Tony's Tax Tips

The Tax Chess Board Part 3

This article originally appeared in the Pasadena Star News on April 8, 2006.

THE TAX CHESS BOARD – Learning about sophisticated tax planning is like learning to play a game of chess. Your opponent, the Internal Revenue Service, has all of their tax chess pieces in place on the tax chess board, and is very experienced at playing the tax chess game. SOME OF THE BEST CHESS PIECES – One of your financial objectives should be to increase your net worth without paying any income tax. This may be accomplished by controlling the timing and flow of your taxable income.

C. Anthony Phillips, CPA

You can attain this by investing in retirement accounts, common stocks, and real estate. While investment considerations may influence your tax decisions, you can choose when to sell your common stocks and real estate.

RETIREMENT ACCOUNTS – A retirement account allows you to deduct contributions you make from your taxable income and earn 1031 income on the account. The accumulation in the retirement account is not taxed until it is distributed to you. Hence, your current net worth increases without paying tax.

COMMON STOCKS - If your common stock investments appreciate, your net worth will increase without any income tax, unless you chose to sell them. You will be taxed in general at the 15% Federal capital gains tax rate, which is less than the maximum 35% tax rate on ordinary income. Again, net worth increases without paying current tax.

REAL ESTATE - If your real estate investments appreciate, your net worth will increase without any income tax, unless you chose to sell them. You will be taxed in general at the 15% Federal capital gains tax rate which is less than the maximum 35% tax rate on ordinary income. By owning investment real estate, you are allowed to depreciate the improvements and reduce your ordinary income, subject to certain limitations. You can also defer the payment of tax on the sale of investment real estate by doing a 1031 exchange. If you invest in a principal residence and have owned and lived in it for two years, you may exclude up to $250,000 of gain on the sale under the provisions of Internal Revenue Code Section 121. Exclude means you never ever pay the tax on the $250,000. If you are married, you may exclude up to $500,000 of gain on the sale. If you die while holding appreciated common stocks and real property, you avoid paying any income or capital gain taxes on the amount of the appreciation. We are not recommending dying as a tax planning tool, but the fact that you will die should be considered in your tax planning.

Tony Phillips, CPA has a certified public accounting firm, Phillips & Company in Pasadena and is President of Downstream Exchange Company which helps investors save taxes when they sell their investment property.

The above is not intended to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.