Hi, everyone. This is the How to Lower Your Tax
Bill podcast. I'm your host, Terrence Hutchins.
I'm a financial and tax advisor in the Dallas
Fort Worth area. And the goal of this podcast
is to help you listeners get educated on different
tax strategies that you can implement to improve
your tax situation immediately. Each episode
will break down useful tax tips you can use to
save money, no matter what your personal or business
income situation. Because our motto is, keep
more of what you earn. So let's get into today's
episode. Thanks for tuning in to another episode
of How to Low Your Tax Bill. We have been going
through some different things that impact real
estate investors. And so we want to pivot slightly.
And as tax season has wrapped up, most people
kind of don't think about taxes anymore. But
there's a lot of information on your last year's
tax return that should impact how you think about
this year. So we're going to talk about some
of that stuff over time. But I also want to think
through what are the facts of your situation
this year that you need to properly be accounting
for. And we're going to talk about this concept
of phantom income. And many times when people
make decisions, they do it with a short term
lens. And so how many times have you, you know,
think about the marshmallow test, where if you
don't eat the marshmallow today, you get two
marshmallows in the future. Most people decide
to just, hey, let me just take that marshmallow
now, because they're not willing to wait for
something better in the future. From a tax lens,
it's generally, what can I do today to help me
save in taxes without thinking about what revocations
will that have in the future? And so I wanna
touch on two concepts that sort of are the foundation
of how these... impact taxes and how you could
actually be paying taxes on income or you could
be paying taxes on a higher level than you actually
have cash to pay or maybe you sold something
and you thought that the tax on it would be commensurate
to the profit that you had but you didn't factor
in some of the other elements. So I'll go through
some specific examples so you guys don't get
lost and you hang in there with me and I think
you'll be able to determine if this is applicable.
You'll definitely want to make some changes or
plan ahead appropriately. So the IRS has what
they call the constructive receipt doctrine,
which means that you get tax on income when it's
made available to you. And sometimes that may
not even be money you receive, but the IRS says
that you have the ability to get it, then you
actually will pay taxes on it in the year that
you have the ability to get it. A simplistic
example of that would be, You get a bonus from
your employer of $10 ,000. However, you don't
pick up the check until January. Well, according
to your employer, the bonus is paid out in December.
They're probably gonna write off in December.
Because of that, you're gonna pay taxes on it
in the year that you effectively received it,
even if you didn't actually have the money in
hand until the next year. So that constructive
receipt doctrine will impact other things, which
we'll go through later. You also have the economic
benefit doctrine. which just means you get tax
on benefits that are secured for you, even if
you can't use them yet. So for example, if you
receive something that you get some kind of benefit
for, this could be stock. It could be money that
goes into a trust. It could be different things.
You could actually pay tax on that money today,
even if you don't actually have it. People get
frustrated with that because they're thinking,
well, yeah, I mean, this money did come to me,
but if I don't actually have it, I can't use
the money in their minds. But from the IRS's
vantage point, you received an economic benefit
whenever you got it. And as a result, you're
going to pay tax on it in that year. And so there's
different things that that rule will impact.
So we'll kind of walk through those. But the
biggest thing that I see people doing that impacts
them that they really don't plan for in the future.
So you probably had this conversation. If you're
a business owner at the end of the year, you
get your tax bill and it's higher than you thought.
And you're thinking, well, what can I do? Or
not even that you get your tax bill. you basically
get your tax projection. Let's say you're planning
a little bit ahead. You're doing this in December,
of course. And now you owe 10, 20, $30 ,000.
Well, you go and say, hey, look, what if I buy
this car? I see that Tesla model Y, which you
probably not buying that now. So maybe you're
buying that, you know, large Mercedes Benz or
that big truck or whatever it is. And you say,
hey, look, if I buy this $80 ,000 car, I heard
this thing called bonus depreciation. I could
take a big tax deduction on it. And so let's
say you do that. you buy this $80 ,000 car after
depreciation expense, that's a $60 ,000 deduction.
So all of a sudden, your $50 ,000 tax bill, $20
,000 tax bill went away. You're high -fiving,
you're thinking, oh, this is amazing. Well, what
happens is that car has a five -year shelf life.
