Tax Myth Buster Series - The Rich Pay No Taxes

Tax Myth Buster Series

The Rich Pay No Taxes

By Wayne M. Lenell, CPA, PhD

Statement of Tax Myth:

Rich people get away without paying any income taxes.

The myth in the statement above implies that “loopholes” exist so that wealthy American taxpayers pay no income taxes.  Recent news about President Trump’s personal taxes help promote the myth.  President Trump is wealthy and, according to news reports (disputed by the president), has paid virtually no Federal income taxes for several years.  This provides credence to the myth that the rich pay no taxes.

Before we analyze how a wealthy person gets by without paying income taxes, a few statistics, courtesy of the “Tax Foundation,” might be useful. 

●             The top 1% of American taxpayers pay more Federal income tax than the bottom 90% of taxpayers combined.         

●             The top 50% of taxpayers pay 97% of income taxes leaving the bottom half with the responsibility for only 3% of Federal income taxes.

●             The top 1% of taxpayers have an average income tax rate of about 27% compared to the average tax rate of about 4% for the bottom half of taxpayer.

The statistics above apply to taxpayers, not all residents.  Less than one-half of Americans must file tax returns and pay Federal income taxes.  The others (dependent children, retirees living solely on Social Security benefits, the underemployed and unemployed, etc.) pay no income taxes. 

So, if the top 1% of taxpayers pay so much in Federal income taxes, it is logical to ask how some wealthy taxpayers seem to escape paying taxes. This discussion requires some definitions.

●             Wealth does not necessarily equate to income.  A person could have millions of dollars in growth stocks that pay no dividends and be very wealthy, but unless the person sells the stock, that person would have no income from those investments.

●             “Paper” gains, such as increases in the value of stock, or appreciation in the value of real estate, add to the value of a person’s wealth, but do not result in taxable income.  A person recognizes taxable income only upon the sale of those assets.

●             There are legitimate tax deductions that reduce, or even eliminate, taxable income.

President Trump, in his personal life, has gained great wealth through real estate investing.  This type of investment is one that lends itself to large tax deductions.  A significant tax deduction associated with real estate is depreciation.  Tax law allows a taxpayer to deduct a portion of the cost of a building (not land) over a defined period.  Residential real estate, for example, has a “life” of 27.5 years according to tax law.

An example of how depreciation can result in positive cash flow, but no Federal tax liability follows: 

A taxpayer purchases an apartment building for $6 million of which $5.5 million represents the building cost and $.5 million represents the land value.  The taxpayer depreciates the building over a period of 27.5 years so takes a tax deduction of $200,000 annually.  The market value of the apartment increases each year, but unless the taxpayer sells the property, there is no tax on the appreciation in market value.  Though the value of the property is increasing, the taxpayer deducts $200,000 as a business expense.  The depreciation deduction is a “paper” deduction, meaning, that the depreciation deduction does not cost the taxpayer any cash flow.  The taxpayer’s taxable income and expenses might look something like the following.

                Rental income                                                                                   $600,000

                                Mortgage interest                                                                           - 200,000

                                Real estate taxes                                                                              - 100,000

                                Utilities and other operating expenses                                   - 100,000

                                Depreciation                                                                                      - 200,000

                                Taxable income                                                                                 $            0

Since the depreciation deduction does not cost the taxpayer any cash flow, the taxpayer has a positive cash flow of $200,000 annually and pays no Federal income tax on the net rental income. 

Imagine a scenario in which the numbers were much larger and it becomes clear that a real estate investor could enjoy a significant positive cash flow becoming a “one percenter,” yet pay no Federal income tax.  Keep in mind, however, that this tax reprieve is only temporary.  Once the investor sells the property, the investor will “recapture” the depreciation expense, meaning that the investor will pay income tax on all the prior years’ depreciation deductions plus any gains on the excess between the original cost (including improvements) compared to the selling price of the property. 

Some consider depreciation a tax “loophole,” designed to favor only the rich.  While that could be the subject of a lively debate, it is important to understand that depreciation is a tax concept that has survived the test of time.  Following the passage of the 16th Amendment to the Constitution of the United States in 1913, Congress established the Federal income tax system.  From the very first year, and throughout Democratic and Republican administrations and houses of Congress, tides of liberalism and conservatism, depreciation has remained intact.  Though Congress has tinkered with the depreciable periods and methods over the years, the depreciation tax deduction has survived.

While some wealthy Americans slip past taxation through legitimate tax deductions for a few or even many years, the myth that the wealthy pay no income taxes is now busted. Wealthy Americans pay most of the income tax burden for all Americans.