‘Rich People Don’t Pay Taxes’? Paul Winkler Responds

Introduction: Hey, welcome to the investor coaching show. I am Paul Winkler.

So this week on one of the financial shows, there was this whole thing about billionaires and tax bills. You know, the desire to go and just take it to the rich is something that’s very common in Washington D.C. And I thought it was an interesting little segment on CNBC. It was talking about billionaires and tax bills and they had these three strategies that are used to avoid taxes by billionaires.

Billionaire Tax Strategies

And, you know, it’s a list of strategies right now and they would just change if you go in, you try to hit them. But you know, that’s the talk, let’s see if we can figure out a way to tax billionaires. Because they’re saying that some of these people don’t pay any taxes at all. They don’t pay any income taxes whatsoever. And so how are they getting around that? Well, the first strategy they talk about is investment losses. And right off the bat, you have to laugh and go, “Okay, well, if you got investment losses, yeah. I think maybe we ought to be able to deduct those against gains so that we don’t have any taxes.” I don’t necessarily see a problem with that. You know, when we have losses though, you have to be really conscious of the fact that, you know, it’s only against capital gains that you’re able to deduct these things without limit.

You know, if you have a loss, those of you that have had a loss in investments, you sold them. And if you don’t have enough capital gains to actually offset these losses, then you just take it against ordinary income. But it’s $3,000 a year, and that’s not very much. It’s a pretty low amount of money, you know? So it can take you a really long time unless you have some other capital gains in your future to actually offset that. Now, if you’re investing, you’re not buying and selling and trading and doing a lot of that activity, which tends to be very costly all on its own–because every time you make a trade, you got a cost right now–if you go and realize your gains, then you can offset those gains with losses if you’ve held them back before. You know, so right off the bat, it’s just kind of funny, you know. Billionaires, you know, how are they avoiding taxes?

Investment Loss

Well, investment loss. So that seems like kind of the hard way of doing it. So they offset their income with investment losses. And then you have people that are day traders–which is a really bad idea–and smaller investors, and those with retirement accounts, you know, they’re doing the same exact thing. But you know, if you’re in my world, I wouldn’t do a whole lot of actually declaring your gains and taking your losses. You know, I did a whole segment about the problems with that in a previous show. So I won’t get into a lot here. But billionaires and tax bills. What else? What else are they doing? What’s the other strategy that they’re doing to avoid paying taxes? Well, one is borrowing.

I think I talked about this recently. It’s a strategy that one will sometimes use. We even use it. You know, it’s kind of good. Where if you actually generate a capital gain, you have to pay taxes on that. It’s kind of a pain, especially if you need money for just the short-run. So let’s say you have what’s called a non-qualified account. So it means it’s a taxable account. It’s not your IRA. It’s not your 401k or anything like that. It’s just a non-qualified account. And you bought, you know, your investments and you put a hundred thousand dollars in, let’s say. And now you’ve gained, you got a gain. You’re paid dividends over the years, and every time you’re paid a dividend, or you get a dividend paid to you, that’s taxable right away.

So that adds to your basis. So let’s say if you got $3,000 in dividends. Well now you’ve put a hundred thousand in. That was your original contribution. Then you put $3,000 on top of that, because that was a dividend that was paid and you paid taxes on that. So if you sold the account, you wouldn’t have to pay taxes on that dividend again. Now, if you have interest earned, it’s going to be taxed straight away. So that’s gonna be part of the basis. It’s going to increase the basis, so to speak. So you got a couple of thousand dollars of interest paid, let’s say. And now you’ve got the $3,000 in dividends, plus a couple of thousand dollars in interest. Now that’s $5,000. Plus the hundred thousand you put in, now your new basis is $105,000.