So if you, let's say in that example, you took
a $60 ,000 deduction in year one, that means
you only have $20 ,000 left for tax purposes
to depreciate. So you have four more years. So
think about that $20 ,000 is gonna be spread
out over four more years. Now you can also write
off the gas and interest and stuff like that.
However, the payment for that car, if you didn't
pay it in cash, is gonna linger with you for
the amount of the loan. So you could be paying
$1 ,200, $1 ,300, $1 ,400 a month. So you're
thinking, hey, I'm only getting a $5 ,000 tax
benefit, but I'm paying $14 ,000 out of pocket.
And when you think about that disparity, you're
basically paying income on that $9 ,000 difference.
So if you're saying, hey, my out of pocket expense
is 14 ,000. My tax benefit is five. Well, that
extra $9 ,000, the IRS basically allowed you
to take it upfront. So that's how they were able
to save taxes in year one. But then you end up
paying more taxes on income that you don't actually
have. So the cash left your bank account, but
you're still paying taxes on that $9 ,000 difference.
And many people do not think about this from
year to year. And it's important to understand,
hey, what is my depreciation today versus what
my depreciation in the future? And look at your
situation holistically so that you can plan accordingly
so that you're not hit with a net, another tax
bill the next year. And then you're trying to
scramble and you're making short -term decisions.
So I always tell people, do not pay a dollar
to save 30 cents. In the same way, if you went
to the mall and you saw a store that you didn't
like had a sale, just keep walking. Don't go
in there and buy something, because it's just
probably gonna collect dust in your house. Well,
from a tax standpoint, you might be putting a
bandaid on the situation today, but it might
end up hurting you in the future if you don't
have a holistic tax plan like that. Other things
that could also happen, for example, with stock
options. So there are different stock options
and on a future episode, we'll go through them
more in depth. But sometimes, if you have a stock
option that does not have the quote unquote risk
of forfeiture. So like it could be a non -qualified
stock, for example. The IRS says, all right,
you got the stock and you may owe tax on the
fair market value of the stock versus the exercise
price. So if you exercise that stock, sometimes
you may not even get the cash for the stock because
you want to keep it. Well, the IRS says, hey,
you exercise the stock, which means that you
could technically get it at any point. So you.
say, hey, the exercise price is $10. The fair
market value is $50. I'm going to tax them $40,
even if I don't actually sell the stock. And
so that's important to know, all right, what
am I doing here? And sometimes it makes sense
to exercise the stock, and sometimes it doesn't,
or sometimes depending on the trajectory of the
company or the timeline you're on, it could make
sense to do that. But you want to be aware, if
I do this, is there going to be a tax impact
as a result? And so many people aren't going
to keep track of that on their own. And so if
you're in that situation where you have stocks
or stock compensation or a component of your
pay, then you want to make sure that you're working
with a professional that can help you with your
claiming or exercise decisions. So that way you
will be able to plan accordingly. The other part
that a lot of people get caught off guard, especially
when it comes to real estate, is what's called
depreciation recapture. And many times you see
online people talk about, hey, I made $500 ,000
and I didn't pay any taxes last year. Well, normally
they probably have some kind of accelerated depreciation,
which is the IRS allow you to use your money
to take a tax deduction today. So then you pay
less taxes. And ideally you have that money to
reinvest. So I always instruct my business owners,
when you're making a decision, you always want
to set your taxes aside. It's always easier to
plan on how to spend money that you already have
set aside. So if you have a $10 ,000 tax bill,
Ideally, we've planned ahead to where, hey, I
have $10 ,000 set aside. If you don't factor
in taxes, you will end up paying more. I try
to stress this to people and I tell them, hey,
try to live your lifestyle based on your after
-tax income. The iris is your partner. We try
to help you leverage their rules so you don't
pay them more than you should. But if you don't
treat them as a partner, meaning that they're
gonna take a portion of your money, or you're
not at least setting aside a portion of your
money that could go to them, then you're gonna
have bad options. In those bad options, you'll
probably end up paying more. Now, when you do
a cost segregation study, for example, you buy
a building, you take this big depreciation expense,
or even if you just took regular depreciation.
