Why Warren Buffett and Other Billionaires Pay Less Tax Than You

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'THE RICH ARE DIFFERENT FROM YOU AND ME'

Make no mistake: Taxation in the United States is an uneven playing field. And recent changes in American tax law have tilted it even further toward wealthy taxpayers. Many billionaires famously pay less in taxes as a percentage of their income than middle-class people. While only the rich can skate by the taxman in some respects, a few of their moves can also help the average working stiff.

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WAGES VS. INVESTMENT

The richest man in the world, Amazon founder Jeff Bezos, reportedly earned a salary of just $81,840 in 2017. Billionaires generally don't make their money from big salaries; their wealth is built on investments in companies and other assets, from real estate to art. The money they make on these investments is taxed differently than the money you make from working.

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DIVIDENDS AND CAPITAL GAINS

Most of the income that billionaire investors report on their taxes is "unearned" — namely dividends (when they own shares in a company that gives a portion of its profits to shareholders) and capital gains (when they sell an asset for more than they paid for it). These are often taxed at a lower rate than earned income. For long-term capital gains, it can be as low as zero.

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PAYCHECK + PAYROLL TAX

Not only do workers pay higher income tax rates, their earnings are also subject to payroll tax. "Earned income from labor is taxed as high as 37 percent, depending on your tax bracket, and then workers also have to pay 7.65 percent towards Social Security and Medicare," says Lyn Alden, founder of Lyn Alden Investment Strategy. "Qualified dividends and long-term capital gains, on the other hand, are taxed at a maximum rate of 20 percent for shares of stock, and they are not taxed any money towards Social Security and Medicare."

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LUCRATIVE LOOPHOLES

Lower tax rates are only the beginning. "Billionaires and multimillionaires also have access to certain partnership structures, write-offs, and other specific accounting tactics to legally reduce or defer their taxable income," Lyn Alden says. These are out of the reach of most Americans, who have far less wiggle room to lower their tax burdens.

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BUSINESS INCOME

Joshua Wu, tax partner at Clark Hill, cites the new Section 199A, which allows non-corporate business owners to deduct up to 20 percent of their qualified business income from a partnership, S corporation, sole proprietorship, or trust. "That 20 percent deduction is not available to people who earn money as normal employee W-2 wage earners," he says.

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THE CAPITAL GAINS GAME

The capital gains tax structure rewards long-term investment: If you sell assets you've owned for a year or less, the capital gains are taxed at your regular marginal tax rate. Of course, the average family can't afford to have money tied up in investments when they need it for practical applications like food, clothing, and transportation. An investor like Warren Buffett has the means to hold onto stocks for years or even decades as they go up in value. He can also defer paying taxes on that increase in his net worth until he actually sells the stock.

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HEIR APPARENT

Billionaires looking to pass on their wealth to future generations can avoid capital gains tax altogether by holding their assets until death, tax lawyer Joshua Wu says. The heirs receive the assets with a "step up in basis" — instead of paying capital gains tax based on the original value of the assets, they pay only if the asset appreciates beyond its value at the time of their benefactor's death.

Furthermore, the 2017 tax law doubled the amount excluded from federal estate tax to $11,180,000 for individuals and $22 million for married couples, a hefty boost for America's richest families.

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STARTING AT HOME

One opportunity the average person has to make a long-term investment and reap capital gains is by purchasing a home. Profits from the sale of a home are a specific form of capital gains that are exempt from tax up to a certain amount: $250,000 for individuals and $500,000 for married couples filing jointly. There are lots of rules, however. For instance, to avoid taxes, you have to own the home and live in it for two of the five years leading up to the sale.

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401(K) CONTRIBUTIONS

How can the average taxpayer play the rich investor's game of deferring income tax? "Many taxpayers fail to take advantage of ways to save money tax-free each year, including maxing out their 401(k)s," says Stacy Caprio, stock specialist at Fiscal Nerd. "This is one way to put away a large chunk of income completely tax-free that will be available to use in retirement." Another is by contributing to a traditional IRA or similar retirement vehicle.

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TAX-FREE RETIREMENT

While a traditional IRA lets you defer taxes for decades, you do eventually have to pay tax on the money you earn on your investments and the money you withdraw in retirement. With a Roth IRA, you don't have to pay capital gains tax on the earnings, and you can withdraw money without paying income tax in retirement. Contributing to a Roth IRA doesn't get you out of paying any income tax now, though.

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BECOMING YOUR OWN BOSS

Starting a small business offers tax savings not available to individual taxpayers. While individuals pay taxes on earnings, businesses pay taxes on profits. "This is a key distinction," says real estate investor Eric Bowlin, who teaches a course on achieving financial independence with passive income from real estate. "Businesses pay for internet, cable, phones, computers, cars, fuel, rent, mortgage interest, and more first, and pay taxes on what's left. Regular people earn money and pay taxes first, then pay rent, car, fuel, internet, etc."

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LOCATION, LOCATION, DEPRECIATION

Many wealthy people and "business owners" buy real estate. Eric Bowlin, who owns 480 rental units, says it's a good tax shelter because depreciation of a rental property can be deducted. "It loses roughly 1/30th of its value on paper every year, but in real life, it actually appreciates," he says.

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PLAYING REAL ESTATE PROFESSIONAL

A self-employed person who buys real estate and actively manages the properties may qualify to list their occupation as '"real estate professional" when filing taxes. "This status allows (them) to deduct losses against non-rental income on their tax returns," says Alina Trigub, founder of SAMO Financial.

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SMALL BUSINESS STOCK AWARENESS

Tax lawyer Joshua Wu pointed to some lesser-known tax benefits available to "normal" taxpayers — for example, people who work for small companies that offer stock as part of their compensation. Recent legislation has made permanent many of the benefits associated with qualified small business stock, including a potential 100 percent exclusion from capital gains tax when the stock is sold. The stock must have been held for more than five years and issued by a "qualified small business," which generally means that it must have less than $50 million in gross assets.

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