Tax-advantaged income generators offer major benefits to sophisticated investors
When it comes to investing, the returns you make aren’t all that matter – the endgame is also about how much cash stays in your pocket after taxes.
In the first installment of our two-part series on investments that offer the biggest tax breaks, we considered several insurance products that can help you achieve your retirement goals with major tax advantages. Now we will explore tax-advantaged income generators that offer a significant opportunity to manage, defer, and reduce how much of your cash is claimed by Uncle Sam.
Investing tax efficiently doesn’t have to be complicated, but advanced tax planning allows you to be strategic about the opportunities you choose to build wealth. While investment strategies shouldn’t be based solely on taxes, the better your tax awareness, the better your returns are likely to be.
Congress eliminated most classic tax shelters in the ‘80s, but a new breed of tax-advantaged income generators has emerged that offer a legal way to lower your taxable income. Top among these choices are investing in oil and gas, equipment leasing, and master limited partnership programs.
These investments take advantage of partnership tax benefits and depreciation deductions to pay substantial tax-advantaged incomes. And while they are subject to the passive loss and at-risk rules intended to bring a screeching halt to 1980s-style tax shelter abuses, they offer solid tax benefits to investors willing to consider more sophisticated investment opportunities.
- Oil and gas. Investors looking for tax-advantaged income combined with potential capital appreciation can reap significant rewards from oil and gas programs. The value of your investment is directly linked to the value of the oil in the ground, adding diversity to your investment portfolio.
So many tax breaks are available to the oil and gas industry that Investopedia writes, “No other investment category in America can compete.” The U.S. government is so committed to developing its domestic energy infrastructure that some programs offer enough deductibles to write off your entire investment in the first year – providing a valuable way to offset capital gains from the sale of other investments.
There are also no income or net-worth limitations, other than a small producer limit to qualify for a depletion allowance. That means even the wealthiest investor can invest in oil and gas and receive these extraordinary tax benefits as long as they limit their ownership to 1,000 barrels of oil per day:
- Intangible drilling and development costs are 100 percent deductible, including labor, fuel, supplies, and any other expenses of drilling a well. These expenses generally comprise up to 80 percent of drilling costs – meaning if intangible costs are $300,000, a whopping $240,000 could be deducted in the year they’re incurred. This is true even if the well doesn’t produce or strike oil. This generous deduction is also exempt from serving as a preference item on an alternative minimum tax return.
- Tangible drilling costs – generally the equipment used to extract resources – are also 100 percent deductible but must be depreciated over seven years.
Interestyou pay to finance the program is deductible.
- Small companies and investors can exclude 15 percent of gross income from oil and gas wells as a “depletion allowance” – a nod to the economic reality that the well will eventually run dry.
- Lease costs can be deducted over the life of the lease through the depletion allowance, including the purchase of lease and mineral rights and lease operating costs.
- A working interest in an oil and gas well is considered an active activity, not a passive one. That means all net losses are active income and can be used to offset other forms of income, including interest and capital gains.
- Equipment leasing. Investors join together in equipment leasing programs to purchase assets or equipment ranging from machinery to ships that they can lease to interested parties. The investors receive any income that’s generated, along with generous depreciation deductions that shelter your earnings from income tax.
Thanks to accelerated depreciation rules, you can front-load your deductions to achieve the biggest savings during the first years of ownership. This depreciation combines with upfront costs and interest on any borrowed capital to shelter your income for the first years of the lease.
The new tax code makes this program even more attractive, making more properties eligible for quicker depreciation and offering more flexibility in deciding which depreciation options to use. For instance, new bonus depreciation rules enable you to immediately deduct 100 percent of the cost of eligible property as an expense in the year it’s placed in service through 2022.
- Master limited partnerships (MLP). Put simply, MLPs are publicly traded limited partnerships that combine the tax benefits of partnership with the liquidity of a public company. Many are involved in real estate or finance, and the biggest ones focus on the transportation of fuel.
MLPs don’t pay tax themselves – rather income and deductions “pass through” to the investors who own them. That means many are eligible to reap the rewards of the tax code’s new 20 percent pass-through deduction – the most significant tax break to small business owners in decades.
This partnership structure also helps investors achieve higher yields by avoiding the double taxation that plagues corporations. When this occurs, the business pays corporate income tax and then shareholders also pay personal taxes on income from their stocks.
Depreciation and depletion deductions are passed on to the limited partners as well, further reducing their taxable income. Another major tax advantage is that quarterly distributions are treated as a return of capital instead of income, enabling investors to avoid paying income tax. In fact, most earnings are tax-deferred until the units are sold, and then they’re taxed at the lower capital gains rate instead of an investor’s higher personal income rate.
Tax efficiency is essential to maximizing returns. Tax-advantaged income generators offer a legal way to shelter all or some of your investment income from taxation – minimizing your tax burden and increasing your net returns. The complexities of investing and the new tax laws make it difficult for most people to understand which products are best suited to helping them achieve their financial goals. A qualified financial advisor can help you select the right kind of investment to grow your wealth while keeping as much as you can in your pocket instead of Uncle Sam’s.
Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on tax planning, and to find out how we can help your business exceed your expectations.