It’s a typical tax accountant’s experience: on a weekly basis we are asked for advice on how to reduce taxes. My first question is, “Did you consider the tax exposure prior to the transaction?” Many times the answer is no. Proper knowledge and utilization of tax strategies is the best way to reduce or eliminate tax exposure. Here are some of my favorite tax myths:
Tax Myth: I just paid off a significant amount of debt for my company. I don’t have any cash, so I shouldn’t have to pay taxes.
Reality: This myth stems from a misconception of what is taxable. While reducing debt is excellent financial behavior and good for a healthy financial future, it has no effect on taxes. The IRS is looking at income as they define it, and not evaluating your individual situation. It’s a matter of taxing profit, not cash flow, and often people believe if they have no cash, it equates to no profit. Not true. For example, someone buys land for $100,000 that appreciates to $1 million – a very real possibility in our current real estate market. He now takes out an equity line of credit for $600,000 and spends it on business or luxury items. He proceeds to sell the land for $1 million, but believes his profit is $400,000 – the balance after repaying the line of credit. Obviously, this is not the case; his profit is $900,000, based on the original purchase price.
Tax Myth: Isn’t there a standard percentage I can deduct?
Reality: People want a cookie-cutter plan for their taxes. The IRS doesn’t work that way. You can deduct your business expenses, but it depends on what you can justify. There is no “standard percentage,” because everything is an individual situation – whether for your business or personal finances. An experienced tax accountant can help you identify opportunities for deductions, as well as providing guidance about moving forward.
Tax Myth: If I sell real estate, it’s automatically a long-term capital gain.
Reality: Not always the case. Real estate is not always held for investment purposes resulting in long-term capital gain upon sale. It can also be treated as ordinary business property. It is important to distinguish between the two from the beginning, as taxes are based on what the property was “intended” for. When purchasing a property, I always recommend drafting a written “acquisition disposition strategy” that clearly spells out the intentions for the property. The intentional use of property can drastically change the taxes that must be paid on it.
Tax Myth: Isn’t all income taxed the same?
Reality: People get confused about how different types of income are taxed. Portfolio income, such as interest, dividends and rents are not taxed the same way as capital gains or income from the performance of services. Revenue for services performed is also subject to Social Security taxes. Knowing how the types of income are taxed is critical for proper tax-planning strategies.
Tax laws change gradually, and there have been two to five tax acts every year for the past five years. Most people are not aware of the affect taxes have on their business and personal finances. Without proper guidance to decipher the opportunities either to take advantage of, or to avoid, people and businesses can experience an unpleasant surprise. Plan ahead and implement sound tax strategies for the rest of 2005, as taxes due on April 15, 2006 can be planned for now and reduced.