And let's just say that building really didn't
go up that much in value. So let's just say over
time, you bought a million dollar building, you
took $300 ,000 in depreciation, and the building
only went up to 1 .1, or hey, maybe I gotta sell
this because the market or whatever. Well, I
have $100 ,000 profit. I'm going to pay tax on
$100 ,000 at capital gains tax rates, which generally
might be 15%. However, you also are going to
pay depreciation recapture on that $300 ,000,
which might be close to the 25%. So think about
it. You basically say, hey, I made $100 ,000
profit and I'm about to pay $75 ,000 in depreciation
recapture plus another $15 ,000 in capital gains.
So hey, I got a $90 ,000 tax bill on $100 ,000
profit. Now, you forgot about that depreciation
in the prior years, and depending on your status
as a real estate professional or passive activity
loss rules, you may not have any losses to offset
that. And so those are things that are important.
When you sell an asset, you need to make sure,
okay, what is the tax impact of that? And I need
to plan accordingly to my facts for that year.
That's why your tax situation is not just a one
-year thing. You want to have a multi -year view
so that if I do decide to sell something, I want
to make sure it doesn't coincide with factors
that make the situation worse, or hey, maybe
it does coincide with other factors where I have
low income years, or I have a big loss I can
use to help offset some of my profit. So those
are things where, hey, I actually have a potentially
as big of a tax bill as my profit, or I have
a profit on paper, but I don't have the cash
to show for it, like with the appreciation on
your big car. Other things that are very common
that most people will find out if they're in
partnerships or as corporations. And so I tell
people, when you own the business, you individually
pay taxes on the profit of the business. Now
what you do with that profit is really up to
you or your partners. But oftentimes, if I see...
partners that join bigger groups. I always want
to compare, hey, what's on line one of your K1
versus let's say line 16. That will tell me how
much money are you paying taxes on versus how
much money came to you in a distribution. We'll
go through this more strategically on a future
episode as far as how you might think about this
as a business owner and how you might have a
tax management plan so that you can properly
account for this. But oftentimes, let's just
say that you made $100 ,000 in profit. you're
gonna pay tax of 100 ,000. Now, whether you decided,
hey, look, I need to leave this money in the
business, or going back to my big car analogy,
on paper you made 100 ,000, but you have all
this debt that you accrued that you're having
to pay on. And when you make a debt payment,
that's a principal payment. Part of it is that
principal payment is not deductible. So if you
have $30 ,000 of principal payments, that's just
cash that's coming out of your bank account.
So even if your profit showed 100, you may have
only got $70 ,000 of cash to show for it, and
then you might have left $20 ,000 in the business.
So now you only distributed out $50 ,000. So
on paper, you're paying tax on $100 ,000, but
what actually came to your personal account was
$50 ,000. And this creates an issue for people.
And this is why we tell people your business
should pay your taxes. So this is why you build
your lifestyle on your after -tax income, but
your business should pay your taxes, meaning
I actually take a distribution of my profits
that are going to go towards my taxes. And then
what I have is left over to use for myself. So
like I said, we'll go through that tax management
process a little bit more in a future episode.
But that's a big, big thing for people, especially
when they're in partnerships or S corporations
where they're like, well, why am I paying all
these taxes when I didn't actually receive this
money? There's something you're going to have
to figure out. And then even if the partnership
wants to pay out a tax distribution to everyone.
to cover their amount of profits that they're
going to be liable to pay taxes on. So if you
have things that cash people off guard that are
taxable, that had an economic benefit, as we
talked about earlier, but they didn't necessarily
impact the amount of cash they had. So, for example,
if you have a debt that gets canceled, that debt
sometimes can be considered income because you
got an economic benefit of not having to pay
it. This happens often with, let's say if you
sold a partnership interest and now. The person
that buys your interest is also assuming the
debt that you're alive before. Well, that is
considered a distribution and that could be taxable
depending on your situation. Or let's just say
you had a $10 ,000 credit card bill that you'd
never paid and the company decided to write it
off. Well, that $10 ,000 could show up on your
tax return on a 1095C form. And that would show,
hey, you made $10 ,000 because that income or
that debt that you had, you now got an economic
benefit from it. And so you may have to pay tax
on that. So I've had people pay tax on that in
situations. You also could have a below market
loan. Now, this is really only going to be scrutinized
for like high network people, but let's just
say you loan your friend money or you loan your
family member an interest free loan. Well, the
IRS basically says you have to charge interest.
