On average, 45% of your lifetime earnings will be paid in tax.
And that’s the average worker. If you’re reading this article you’re likely not average.
You’re also probably familiar with basic tax saving strategies like contributing pre-tax dollars to retirement accounts or opening a Healthcare Savings Account “HSA”.
All that stuff is good.
But if your household is earning $100,000 or more per year, they won’t move the needle.
In this article, I highlight 6 powerful tax saving strategies that every high income earner should know about. When applied strategically over long periods of time, these strategies can unlock significant wealth creation.
1. Real Estate Professional Status
The Strategy:
Qualify for real estate professional status and use depreciation from your rental property investments to offset active income from your day job.
Best For:
Households with one partner who does not have a full-time job and is interested in managing rental investment properties.
Primary Downsides:
- Requires you to not have a full-time job
- Requires 750 hours of your time per year to qualify
- Requires you to hold real estate as an investment for the long-term
Further Reading:
- The Single Best Tax Strategy for High Income Earners
- The Investor’s Guide to Qualifying as a Real Estate Professional
2. Short Term Rental Tax Loophole
The Strategy:
Convert your investment property into a non-rental activity by operating it as a short term rental “STR”. Use depreciation from the property to offset active income from your day job.
Best For:
Any individual or household that cannot qualify as a real estate professional.
Primary Downsides:
- Requires at least 100 hours of your time to operate the short-term rental
- Cannot use your short term rental for personal use more than 14 days per year
- Requires you to hold real estate as an investment for the long term
Further Reading:
- The Single Best Tax Strategy for High Income Earners
- The Investor’s Guide to the Short Term Rental Tax Loophole
3. Small Business Deductions
The Strategy:
Professionalize your a side hustle and deduct common business expenses.
Best For:
Pretty much any high income earner with time to professionalize their side hustle and diligently track common business expenses.
Important to Know:
- You do not need to formalize your side hustle to deduct business expenses. That means you don’t need to create an LLC nor file for an EIN.
- There are ways to professionalize your side hustle without forming a separate legal structure. This includes creating a website, documenting a business plan, creating social profiles, and keeping accurate records of your receipts.
- I would recommend opening a separate business checking account (and likely business credit card) to separate your personal transactions from your business expenses.
- Be careful not to show a net loss from your side hustle for more than two years in a row. If you do, the IRS may classify your business as a “hobby” and you will no longer be able to claim the common business deductions.
- You can always change your side hustle every few years.
- When you file your personal taxes, you will attach a Schedule C to your 1040 tax return. The Schedule C reports your 1099 income.
- There is no limit to the amount of Schedule C business losses you can use against your other income. But to reiterate, you should not claim losses from the same business for more than two consecutive years, otherwise the IRS may classify the activity as a “hobby”.
Most Common Small Business Deductions:
| Deduction | Rules |
|---|---|
| Home Office | If a portion of your home is used exclusively for business purposes, you can deduct the percentage of your total home costs, regardless of whether you rent or own. This may include rent, mortgage interest, insurance, property taxes, utilities, etc. For the greatest impact, use the actual expense method rather than the simplified method. |
| Automobile Expenses | You can deduce common automotive costs when used for business purposes. You can choose to deduce actual expenses incurred (eg. gas) or the standard mileage rate. Be careful, here. If you are running an eComm business, for example, it may be difficult to prove a legitimate business use. |
| Internet & Phone Costs | If you use the internet or your telephone for your business you can deduct those expenses. In this day and age the vast majority of side hustles should be able to take advantage of this deduction. |
| Meals & Entertainment | If you have a meal and discuss business items with a colleague or potential customer, you can deduct those costs (100% of the cost, post-COVID). |
| Travel Expenses | If you are traveling for business purposes — to visit a property you own, check on a potential customer, diligence a competitor, etc. — you can deduce those travel expenses. |
| Education | Many high income earners are also lifelong learners. You can deduct costs to attend a professional conference, take an online course or access a book or guide. |
Process for “Audit-Proofing” Business Expenses:
- Download a free and easy to use expense tracking app like Expensify
- Take a photo of all your receipts and invoices
- Record the date of expense, vendor, amount paid, and the business purpose
- Carefully store these business expenses for up to 3 years
- Further Reading: How Long to Keep Business Tax Records and Receipts
4. Section 1202: QSBS
The Strategy:
Start a C Corp, operate it for at least 5 years and when you sell, take the Qualified Small Business Stock “QSBS” exclusion to avoid paying long-term capital gains tax on the first $10 million of gains.
Best For:
Individuals looking to build a business and optimize for exit value, rather than short-term cashflow. This strategy is commonly employed by VC-backed tech companies that pursue growth at all costs to ultimately build for an exit down the road. However, it can be just as effective for the typical high income W2 employee who forms a side hustle to build long-term equity and isn’t focused on near-term cashflow. In that scenario, the side hustle can effectively fund its own tax-free growth for 5 years.
Primary Downsides:
- This strategy is only available to C Corps, which are notoriously double taxed (at the entity-level and on your the owner’s personal tax return)
- You must hold the C Corp stock for at least 5 years to qualify for the tax exclusion
- The majority of states do not accept the Section 1202 exclusion, so you will still have to pay state income tax on the net proceeds
Important to Know:
- There are ways to minimize the amount of income that is “double taxed” through your C Corp. Most importantly, you can avoid paying corporate tax on the first $250K of accumulated profit, so long as the profit remains in the business and is not distributed to shareholders via a dividend.
- You will need to work with an attorney to ensure you setup your legal structure correctly. It’s not overly complex and shouldn’t take an experienced attorney more than 2-3 hours to create.
5. Opportunity Zones
The Strategy:
Invest dollars from a recent capital gain into a Qualified Opportunity Zone “OZ” Fund and defer taxes until 2026, at the earliest. Furthermore, your OZ investment grows tax-free, so long as you hold the investment for at least 10 years.
Best For:
Anyone with a significant capital gain who wants to own more real estate. This can be particularly effective for high income earners with a significant short-term capital gain, since those gains are taxed as Ordinary Income.
Primary Downsides:
- Strategy only applies to capital gain income
- Taxes on the initial invested capital gain are deferred, not completely avoided
- You have to hold your OZ investment for 10+ years to benefit from the tax exclusion
- Opportunity Zones are generally in less desirable locations, making the investments potentially more risky
Important to Know:
- A capital gain is created be selling an appreciated asset (business, real estate, equities, crypto, etc.) and can be either short or long-term.
- Opportunity Zone investing has been around since 2017 when it was enacted as part of the Tax Cuts and Jobs Act
- I strongly recommend investing with a real estate syndicator offering an Opportunity Zone fund. There are many complex rules that must be followed to qualify for the 10 year tax exclusion. It’s likely not the best use of your time to navigate the always changing legislative rules on OZ investing. Caliber and Arctaris are a couple syndicators I recommend that offer dedicated OZ funds.
6. Tax Loss Harvesting
The Strategy:
Strategically sell assets that have fallen in value to capture taxable losses. Use those losses to offset income from other sources. Investors will often buy back into their position in a similar asset.
Best For:
Individuals with investments that, if sold, would produce a short-term capital loss that could be used to offset their ordinary income.
Primary Downsides:
- Limited to $3,000 of capital losses that a taxpayer can deduct in a single tax year.
- The Wash-Sale Rule prevents you from buying the same security that you sold for 30 days. So you can’t sell Apple stock at a loss and buy it back a day later. You can, however, sell one S&P 500 index ETF at a loss and buy a different S&P 500 index ETF the next day, without triggering the wash-sale rule.