See, that’s how it works right now. Let’s say that you have a lot of capital appreciation, which is where you might have–

Gains Taxes

Well, the other thing you might have also on top of that, before I go on to capital appreciation, you might have short or long-term capital gains that you have to pay taxes on. Now, if it’s short term, that means you didn’t hold it for over a year and it’s taxed at your highest rate. If it’s long-term, you’re going to be taxed at a lower rate. You know, that could be zero for some people, it could be 15% for others, 20% for others, and you might have a surtax tax if your income is high enough. But, and typically, you know, for a lot of people out there in the listening audience they’re going to be at zero. I mean, it’s going to be nothing. And it might be 15.

Now that may change, who knows. That may go up, it may be changed with new rules coming down the pipe, who knows. But anyway, that’s the way it works right now. So let’s say if we go and hold a stock for more than a year. Or hold a mutual fund, hopefully. I’m hoping you’re not holding individual stocks after listening to this show, knowing that you’re taking risks that you’re not getting paid to take. It’s not a really good idea. You’re, as Evan said so well in a previous show when he made the comment about it, “Hey, you know, here’s the thing. If you’re buying a single stock or you’re buying a couple of stocks, you’re making the assumption that it’s going to do better than everything else out there.” Which is kind of a–that’s a pretty interesting assumption you’re making there. You’re assuming that what you have chosen is going to do better than everything else. Kind of a farfetched assumption, really when it gets down to it.

Long Term Gains

So anyway, let’s say that you’re holding mutual funds, and you hold a mutual fund for over a year–or the ETF or something like that. And now you sell it and there’s a gain. Now you have to pay long-term capital gains taxes on that, you know? So that would be something that you might avoid a lot of times, especially in the accumulation phase. Because you don’t want to be buying and selling all the time. You may be doing that because you’re trying to time the market, or you’re assuming that one area of the market is going to do better than others. So you’re going to sell the area you don’t think is going to do well.

You might say, “Oh, you know, I really don’t think, you know, small value stocks are going to do well. So I’m going to sell everything in that. I’m going to go and buy this, you know, large value stock fund, or something like that, or this international small fund or whatever. Because I think it’s really good. I think international is just due or just going to take off. So I’m going to sell everything in one area.” Well, you’re going to have to actually go and declare those capital gains when you do that.

And you know, the other thing might be though, this: Let’s say, you’re that person who’s got this portfolio. It’s all diversified properly. You’ve done everything as best you can in the right manner. And you know, the portfolio is well diversified between U.S., international, small, large, value, growth.

Loans

And, and you’re just like, “I need some money in the short run.” Well it’s a non-qualified account, or a joint account, or a personal account. And you’re going, “I need some money in the short run and I got to pay something because I’ve got some money coming in six months from now. But I really need money right now. Do I go and decimate my joint account or my personal account and then all of a sudden trigger those capital gains taxes, just so that I can put the money back in there six months from now when new money flows in and I can replace it?”

Or, “Do I go and take a loan?” And you can get a loan against non-qualified assets a lot of times. And some of them are really, really inexpensive. I mean, you know, it might be a super, super low interest rate. What you got to really watch for is a lot of investment firms will tack on their own fees on that. And that’s one of the things I just go, “No, no, no, no. Stay away from that.” But it could be a super, super low interest rate. It might be just a couple of percent, just to give you an idea. And then what you do is you pay the loan back when the other money comes in. That way you haven’t gone and triggered capital gains taxes. Well that’s something that billionaires do. They actually will generate income, not by selling, but by taking loans against the stocks or the investments that they own.

That’s another thing. You know, you’ve got homeowners that borrow against their homes and I don’t really recommend it. Home equity loans and things like that, because they can be callable loans. But those are some of the things that you can do. You know, you might have a reverse mortgage or something like that. You can actually generate some money from, so you don’t have to go and cash out. And that’s actually a strategy that often may be used by the way, you know, these reverse mortgages. If you’re over age 62 and you qualify for one you go and a line of credit or something. I like that instead of going and selling stocks, you know. You can Get the money that you need.

