It is the right, and IMO, duty of every citizen to structure their financial affairs to pay as little tax as possible and to avoid paying taxes whenever possible. Tax avoidance is not illegal, tax evasion is. The two are completely different from each other. Avoiding income tax is not the same as evading it. If you have ever contributed to an IRA, 401K or RRSP, you are in fact avoiding income tax. There are many ways to avoid income tax. Here are some methods used by the rich and powerful to avoid tax. Look for part 2 soon.
Don’t Make Income
This is not as stupid as it sounds. Out of all the things the government taxes, employment income is at the very top of the list. Therefore, if you want to avoid the biggest tax hit, don’t make income. How do you live with no income? You borrow it.
If you make $100,000 at a job, it gets taxed because it’s income. If you borrow $100,000 from the bank, it’s tax free because it’s not income. At this point, most people will say, “Ya, but you have to pay it back!” I say you have to be more creative. The next two examples should help illustrate this.
The Real Estate Equity Play
In this situation, our asset rich real estate developer put mortgages on his properties to the point where the rental income equal all expenses. If we assume he can borrow 75% of his equity and still be revenue neutral he would be able to borrow a nice chunk of cash to live on. If our mogul has $1 million of income producing real estate, he would borrow up to $750,000 tax free to do with as he pleases.
The money is not taxed because it’s not income. The rental income covers the cost of servicing the debt and other expense so the net income from operation is zero. So no income tax on that either. As the value of the real estate increases, the investor will be able to borrow more.
Borrowing against assets is a way to realize unrealized gains. Instead of selling the asset to realize the gain and getting taxed on it, the owner borrows against it to get the money out without paying any tax. It’s a lot easier to borrow $1 million than it is to make $1 million. It’s also tax free.
The Life Insurance Wrap
In this scenario, our tax avoiding friend has a life insurance policy with a big cash surrender value (let’s say $1 million). If he takes out the $1 million, he would lose the insurance and the money would be added to his income and be taxed at nearly 50%. It’s not a good deal and only a fool would do that.
What you would do in this is this situation is borrow against the cash value of the policy. A bank will lend up to 90% of the cash surrender value. That’s $900,000 to spend as you please. You can take it all at once or have it paid out over time. Because the money is a loan, it is not income and therefore not taxable. Furthermore, the bank will capitalize the loan so you will never have to pay it back.
How does the bank get its money back? When you die, the death benefit will pay off the bank loan plus accrue interest and any money left over will go to your beneficiary tax free. See my post on Using Life Insurance To Shelter Income for a more detailed explanation.