So there's kind of two components to this. You
have the element of, all right, if I sort of
give money away in this quote unquote loan, but
I'm charging below market rates, then the IRS
could consider that a gift. And if you're a high
net worth person, you may have so much gifts
that you've given that, or let's say you have
all these loans that have accrued, that the IRS
actually are considering gifts. to where it now
actually starts taking away from your gift tax
exemption. The other part is more so, hey, I
see this more with like installment agreements,
for example, where, hey, I'm gonna give you money
or, hey, I'm gonna sell you this item and you're
gonna pay me back over time. Well, the IRS says
you have to charge interest in that situation.
And so if you receive money back, the IRS is
gonna say, hey, your agreement said you're gonna
receive $10 ,000 back. So hey, you sold it for
50, you're gonna get $10 ,000 back for five years,
hypothetically. Well, the IRS is gonna say, hey,
that payment, a portion of that is gonna be interest,
and you're gonna pay tax on that interest. And
so it's important to, if you do an installment
agreement, that you do have at least the minimum
interest rate tied to it. Because if you receive
that money, Instead of you paying capital gains
on all of it, let's say when you receive it back,
you're going to pay income tax on the interest
component. And that will throw people off and
it will make them want to rethink how they do
things. So a few other things, I see interest
on investment items. So for example, if I buy
a zero coupon bond, even if I'm not getting my
interest into the bond matures, the amount of
interest that's effectively accruing, I could
pay tax on that amount. So, hey, I bought this
bond for 10 ,000, but it was actually only worth
9 ,000. So I bought it for nine. That thousand
dollars, let's say, it matures over five years.
Well, $200 of that is basically considered the
imputed interest, as the IRS would consider it.
And I'll pay tax on that $200, even if I don't
receive my money back until the end of the five
years. So that's kind of technical. But those
are things that if you're in investment situations
or you're selling things over multiple years,
or you have an agreement that spans multiple
years, it's important to understand what is the
amount of tax I owe today versus what I could
pay in the future. Or if I'm taking depreciation
today, how's that going to impact my cash flow
tomorrow? And then how's that going to impact
my taxes? Or if I'm in a partnership, what's
our profits? How much am I going to pay tax on
those profits versus how much cash am I actually
receiving? So those are probably your three big
categories relative to that whole constructive
receipt or economic benefit doctrine that I mentioned
earlier. to be aware of so that you could plan
accordingly and you're not caught off guard by
the tax bill that you have. So let me give you
an old tax case that will illustrate this point
and how sometimes the IRS isn't friendly when
they think you have received money that you may
not actually possess, but they feel that you
have an economic benefit from it. In 1945, there
was a case called Sproul versus Commissioner.
where Mr. Sproul's employer wanted to reward
him for work he had done in the past. So the
company put $10 ,500 into a trust and that trust
was the management of someone else. And then
it was supposed to be paid out to him over subsequent
years in the future. And when the trust was funded,
the IRS deemed that this money was his, even
if he couldn't get to it right away. So they
said, hey, the money went in 1945. You're not
going to get it till 1946 or 1947, but you're
guaranteed to get that money. So you have no
risk of that money, of that money being forfeited.
And because there's no risk of it being forfeited,
it effectively is yours. And so you have the
right to the money. And because of that, you're
going to have to pay tax on that $2 ,500 in 1945.
All right. And so if you have an employer that
does this, so this happens with like non -deferred
comp. It could happen with stocks where from
the IRS's debt point, you have an economic benefit,
which means you receive this money. You receive
this stock today, even if there are terms that
kind of spell out when you're going to get it
in the future. If you don't have a risk of losing
the money or there's no strings attached to you
eventually getting it, then that money could
be considered taxable in that year, which means
I'm going to have to report. money and pay taxes
on dollars that aren't physically in my possession.
And so that is important to understand if you're
in that situation, you need to plan accordingly.
And the IRS may not, you know, they might rule
against you or the tax court, I should say might
rule against you in that situation because there's
different precedent that like this case that
would suggest that Mr. Sproul did have to pay
the tax on that $10 ,500 in the year that he
received it. So hopefully you took some good
tips away. As our motto is, keep more of what
you earned and we will talk to you on a future
episode.