Uncommon Ways To Reduce Your Taxable Income

A handful of uncommon (and typically complex) strategies may help you reduce earned income in select situations

Strategy Overview

Beyond the more commonly utilized (and previously mentioned) Income Tax Strategies, a handful of less common strategies also exist, which may help you reduce earned income in select situations. Each of these strategies is complex with strict requirements, and many require making an investment (typically a large one). But in some situations, the reduced earned income can be very significant.

The strategies detailed below are complex. We highly recommend consulting with a licensed tax professional before pursuing these.

Tax Details

In most situations, the "character" of income or gains cannot be changed (e.g. a capital gain/loss stays a gain/loss and is not earned income). But in some situations, and/or for some investments, there are steps that may be taken to allow the character of the income to shift. We detail a number of these circumstances below, as well as a unique relocation opportunity.

Real Estate Professional Tax Status

Real estate investments are known for their potential tax benefits (most notably the deduction of depreciation, a non-cash expense). What is less known, however, is that the IRS has a special tax status known as a "real estate professional." There are strict requirements to qualify for the status, but if you or your spouse do, your real estate losses can be treated as active losses (vs. passive). Active losses can be used to offset other types of income (e.g. salary, cash bonuses, income from stock-based compensation).

This can be a powerful tool in reducing your overall tax liability, especially for a married filing jointly household, as only one spouse needs to qualify (but both members of the household get the benefit). For more details you may consider reading: Navigating the Real Estate Professional Rules

Solar Investments

Investments in solar power are continuing to grow. In addition to certain tax breaks that the IRS has offered to encourage households to install solar, the IRS also offers tax benefits to individuals who invest in solar assets (note: active participation in the investment is required) -> including both tax credits and depreciation benefits on the asset. For more details you may consider reading: Solar Asset Purchase Tax Benefits

Oil And Gas Investments

Investing in a "working interest" of oil and gas can provide significant tax advantages. The US tax code specifies that a working interest is an "active" versus "passive" activity, and as such, all net losses are considered active income and can be used to offset other forms of active/earned income like wages. Costs, such as those associated with drilling, are deductible (typically generating losses, especially in early years of the project, as they have no salvage value). For more details you may consider reading: Investopedia: Oil Tax Breaks

In our experience, most "working interest" oil and gas investments that are available to individuals are both (i) very risky, and (ii) poor investments (i.e. the bigger and more knowledgeable institutional players have opted not to invest).

Select Derivative-Based Investments

Derivatives-based strategies are more complex and require a strong understanding of finance, investments, and structured financial instruments. That said, the IRS has unique rules for certain derivatives, which can offer beneficial tax treatment. For example:

• Losses from "swaps" transactions are typically classified as ordinary income. While restrictions and rules apply, if you invested in swaps and realized a loss, that loss would be ordinary/active, and as such could offset other earned income e.g. salary, cash bonuses, income from stock-based compensation). For more details you may consider reading: Tax Treatment for Swaps

• Most future contracts have special "60/40" tax treatment, wherein 60% of gains/losses, regardless of the holding period, are classified as long-term capital gains and 40% are classified as short-term capital gains. For more details you may consider reading: How are Futures and Options Taxed

• Some ETFs allow you to effectively have interest income taxed as a capital gain (which can be tax-loss-harvested). In recent years, some ETF products have emerged that take advantage of certain taxation rules and package them into a more readily accessible ETF for investors. One example is Alpha Architect Product Overview for BOXX (provided solely for educational and reference purposes; not a recommendation).

Derivatives are complex instruments, and the tax treatment can be even more complex. We strongly recommend consulting with a tax professional familiar with the products and markets before making any investment

Relocating to Puerto Rico

Providing an overview of the potential tax benefits and risk of relocating to Puerto Rico is well beyond the scope of this knowledge base. However, we would be remiss if we didn't mention it as a tax strategy. Quoting an firm who has far more experience and knowledge of this than we do:

U.S. citizens who become bona fide residents of Puerto Rico can maintain their U.S. citizenship, avoid U.S. federal income tax on capital gains, including U.S.-source capital gains, and avoid paying any income tax on interest and dividends from Puerto Rican sources.

(Additionally)...expatriation rules do not apply to U.S. citizens who relocate to Puerto Rico because the relocation by itself does not require any renunciation of U.S. citizenship. Therefore, if an individual relocates to Puerto Rico, the move does not result in an expatriation tax.

For more details you may consider reading: Is Relocating to Puerto Rico the Right Move for You?

Key Benefits

• Potential to utilize paper losses from investments to offset earned income. Income such as salaries, bonuses, and/or stock-based-compensation is all earned income, and could be potentially partially offset with an investment in one of the above strategies that generates (paper or real) losses.

• Potential to optimize when, if, and how you are taxed. Select derivatives investments, and potential relocation to Puerto Rico may offer additional flexibility and/or preferential tax treatment

• Potential to use investments to manage your tax brackets. Some of the investments detailed above may be considered as part of an overall strategy to manage your tax bracket.

Key Considerations/Flags

• Many investments have strict qualification criteria. Depending on the investment, you may need to prove material participation, be an accredited investor, relocate, and/or follow other rules to qualify for the tax benefits.

• Investment risk of loss. Investments should first and foremost be evaluated for their independent risk/reward. Tax benefits can be a nice perk, but should be a secondary concern. The investments noted above may have unattractive risk/reward and/or high risk of loss.

• More complex tax situation. If you utilize one or more of the strategies detailed above, your tax profile and associated tax returns will very likely increase in complexity. This increases the risk of error, as well as will likely require you to pay more to file your tax returns.

Strategy: When to Consider This and When to Avoid It

🟢 When to Consider This Strategy:

• You have an unusually high amount of ordinary wage or self-employment income and want to offset some of it with deductions.

• You have the cash resources to make select investments, and believe they are appropriate for your overall investment portfolio, risk profile, and strategy.

• You are willing and able to meet the qualification criteria required for certain investments.

• You fully understand the investment (some, such as derivatives, may be extremely complex) and are comfortable with the high risks involved.

🔴 When to Not Use This Strategy:

• You do not have the cash resources to make the investment.

• You do not understand the investment, or are in any way concerned about the risk, potential reward, and requirements to invest.

• You do not meet, or are concerned that you will not meet, the requirements to achieve the beneficial tax status (e.g. the requirements to be considered a Real Estate Professional for tax purposes).

Example