“Intelligence pushes you toward the idea that complex problems require complex solutions”
~Morgan Housel, Money psychology expert*
Paying taxes often causes a visceral reaction. I get it! It is probably the single most painful financial task we have to face on an annual basis. Furthermore, many of you recently received large contract bonus paychecks. For some of you, income taxes will be withheld up front and others may owe a large tax bill, due to under withholding, next April when tax-year 2024 income taxes are due.
This angry, visceral reaction causes us to go to great lengths to outsmart the tax man. Many of us seek complex solutions to avoid taxes at all costs. Unfortunately this sometimes leads to bad investment decisions or large, unwanted purchases (trucks, tractors, airplanes!) that we may not want or need, all in the name of reducing our tax bill. Do not let the tax tail wag the dog! This is easier said than done and akin to buying high and selling low in the world of investing.
While there are effective strategies to reduce our tax burden, we should not do things that reduce our overall wealth and net worth.
Avoid the Complexity Trap
Pilots are known for their type-A personalities and “get ‘er done” attitude. Pilots work hard to solve problems and make things happen under very difficult circumstances. However, it is human nature to spurn the simple solution for the complex. This phenomenon is called the complexity bias. https://fs.blog/complexity-bias/
Be aware that complex tax reduction solutions often come with higher IRS audit risk as well as risks of repayment penalties and interest. Extreme cases may even warrant prison time. For some good entertainment while you are waiting on your delayed flight, simply search the internet for, “Airline Pilot Tax Fraud.” You will find some very interesting characters doing things to evade taxes that might sound familiar and not too far fetched from some of the conversations we’ve had on the flight deck!
While we are often tempted to overcomplicate our tax strategies, especially with big-ticket purchases, it’s essential to recognize that complexity can lead to costly mistakes. Here are a few key rules to follow:
- Do not reduce your wealth and net worth in order to stick it to the tax man!
- Do not seek out complex tax strategies that are high IRS audit risks when there are several simple, audit risk-free strategies to reduce your lifetime income tax burden.
- Do not spend money on big-ticket items that you do not want or need in order to reduce your tax bill. This is mathematically equivalent to spending one dollar to save thirty cents.
- Reducing your income tax burden over your lifetime may be more profitable than reducing your current tax bill.
Tax Strategies
Sometimes we have to choose whether to reduce taxes now or invest in strategies that could reduce our income tax burden during retirement. Unfortunately, it’s hard to imagine our future selves and what we will need, which can lead us to decisions that might benefit us today but are very costly in the future.
Below are four tax ideas that can help you legally avoid paying more taxes than you are required to pay. But first here are three strategies that require special care and attention to detail in order to avoid gaining the attention of the IRS:
Strategies that Require Special Care
1. Claiming Residency in Another State using your Condo or Crash Pad
Many high-tax states get very aggressive about going after folks that reside in their state but claim to be residents of another state. Of course there are circumstances where this is absolutely legitimate but use caution and keep extensive documentation.
You can search the internet for requirements to be an actual residence of each specific state, but here are a few that are standard in most states:
- Spend 183 days or more in the state you claim to be a resident of
- Enroll your children in school there
- Register to vote
- Receive your mail
- No tiny homes…
For example, New York will look at the size of your house in Florida to make sure your residence in Florida is similar in size to your captain mansion in New York. Evidently purchasing a tiny home or small condo in Florida is a tell-tale sign that you don’t spend much time there.
- Here is a great article from Kiplingers that goes into more detail about how to be a legitimate resident of the state of Florida.
2. Deducting Your Airplane (e.g., because you’re teaching your kid how to fly)
The details of when and how to deduct airplane expenses are very complicated and beyond the scope of this article. However, here are a few things to keep in mind.
- You cannot deduct the cost of your airplane (depreciation) unless it is used more than 50 % of the time for your (legitimate) business.
- It is not a deductible expense because you need to keep your flying ratings current.
- If at any time during the depreciable life of the airplane, personal use exceeds 50% there will be an immediate depreciation recapture. (I.e., you will owe a lot of taxes all at once.)
