What's Next: Tax Secrets Of The Rich

Column for What’s Next website TAX SECRETS OF THE RICH

By Mark Levine Hemingway was wrong when he wrote the only difference between the rich and the rest of us was they have more money. They also have better accountants who come up with unique ways—some iniquitous, but all ingenious—to avoid taxes. Be forewarned: None of the tax secrets of the rich are for the faint of heart or feeble of wallet. And two of them, to be blunt, don’t pass the smell test.

Charitable remainder trusts: Say you jumped on AOL early and now have a block of stocks that is now worth $100,000. What can you do to avoid taking a huge tax hit?

Have your lawyer establish a charitable remainder trust, and then give the block of stocks to the trust. Instruct the trust to sell the stocks for $100,000, invest the cash, and pay you an income of, say, eight percent for life. You will have avoided capital gains taxes and as a result will be earning interest on a larger principal. Designate a charity to receive the trust’s remaining principal if you die and you’re also eligible for an immediate tax deduction (and probably an immediate testimonial dinner). If you’re so inclined, you can use the money you save through that tax deduction to buy a second to die life insurance policy which will pay your kids the money they would have inherited if you didn’t give the asset to charity.

Donating appreciated stock: Another way to avoid taxes and look like a philanthropist in the process is to donate appreciated stock to a charity rather than selling it. Not only will you avoid paying capital gains taxes, but you’ll receive a tax deduction based on the pretax value of the donation. As the Bible says, charity never faileth.

Deemed sales of stock: Any stock acquired after January 2, 2001, and held for more than five years, will now be subject to 18 percent capital gains tax rather than 20 percent. On your 2001 tax return you can elect to make a “deemed sale” of stock as of January 2, 2000, in order to qualify for the reduced rate.

Say you own a block of stock for which you paid $10,000. You can elect to “deem” that you sold the stock on January 2, 2000. If you have had no gain at that point, any appreciation from then on will be taxed at the lower rate. You’ve saved yourself two interest points through a bookkeeping maneuver. If you have had a gain at that point you’ll be required to pay 28 percent on the appreciation up to January 2, 2000, but then only 18 percent on subsequent appreciation.

Using stock as currency: The IRS doesn’t require taxpayers to automatically report the transfer of stocks. That loophole is being used by some to facilitate barter transactions.

Say you own a block of stock you bought for $1,000 which is now worth $20,000. If you sold the stock and realized the gain you’d be responsible for paying taxes on it. But what if you transferred the stock to your child’s private school in lieu of paying the $20,000 tuition bill? Some “aggressive” tax advisors posit that there hasn’t actually been a taxable exchange since you haven’t gotten anything back for the transfer. The scuttlebutt is some educational institutions are going along with this little charade. Even so, this plot smells worse than that private school’s locker room.

Real estate swaps: If you and your friend simply swapped similar pieces of property—say one suburban home for another—neither of you would be responsible for paying sales tax or capital gains tax since there wasn’t actually a sale.

Say you bought a beach house on the New Jersey shore for $500,000. Now it’s worth $750,000, you want to sell it and buy a ski chalet in Vermont, but you don’t want to pay taxes. You could look for a friend to swap with, but the chances of finding the perfect partner are slim. Instead you hire a middle man. Put your beach house up for sale and look for a ski chalet. Having come to terms with both a buyer for the beach house and the owner of a ski chalet, sell your beach house to the intermediary. He sells it to the buyer and uses the proceeds to buy the ski house. If he buys and sells for the same amount there’s no tax due. If you end up with any profit it’s called a “boot” and you’re liable for taxes only on that amount.

Exchange funds: Imagine you’re an executive who just received a huge block of stocks as part of an early retirement offer. Sell your thousands in stocks you’ll be liable for a huge tax bill. Hold them you’ll have a risky undiversified portfolio. What are you to do?

Investment houses have established “exchange funds” to help you out. Rather than selling your $100,000 in Time Warner shares, you invest them in a partnership established by a brokerage company. Coincidentally, the other members of the partnership were in situations similar to your’s and have brought to the party their own $100,000 blocks of stock in their companies, be they General Electric, Microsoft, Intel, or Oracle. You have diversified your portfolio without having to sell any of your stock and pay any taxes.

Pension asset transfers: Money left in a pension or profit-sharing plan after death is subject to both estate taxes and the income taxes the decedent deferred all those years. The result is heirs receive only about 20 percent of any funds left in such plans.

If you have $1 million you know you’ll never touch sitting in a pension fund, transfer that money into a new pension fund, established by a law firm specializing in this process. The fund takes $200,000 of your $1 million investment and buys a specialized second to die life insurance policy, with a death benefit of $4 million. After holding the policy for a couple of years the fund distributes the policy. While you may be able to extract, say, $190,000 from the pension fund, you’re only liable for taxes on its, for instance, $80,000 surrender value.

Meanwhile, you’ve also established a death benefit of $4 million for your kids. Rather than paying tax out of pocket, cash is taken out of the insurance policy. Next, contribute the policy to an irrevocable life insurance trust for the benefit of your children. The taxable worth of that transfer, is, once again, only the surrender value. Money can once again be subtracted from the policy to pay those taxes. In effect this multifarious shell game lets you licitly pass much more money along to your heirs without paying any taxes out of pocket.

Artificial tax losses: Whenever a wealthy individual is going to recognize a very large gain during a tax year, his tax advisors start hunting for ways to offset that gain. The latest hustle uses foreign currency trading.

The gimmick begins with a limited liability company, established by either an accounting or law firm, with the stated purposes of engaging in foreign currency trading. The company makes a few small trades in, let’s say, the Japanese Yen, to establish it’s bona fides. Meanwhile, you start doing foreign currency trading on your own. If you want a $1 million loss you buy a long option for $1 million and sell a short option for $980,000 on the Yen. The positions are structured to cover each other so you need only invest $20,000. Hold the positions for a couple of days and then use them to the open an account with the limited liability company. Hold that account for 30 days, then cash out.

In exchange for the five percent fee you paid to buy into the company you received a legal opinion letter, stating your tax basis in the limited liability company includes the long position, but not the short position, since the latter is a contingent liability. So, according to that letter, your $20,000 has bought you a $1 million loss. That letter means you won’t pay a penalty if--or more accurately, when--you are audited. You’ll be liable for taxes and interest, but you’ll have use of the money for the couple of years it takes for the IRS to catch up with you, in which time you may make enough money to justify this chicanery to yourself, if not the Feds.

Tax free rental income: Finally, here’s a simple tax secret of the rich we all might be able to use. For a home to be considered a full or partial rental property, requiring reporting of the income and allowing deduction of the expenses, it must be rented for at least 15 days. That means if you rent your home for 14 days or less the money you earn is tax free. And not only isn’t it subject to taxes, but it doesn’t even need to be reported by either the landlord or tenant.

This allows the rich to rent their Palm Springs homes for a tax free $20,000 a fortnight during the winter. It also gives the rest of us a chance to make some cash by, say, renting a lake side cabin for $2,000 a week during fishing season, or a primary home for $250 a day on graduation and homecoming weekends at nearby State U. By the way, the IRS relies on you to report if your tenant stays for more than 14 days.