For those of you who have not already heard, a few pages from Donald Trump’s 1995 tax returns were leaked to the New York Times a few days ago.
Experts examining the documents have determined that based upon what they saw, which included losses of over $900 million, it is very likely that Donald Trump paid no taxes for almost 20 years after that. This raises three questions.
First, how can you declare over $900 million in losses on your federal tax returns and not be living out of a cardboard box in the alley?
Second, how can you legally go for almost twenty years paying zero federal income tax on your earnings?
And finally the third and potentially most important question, how can WE pay no taxes like Trump?
How to Declare a $900 Million Loss
One thing that helps Trump is his business. Real estate holds a special place in the hearts of regulators, investors and wealthy people all across the country. It is one of the only asset classes where you can make money hand over fist and still declare losses for tax purposes and pay no taxes.
I’ll call these losses “phantom losses” to distinguish them from actual cash losses. You could even use these phantom losses to shield other income from taxes as well. Here’s how it works.
When you own real estate, you are allowed to deduct the cost of the structures over time, this is called depreciation. That means that instead of deducting the purchase price of your property all at once in the year of purchase, you will deduct the cost over a number of years.
For residential rental properties, you can depreciate them over 27.5 years and for commercial properties, you can depreciate them over 39 years. It’s important to note that only the buildings and improvements can be depreciated, not the actual land. You’ll have to work with your accountant or appraiser to allocate the value between the two. The important thing to know about depreciation is that you can deduct it from your taxes as if it were an actual expense.
Here’s an example to illustrate how depreciation works. Suppose you own an office building that you bought for $500,000. You had previously worked with your accountant and appraiser and determined that a fair value for the land was $110,000 and a fair value for the building was $390,000. Perfect.
For purposes of this example, I’m going to keep things simple. I’m going to assume that you use straight line depreciation, meaning that you depreciate the same amount every year. In some situations, there are other methods that may be used. Let’s see how real estate depreciation works.
In a given year, you make a net profit of $5,000 on the property. Not a great return, but at least you didn’t lose money, right? Actually, according to Uncle Sam, you did lose money. Since it is a commercial property, you depreciate the cost of the structure over 39 years. The structure is worth $390,000, so you can depreciate $10,000 each year for 39 years. What does this do to your taxes?
It creates a phantom loss. You really made $5,000 in cash, but you get to deduct the $10,000 in depreciation from your actual income. So, for tax purposes, you actually LOST $5,000. Wait, what? Yup, even though you had an extra $5,000 in the bank at the end of the year, you lost $5,000 as far as your taxes are concerned.
Suppose you also owned another property that made $15,000 that year, but after taking $5,000 in depreciation, it only made $10,000 for tax purposes. What would your taxes look like that year?
At the end of the year, you would have actually made $20,000 in cash ($5,000 from property #1 and $15,000 from property #2), but you would only pay taxes on $5,000 of income because you were able to deduct $15,000 of depreciation ($10,000 from property #1 and $5,000 from property #2). In this case, 75% of your income was tax-free.
Net Operating Losses and Legal Structures
Another thing that helps Trump and other wealthy individuals to pay no taxes are the complicated legal structures that can be formed to maximize tax benefits. Through a combination of LLCs, S-Corporations and partnerships, wealthy individuals (along with their tax advisors and attorneys) can structure the ownership of and revenue from various assets with a specific goal in mind, to minimize taxes and maximize cash-in-pocket.
They can maximize these effects by funneling their expenses, revenues and depreciation to different legal structures they’ve created. It’s often the case that very wealthy individuals won’t even own any of their homes personally (except potentially their primary residence).
By having assets held by different legal entities, they can funnel many ordinary living expenses through their companies. This allows them to minimize the amount of taxes those companies pay and reduce their personal expenses as well.
Doing this in an optimal way maximizes real estate depreciation benefits as well as net operating losses from those respective entities. Like real estate depreciation, net operating losses generated from their entities and structures can be used to offset income from other sources.
If the tax losses are large enough, say over $900 million, these losses can even be carried forward and used to offset income in future years. The bottom line? You pay no taxes.
How Does Trump Pay No Taxes?
So how did Trump manage to take over a $900 million loss? He has two things going for him. First, he is in the commercial real estate business, so real estate depreciation is his friend. It’s also no secret that he lost a lot of real money at that time as well, but a huge chunk of his loss was from depreciation.
Second, he is ultra-wealthy, so he had the brightest minds in the business setting up legal structures to maximize his depreciation losses and other net operating losses to maximize his tax deductions every year. There’s the $900 million loss.
If they do a good enough job generating paper losses, then they can carry those tax losses forward year after year to reduce his income tax liability in future years. In this case, experts estimate that it could cover him for 20 years where he would pay no taxes.
Is any of this illegal? Not if done properly. Is it a loophole? It depends on who you ask. Is it moral? That’s a question for another time. Regardless, it’s how business gets done and it’s how the ultra-wealthy shield their income from taxes.
How to Pay No Taxes Like Trump
So, the million dollar question. How can you and I use what we’ve learned about Trump to pay no taxes like Trump? First, you should always take every avenue to legally minimize your tax bill (see The Brutal Effect of Taxes on Your Savings). This includes stuffing as much money as possible in tax-deferred accounts.
Second, if you have the means and the interest, you should look into buying real estate investment properties. The depreciation benefits can be meaningful and significantly increase your return on those investments. Work with an accountant to get the biggest bang for your buck.
Third, look at starting your own business. Although you won’t have (or need) the complicated legal entities that guys like Trump set up, you can still take advantage of tremendous tax benefit by starting your own company, no matter how small. You can write off certain expenses on your taxes, like a portion of your house if you work from home, a portion of your car’s mileage, etc… It all adds up. Need inspiration? Read Three Reasons to Start Your Side Hustle Today.
So, what do you think? Do you want to pay no taxes like Trump?
What do you think about Trump’s tax strategies? If you own real estate investment properties, what do you think about the tax benefits? If you don’t have real estate investment properties, does this increase your interest in getting some?