And especially if you have down markets and you want to rebalance the portfolio or you need money, you need income. But you’re like, “Ah, man, I really don’t want to trigger a sale from my investment portfolio that has a gain but it just happens to be down this year.” It has a gain in it. You know, maybe you put a hundred thousand in it and it grew to $200,000, let’s say, but it’s down to $175,000 and you don’t want to sell low. You don’t want to go in and trigger a sale when it’s at $175,000 because, you know, markets go up and they go down. I would rather borrow the money and then let the market come back and then I can repay it. You know you can do something like that. That’s a strategy that can be used. all kinds of neat stuff out there that you can do when it really, really gets down to it, if you know what you’re doing. So what happens here is that people will do that all the time just to avoid taxes. Another thing: Would this trigger a Step-up in Basis change? No.

Charitable Deductions

Another thing you can do is, you can give to charity and you can offset. Well what’s happening there? You’re giving away money. It’s not yours anymore. Again, another strategy to avoid taxes, but it takes something pretty, pretty monumental to avoid the taxes, which is giving away the money. And a lot of people, you know, give. 11 million Americans deduct for charity. Now it used to be more than that before the standard deduction went up so high, but there are a lot of people that do that. A lot of people that use that strategy, I think, would be a little bit upset if anything ever changed in that particular area.

Step-Up in Basis

So we look at these things that they’re doing to avoid taxes and you know, some people are coming out and saying, “Well, here’s what we gotta do. We gotta get those rich people. And what we’re going to do to get those rich people is, we are going to get rid of the Step-up in Basis.”

So, you know, if they’ve built up a bunch of wealth and they try to pass it to the next generation, you know, maybe they built a business, maybe they built a farm. Maybe they built up an investment portfolio or something like that. And then what we’re going to do is when they die, instead of, let’s say you put–let’s use our example again–let’s say you put a hundred thousand dollars in something and it grew to $250,000 and then you pass away and your heirs get it.

So you’ve got $150,000 gain if you sold it while you were alive, but if somebody inherits it from you, then they get a Step-up in Basis. Let’s just say it’s a personal account to keep this really simple, because it gets a little more complicated with joint accounts. Let’s say that we do this and now your heirs get it. And they sell it. Well, instead of the basis being a hundred thousand dollars, forget that. You know, that you got some dividends in there, and interest that increases the basis. And that just complicates things. But let’s say that you did that, and now they sell it for $250,000. Well, what’s the tax? Well, nothing. Why? Because the new basis was $250,000.

Now, if it grew from the date of death, it grew from $250,000 to $260,000. Then there would be a $10,000 capital gain. But the new basis is way higher on $250,000. You see? So this can be really helpful for people if you think about it.

Well, what if they go and change this? What if they came in and said, “That’s it we’re going to get rid of Step-up in Basis.” And there was a study done by the Family Business Estate Tax Coalition. They went and looked at, you know, what they thought the effect would be of doing this. And they said, you know, this would damage the economy. They did this study looking at how is this going to affect GDP?

They said, there’d be like 80,000 fewer jobs in the first 10 years, a hundred thousand fewer jobs each year thereafter. And they just started looking at a lot of numbers, and I don’t know exactly how they went about it. But they figured that GDP was going to be reduced by about $10 billion annually, a hundred billion dollars over 10 years. So they’re looking at it going, “Well, this could be pretty significant.”

And you know, this is something that I have discussed before, but you know, you look at it and go, “Why have a step up in basis?” You know, what’s the benefit of having some kind of a step up in basis? And there are a lot of reasons that we have this, that where you have this ability to actually go and pass on your assets and it develops a new basis once you pass away.

Inheritances and Step-up in Basis

Number one, I think of–and I see this all the time–you know, one of the things that I see quite frequently is you’ll have somebody pass away and their heirs get their property. Whether it be investments, or farmland, or house, or whatever. And the reality of it is, a lot of times the heirs just haven’t saved that well for retirement, for whatever reason, you know. So when they get this property, having to pay out a bunch of taxes puts a real dent in what they’re able to do and can actually challenge their ability to take care of themselves down the road. And that’s one thing.

