investors can deduct depreciation (a non-cash expense) to reduce taxable income, even if the property gains value,” said Rivera.
Depreciation isn’t the only allowable deduction, according to the IRS. Things like property tax, mortgage interest, repairs and operating expenses can also be deducted up to a certain point. Certain expenses paid by the tenant are also deductible.
1031 Exchanges
Another tax law geared toward real estate investors is the like-kind exchange under section 1031 of the American tax code.
“With a 1031 exchange, [real estate investors] can defer capital gains taxes by reinvesting profits from one property into another,” said Rivera.
The exchange must involve non-personal real estate properties — except in the case of businesses. Investors will still need to report the exchange using Form 8824 Like-Kind Exchange.
Carried Interest Tax Rule
Carried interest once again takes advantage of the lower tax rate on capital gains than earned income.
“There are ways that fund managers (private equity, hedge funds) can treat their share of profits as capital gains instead of income — another way to pay less tax on high earnings,” said Rivera.
In this case, an asset must generally be held for at least three years to be taxed at the long-term capital gains rate, per the Congressional Budget Office. While the exact tax rate varies, long-term capital gains are generally taxed at a rate no greater than 15% for most individuals. It can go up to 25% in certain cases, but this is still lower than the ordinary income tax rate.
Tax Deductions
The IRS allows for certain tax deductions beyond real estate, which can help keep the wealthy, well, wealthy. These deductions can lower how much tax is ultimately paid.
Some of the biggest tax breaks, according to the The Peter G. Peterson Foundation, include:
Exclusions of pension contributions and earnings on retirement plans (like IRAs and 401(k) plans)
Exclusions of employer contributions for employee health insurance
Exclusions/reductions on long-term capital gains and dividends earned from stocks
Qualified business income deduction (up to 20%)
Exclusion of unrealized capital gains (upon the owner’s death)
“Business owners can deduct a wide range of expenses, and real estate investors can write off depreciation, even if their property is going up in value,” said Rachel Richards, CPA and Head of Tax at Gelt. “These aren’t shady backdoors — they’re built into our tax code, and the wealthy are often just better positioned to take advantage of them.”
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This article originally appeared on GOBankingRates.com: 5 American Tax Laws Keeping the Rich Wealthy
