The Tax Man Cometh, Be Not Afraid!

“Intelligence pushes you toward the idea that complex problems require complex solutions.”

Morgan Housel, expert in the psychology of money, author*

Paying taxes often causes a visceral reaction. I get it! It is probably the single most painful financial task we face on an annual basis. Furthermore, many of you recently received large contract bonus paychecks. For some of you, income taxes will be withheld up front, while others, because of under-withholding, may owe a large tax bill next April when tax-year 2024 income taxes are due.

This angry, visceral reaction causes us to go to great lengths to outsmart the tax man. Many of us seek complex solutions to avoid taxes at all costs. Unfortunately, this sometimes leads to bad investment decisions or large, unwanted purchases (trucks, tractors, airplanes!) that we may not want or need, all in the name of reducing our tax bill. Do not let the tax tail wag the dog! In the world of investing This is easier said than done and akin to buying high and selling low.

While there are effective strategies to reduce our tax burden, we should not do things that reduce our overall wealth and net worth.

Pilots are known for their type-A personalities and “get ‘er done” attitudes. Pilots work hard to solve problems and make things happen under very difficult circumstances. However, it is human nature to spurn the simple solution for the complex. This phenomenon is called “the complexity bias.” https://fs.blog/complexity-bias/

Be aware that complex tax-reduction solutions often come with higher IRS audit risk, as well as risks of repayment penalties and interest. Extreme cases may even warrant prison time. For some good entertainment while you are waiting on your delayed flight, simply google the following, “Airline Pilot Tax Fraud.” You will find some very interesting characters doing things to evade taxes that might sound familiar and not too farfetched given some of the conversations we’ve had on the flight deck!

Rule number 1: Do not reduce your wealth and net worth in order to stick it to the tax man!

Rule number 2: Do not seek out complex tax strategies that heighten the risk of an IRS audit when there are several simple, audit risk-free strategies to reduce your lifetime income tax burden.

Rule number 3: Do not spend money on big-ticket items that you do not want or need in order to reduce your tax bill. This is mathematically equivalent to spending one dollar to save thirty cents.

Rule number 4: Reducing your income-tax burden over your lifetime may be more profitable than reducing your current tax bill.

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Below are four tax ideas that can help you legally avoid paying more taxes than you are required to pay. But first here are three strategies that require special care and attention to detail in order to avoid gaining the attention of the IRS:

1. My captain house is in Chicago, but I have a small condo in Florida where I am a resident.

Many high-tax states get very aggressive about going after folks who reside in their state but claim residence of another state. Of course, there are circumstances where this is legitimate, but use caution and keep extensive documentation.

You can google the requirements to be an actual resident of (Florida, Texas, Tennessee, Nevada, etc.) but here are a just a few that are standard in most states:

• Spend 183 days or more in the state in which you claim to be a resident.
• Enroll your children in school there.
• Register to vote.
• Receive your mail.
• No tiny homes.
  • For example, New York will look at the size of your house in Florida to make sure your residence in Florida is similar in size to your captain mansion in New York. Evidently purchasing a tiny home or small condo in Florida is a tell-tale sign that you don’t spend much time there.
• Linked here is a great article from Kiplinger that goes into more detail about how to be a legitimate resident of the state of Florida.
  • What are the requirements?

2. I want to deduct the costs of my airplane because I’m teaching my kid how to fly.

The details of when and how to deduct airplane expenses are very complicated and beyond the scope of this article. However, here are a few things to keep in mind.

• You cannot deduct the cost of your airplane (depreciation) unless it is used more than 50% of the time for your (legitimate) business.
• It is not a deductible expense because you need to keep your flying ratings current.
• If at any time during the depreciable life of the airplane when personal use exceeds 50%, there will be an immediate depreciation recapture. (I.e., you will owe a lot of taxes all at once.)

3. I want to invest in real estate so I can deduct losses against my airline income.

Remember rule number one, do not reduce your wealth to save taxes. It is not uncommon to see bad investments in real estate when high-income pilots are desperate to reduce their tax burden. In fact, it seems that we almost feel an obligation to purchase real estate solely for the tax deductions at a certain income level. I have heard many pilots confess that they must not be very tax savvy because they do have a real estate investment – or three. Here are a few things to know before jumping into real estate investing:

• Over a certain income level (currently $150,000) you cannot deduct real estate losses against your airline income. For example, if you replace the roof on your rental home and therefore show a loss of $10,000 on your rental property income statement you cannot deduct the loss against your current airline income. (However, the loss can be carried over.)
  • Note: If you are considered a Real Estate Professional, the above may not apply. Being a real-estate professional is a very high standard set by the IRS and is nearly impossible for an airline pilot to obtain unless they have a spouse, “in the business.”
• Real Estate can be a great investment. However, there is one rule of thumb I read a long time ago about real-estate investing that is good to keep in mind; in real estate investing you need to make money on three occasions; when you buy, when you rent and when you sell. That is not easy to do!
• If you do not enjoy being a landlord and managing the business of real estate, I would avoid it altogether. There is no tax deduction worth making you miserable. If you plan to hire a property-management firm to delegate the pain, make sure they don’t eat into your profits too much. Some agencies can charge as much as 30% or more depending on the level of support. There are cheaper ways to invest in real estate if your costs become excessive. (Publicly traded Real Estate Investment Trusts aka REITs.)

Finally, here are four smart, simple ways to reduce your income tax burden over your lifetime.

• Backdoor Roth
  • This strategy is based on the IRS rule that anyone, regardless of income, can contribute to an after-tax, non-deductible traditional IRA.
  • Secondly, anyone, regardless of income, can convert a traditional IRA to a Roth IRA if they pay the taxes on the gains (if any) in the traditional IRA.
    • There are more things to know before executing the back-door Roth IRA, so as usual, consult your tax and investment advisor.
• Health Savings Account
  • If you are relatively healthy and only see the doctor for preventative care and the occasional sniffles, a high-deductible health plan may be right for you. If that is the case, a Health Savings Account (HSA) is a great tax savings account. It is the only account in existence with triple tax savings: tax deductible savings, investments grow tax free and if monies are used for qualified medical expenses, withdrawals are tax free.
• Taxable Brokerage accounts (non-IRA, non-401k investment accounts)
  • This is the most overlooked and advantageous account once you’ve maximized your 401k and potentially the (back-door) Roth IRA. The taxable brokerage account is very flexible. There are no contribution limits and no withdrawal penalties. It is taxed at capital gains tax rates, which for most of you is much lower than your income tax rate. Finally, if you invest in low-turnover mutual funds (index funds) and Exchange Traded Funds (ETFs), you can essentially create your own tax-deferred growth.
• Real Estate
  • Even though I bashed real estate previously, it can be great for rental income and investment diversification. People can be very successful investing in real estate if they enjoy putting in some sweat equity and managing the rentals themselves.
    • Short-term rentals may qualify for cost segregation, bonus depreciation.
• Bonus: Take your new contract-ratification bonus and buy an electric vehicle. If you make less than $300,000 adjusted gross income, you may qualify for a federal tax credit of $7,500!

Resources:

Morgan Housel CNBC article: “Why the smartest people make bad decisions – compared to those with average IQ.”

How to establish Florida residency? Kiplinger Article

Real Estate Cost Segregation Study