Another thing is, hey, it may actually get rid of the incentive to sell the property. You know, have you ever actually inherited a piece of property yourself? And you go, “Man, you know, I don’t want this, I think I need to get rid of it.” And, you know, the reality of it is, it may be property that may be super valuable to somebody else because of its location, but it’s not that valuable to you. And it may not be that valuable to the economy where it is, how it’s held right now, when you inherit it. Now, maybe somebody else–I remember one guy actually got rid of a big piece of property and somebody came in, swooped in. It wasn’t worth that much.

He swooped in, bought the property and went and put a beautiful trailer park on it. I mean a really nice RV park on it, and fixed it up and did a tremendous amount of things that were just really imaginative. And you look at that property now versus what it used to be, and you go, “Wow! There’s a huge difference.” What that thing looks like now, versus what it did look like before. And the value has been increased significantly and the value to the economy, if you think about it. Property actually generates income and income generates jobs, and those jobs generate more buying activity and more economic activity. It’s kind of this chain reaction that happens. And it’s really, really tremendously important. And this is where some of that GDP numbers may be coming from, calculations like that.

And you know, so if you get rid of the incentive to sell low basis property, because, you know, my heirs sell it and now they gotta pay the taxes. We were waiting until mom or dad passed. You know, we weren’t in a rush by any means for that to happen. But we were waiting for that before we sold the property. Now we don’t have the Step-up in Basis anymore. I may as well hang on to the property. And now you’re stuck with a piece of property, and there are a lot of people out there within the sound of my voice who know what this is like.

You bought a piece of real estate. Maybe you’ve owned it for years and now you’re going, “Hey, you know, I really, I want to retire. I want to get rid of this property. I don’t want to do a 10-31 Exchange. I don’t want to keep holding property forever.” And you feel stuck because you know, you’re going to pay a lot of taxes on the gains. It can be really frustrating.

The Details

Now, the other thing that’s really frustrating is this. It has to do with calculating the basis and the challenge. Well, remember I said that you have to add the dividends you add interest you add capital gains, where taxes are paid. What was paid for the stock? Oh my goodness! How many times have I run into that? We’re trying to figure out what–and this is with living people. You know, clients that are living. And we’re trying to figure out, they bought this stock, that stock, this mutual fund, that mutual fund. What did they actually pay for it?

Maybe they don’t have records of that. Now not only that, what was paid for, but what were the dividends that were declared on the stocks and how much did that add to the basis? How much interest was paid? Let’s say it’s a piece of property, rental property or something like that. Okay. Well now if we have the basis, what we put into it, we can actually increase the basis based on things that we bought. Maybe things that we did to improve the property or something like that. And we’re trying to figure out all the receipts and all of the information on that. Now, if I can’t do this for somebody that’s living, how do you do it for somebody who’s no longer living? You know, you got parents that have passed away and you’re trying to go and backtrack and figure out all the records. What a nightmare that is.

And you know, the other thing is this. If you have property and you’re trying to figure out A) What the taxes are, and B) you’re figuring out what the basis is. Then you have to sell the property a lot of times to pay the tax. You know, so people have farms, family farms, and now you’re going to have to pay a tax because you don’t have this step up in basis anymore. And you’re going, “Oh, do we have to, you know, get rid of the family farm? Do we have to take out loans and pay the taxes? You know, what are we going to do? Are we going to have to lay off employees?”

I mean, there are all kinds of issues that can come up with this. So it’s just one of those things that we have to keep an eye on. And okay, how do we adapt? And, you know, the answer right now is: Not sure, until it actually comes to fruition, if it does come to fruition. But this is why this is such a big deal. Maybe you understand a little bit more about Step-up in Basis, and how all of this works, and why this is being debated so furiously right now at this point in time.

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