How the wealthy pay less tax: the line between income and wealth, and the empty suite that does not exist

The one line

I once sat across from a man who earned more in a year than most people earn in a career and who was angry that a billionaire he read about paid less tax than he did. He was right about the fact and wrong about the reason. The billionaire did not have a better accountant. The billionaire had a different kind of money. Pay is income, and the code taxes income the year it arrives, at rates that climb with the amount, and beyond the accounts, the entity, and the state, there is little to be done about pay. Assets are wealth, and the code taxes wealth only when it moves: when something is sold, given, or inherited. A share that rose from ten dollars to a thousand and was never sold has produced no tax, and no law says it must. Most of what the very rich have is exactly that: stock, buildings, and companies that rose and were never sold. That is the whole answer, and everything on this page is a footnote to it.

What the newspapers call buy, borrow, die

If the assets are never sold, how does the owner live? By borrowing against them. A bank will lend against a large stock position or a building at a low rate, and a loan is not income; it is not taxed at all. The owner spends the loan, the assets keep rising, and the interest is often smaller than the tax a sale would have cost. At death the assets pass to heirs, and the law gives them a new cost basis equal to the value on that day, which erases the lifetime gain for tax purposes. The loans are repaid from the estate. The gain that built for fifty years is never taxed by anyone. That pattern has a nickname in the newspapers, buy, borrow, die, and it is legal as the code stands. It is also only available to people whose money is already wealth, which is why the man across the table could not use it, and why the way to become someone who can is the boring one: turn income into assets and hold them.

The tools around the center

Real estate converts cash flow into paper loss. A building is depreciated over decades, meaning a slice of its cost is deducted every year even as it rises in value, and a cost segregation study pulls parts of that deduction forward. The building can show a loss on the return while putting cash in the owner's pocket. Those losses are normally passive and can only offset passive income, which is the wall a salaried person hits; a person who qualifies as a real estate professional under the rules can use them against other income, which is the exception the wealthy meet by actually working in real estate. When a building is sold, the depreciation taken is recaptured and taxed, unless the owner exchanges into another building under the like kind rules and defers it again, and again, until the step up at death makes it disappear.

Municipal bonds pay interest that federal tax does not touch, which at the top rate is worth more than a higher taxable yield. Giving with appreciated stock avoids the gain and takes the deduction; a donor advised fund lets a person bunch several years of giving into one for the deduction and give from it slowly; a charitable remainder trust sells an appreciated asset without immediate tax and pays the donor income for life, with the rest going to charity. Owners can open retirement plans, a cash balance plan on top of a 401(k), that shelter several hundred thousand a year at high income, deductible now and taxed later. Deferred compensation pushes pay into lower earning years. A founder's stock held under the right conditions may qualify for a large exclusion from federal tax on the gain when sold. The state a person lives in decides a slice of every year that dwarfs any fee, under residency rules that are strict and audited. And at the top, trusts move the future growth of an asset to heirs while the giver is alive, so it is never in the estate to be taxed at death.

The empty suite, corrected

A story goes around that the way to use commercial property is to buy a building, always leave one suite empty, claim the empty suite as a loss, keep making improvements, and claim losses every year while building equity. Here is what is true inside it, and what is not. A building's expenses, property tax, insurance, interest, management, and above all depreciation, are deductible whether the suites are full or empty. Improvements are added to the building's cost and depreciated over time, some of them faster under rules for certain interior improvements. So a building can and often does show a loss on paper while it pays the owner cash and rises in value, with the loan paid down by the tenants' rent. That is the real thing, and it is a good thing to understand.

What is not true is the suite. Rent you did not receive is not a deduction; there is no line on a tax return for income you chose not to have. An empty suite reduces your income and changes nothing about your deductions, which are the same whether it is full or not. A deliberately vacant unit is a cost with no benefit, and a pattern of it invites questions rather than deductions. And the losses are not yearly forever: depreciation runs on a schedule, passive losses are walled off from salary for most people, and the depreciation comes back as recapture at sale unless it is exchanged forward. The person who told the story had heard about depreciation, improvements, and leverage, which are real, and remembered an empty suite, which is not.

A worked example

An owner buys a small commercial building for $1,500,000, of which $1,200,000 is the building and $300,000 is land, which is not depreciated. The building depreciates over the nonresidential schedule, roughly $30,800 a year. Rents bring in $150,000 a year and expenses, interest, tax, insurance, and management, run $110,000, leaving $40,000 in cash. On the return, the $30,800 of depreciation comes off too, so the taxable income from the building is about $9,200 while $40,000 landed in the bank. A cost segregation study might move a larger slice of the building into shorter schedules and turn that $9,200 into a paper loss for several years. Whether that loss can touch the owner's salary depends on whether they meet the real estate professional test; if not, it waits for passive income or for the sale. Ten years on, the building has been paid down by tenants and may be worth more, and the owner can sell and pay tax on the gain and the recaptured depreciation, or exchange into a larger building and defer all of it. None of those numbers include the empty suite, because the empty suite was never part of it.

What does not work

Losses you did not actually suffer. Expenses that were not actually for the business. Residency claimed on paper and lived elsewhere. Trusts where the giver keeps control. Anything sold as eliminating tax on ordinary salary, which no legal tool does. The rules that pull these back are old, tested, and enforced most eagerly against the people who can afford to try them.

Questions to answer before you leave this page

How much of what you have is income this year, and how much is wealth already turned into assets? Which of the tools above apply to your kind of money, and which are for a kind you do not have yet? If you own or are considering property, would you qualify as a real estate professional, and if not, what would the losses actually offset? Have you checked the building story against the depreciation schedule, the passive loss rules, and recapture, rather than against the person who told it? And who, licensed and paid by you rather than by a product, is going to check the arithmetic?