- All of the excess bonus depreciation is recaptured if the business use of the property falls below 50% and also a portion of the accelerated depreciation (the excess over the straight line) is recaptured if business use falls below 50%. (Updated 09/19/24)
3. Investing in Real Estate to Deduct Losses Against Your Airline Income
Remember rule number one – do not reduce your wealth to save taxes. It is not uncommon to see bad investments in real estate when high-income pilots are desperate to reduce their tax burden. In fact, it seems that we almost feel an obligation to purchase real estate solely for the tax deductions at a certain income level. I have heard many pilots confess that they must not be very tax savvy because they do have a real estate investment…or three. Here are a few things to know before jumping into real estate investing:
- Over a certain income level (currently $150,000) you cannot deduct real estate losses against your airline income. For example, if you replace the roof on your rental home and therefore show a loss of $10,000 on your rental property income statement you cannot deduct the loss against your current airline income. (However, the loss can be carried over.)
Note: If you are considered a Real Estate Professional, the above may not apply. Being a real estate professional is a very high standard set by the IRS and is nearly impossible for an airline pilot to obtain unless they have a spouse, “in the business.”
- Real Estate can be a great investment. However, one rule of thumb I read a long time ago is good to keep in mind; In real estate investing you need to make money on three occasions; when you buy, when you rent and when you sell. That is not easy to do!
- If you do not enjoy being a landlord and managing the business of real estate, I would avoid it altogether. There is no tax deduction worth making you miserable. If you plan on hiring a property management firm to delegate the pain, make sure they don’t eat into your profits too much. Some agencies can charge as much as 30% or more depending on the level of support. There are cheaper ways to invest in real estate if your costs become excessive. (Publicly traded Real Estate Investment Trusts aka REITs)
Smart Tax Strategies for Long-Term Savings
Instead of risking your financial future with complex schemes, here are four simple, effective ways to reduce your income tax burden over your lifetime.
1. Backdoor Roth IRA
This strategy is based on the IRS rule that:
- Anyone, regardless of income, can contribute to an after-tax, non-deductible traditional IRA.
- Anyone, regardless of income, can convert a traditional IRA to a Roth IRA if they pay the taxes on the gains (if any) in the traditional IRA.
There are more things to know before executing the back door Roth IRA, so make sure to consult your tax and investment advisor.
2. Health Savings Account (HSA)
If you are relatively healthy and only frequent the doctor’s office for preventative care and the occasional sniffles, a high-deductible health plan may be right for you. If that is the case, a Health Savings Account (HSA) is a great tax savings account. It is the only account in existence with triple tax savings: tax-deductible contributions, tax-free growth, and tax-free withdrawals for medical expenses.
3. Taxable Brokerage Accounts (non-IRA, non-401k investment account)
This is the most overlooked and advantageous account once you’ve maximized your 401k and potentially the (back door) Roth IRA. The taxable brokerage account is very flexible. There are no contribution limits and no withdrawal penalties. It is taxed at capital gains tax rates, which for most of you is much lower than your income tax rate. Finally, if you invest in low-turnover mutual funds (index funds) and Exchange Traded Funds (ETFs), you can essentially create your own tax-deferred growth.
4. Real Estate
Even though I bashed real estate previously, it can be great for rental income and investment diversification. People can be very successful investing in real estate if they enjoy putting in some sweat equity and managing the rentals themselves. Short-term rentals may qualify for cost segregation, bonus depreciation.
Bonus Tip: Electric Vehicle Tax Credit
If you’ve received a contract ratification bonus, consider purchasing an electric vehicle. If your adjusted gross income is below $300,000, you might qualify for a $7,500 federal tax credit.
Tax season doesn’t have to be a burden. By avoiding unnecessary purchases and focusing on long-term strategies, you can reduce your tax burden without compromising your financial future. Stick to these principles and consult a tax professional to ensure you’re on the right track. Smart planning is key.
Resources:
Morgan Housel CNBC article: “Why the smartest people make bad decisions – compared to those with average IQ.”
How to establish Florida residency? Kiplingers Article
Real Estate Cost Segregation Study
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Email: info@leadingedgeplanning.com