Planet Money - My Favorite Tax Loophole

Episode Date: December 3, 2022

There's a big difference between tax avoidance and tax evasion. But sometimes even avoiding taxes (legally) can feel like you're getting away with something. Today, we share some of our — and your! — favorite loopholes in the U.S. tax code.Subscribe to Planet Money+ in Apple Podcasts or at plus.npr.org/planetmoneyLearn more about sponsor message choices: podcastchoices.com/adchoicesNPR Privacy Policy

Support for NPR and the following message come from the Kauffman Foundation, providing access to opportunities that help people achieve financial stability, upward mobility, and economic prosperity, regardless of race, gender, or geography. Kauffman.org. This is Planet Money from NPR. I found an old accounting joke the other day on the Wisconsin Small Business Development Center website. The joke is somewhat better than that setup makes it sound, but here goes. Three accountants are interviewing for an entry-level position. The CFO asks the first candidate, what's 1 plus 1?

The candidate responds, 2. The CFO shows them the door. Candidate two is asked the same question, same answer, same response, same outcome. Finally, it is candidate three's turn. What's one plus one? Leaning forward in her chair, she says, what do you want it to be? And that is what we are talking about today. How accountants find ways to use the tax code.

Finding little loopholes and provisions to help people avoid paying taxes they don't actually have to pay. Because if the tax code says you can do a thing, you can do the thing. Listener Mike, who's a tax attorney and accountant, actually explains this for us. Take it away, Mike. A taxpayer can arrange their affairs to make their taxes as low as possible, and there is not even a patriotic duty to increase taxes. That ethos has given me a career in helping clients arrange their affairs to only pay the appropriate amount in taxes each year and not anymore.

Mike is saying there is a difference between tax avoidance, when you arrange your affairs to make your taxes as low as possible, and tax evasion, when you owe taxes and just don't pay them, which is cheating. That's not legal. So we asked you, our listeners, to send us your favorite parts of the tax code. And so many of you seemed delighted to finally be asked this question. I've told so many people about this at cocktail parties. It is one of the things that I bring up constantly. My favorite section of the tax code is section 1202. My favorite tax code section to talk about, which is actually my least favorite tax code section.

Section 1291 to 1298. Help me out there, Planet Money, because this is just frustrating, the loving stuff anatomy. Hello and welcome to Planet Money. I'm Mary Childs. Today on the show, tax fun. Your and our absolute favorite parts of the U.S. tax code. We hate to love it. We love to hate it. We just, we have a weird system developed over centuries with rules piled on top of rules.

So we are spending today's show looking for loopholes. And we found so many of them. And here we present the 11 best ones from us and from you, our listeners. We will get down to some funny accounting business. Okay, today we are talking about tax loopholes. All those odd little pockets and things you're allowed to do that you can absolutely do within the limits of the law because it's sitting right there in black and white in the tax code. And yet it sort of feels like you should maybe not be able to do it. And yet it's right

there. So, for example, if you can get your sprawling estate to count as a farm, you get a huge tax break. And depending on your state, it's not that hard to do. Or if you have a Mercedes G-Wagon, that enormous foxy status symbol car, it weighs so much that it can sometimes count as heavy machinery, giving you a tax benefit. And also, apparently, if you hunt giant sea mammals subsistently, there is a tax break for you, which we learned about from a very smart listener. We will be hearing from very smart listeners throughout the show. Hello, I'm Thomas Wynandy, an economist, and I've actually done research using data from the IRS tax code. My favorite gem that I've come across is the fact that you can receive a charitable deduction for whaling.

Not for whales, for whaling. In the case of an individual who is recognized by the Alaska Eskimo Whaling Commission as a whaling captain who engages in such activities during the taxable year, shall be treated for the purposes of this section as a charitable contribution. Okay, that is three quick loopholes. And here to join me in more loopholery is my esteemed colleague, Barrister Jeffrey Guo. Hello, Jeffrey. Hey, Mary.

Hi. Are you so excited about this? I love this idea. Do you know tax was like my favorite class in law school? No, that does make sense. Yeah. Here's a little one for you. You know, you can sometimes write off the cost of cat food. Oh, come on.

Yeah. There's this family that claimed it as a business expense because they ran a junkyard. And the IRS was like, yeah, that checks out. Every junkyard needs a bunch of cats. Wait, why? To scare off the snakes and the rats. They're business cats. That is a legitimate business

expense. That makes sense. Okay. Here comes our fifth loophole. Jeff, have you heard of a 1031 exchange? Oh my God. Yes. This is the one where like, if you have a house and you sell it, you don't have to pay taxes on the profits if you just roll that money into another house. Yes, exactly. And of course you knew that. This one is known now for being a favorite of real estate moguls, but it goes back to cows. The first version of this is from 1921. And originally it was intended to help farmers be able to trade livestock or land, almost to maintain the structure of a barter.

So it applied to anything from industrial equipment to cows and trees. There are a few legal arguments for why this provision exists. First, if someone is trading one thing for another, the profits are not in cash, so they just may not have the money to pay the tax right there. Then there's the problem of valuation. If you've traded one thing for another, there was no price. So how do you assess taxes on a thing with no price? And 1031 exchanges, it became this huge business. There are a lot of people whose entire job is finding and structuring real estate deals to qualify. We should note that in 2017, to raise more tax revenue, Congress made 1031 apply only to real estate.

Wait, what? So this whole thing was created to help farmers trade cows or whatever, and now you can't use it to trade cows? Right. And obviously, this tax break only benefits those who had enough money to invest in real estate in the first place. So it saves taxes for those who are most often best positioned to pay them, which obviously exacerbates inequality. best positioned to pay them, which obviously exacerbates inequality. So that is my pick. That's the tax loophole I will never get over. 1031 exchanges, a multi-billion dollar savings to landowners and real estate investors. That is the one to beat. I doubt any of my beloved colleagues will be able to. Jeff, what do you got? I got a pretty good one. Mine is a trick that lets billionaires get away with paying almost no income tax.

It's called buy, borrow, die. Oh, very metal. It's very metal. And what I love about this way of dodging taxes is that it involves basic fundamental features of the tax system. There's nothing fancy about it. It is the least fancy thing billionaires do, maybe. This is an open secret. Not even a secret.

It's just open. Is this like Tax 101? Tax 101. Manoj Viswanathan is a law professor at UC Hastings. He specializes in tax law. I called him up last week. He was actually having trouble finding a quiet room because he was in the middle of a wedding in India. Manoj says his students are often surprised

when he tells them that Americans are pretty good about paying their taxes. We've got overcompliance. People are more honest than they, as a mathematical matter, need to be. Wait, really? Yeah, yeah. A rational person would, I don't want to give advice on how you should cheat on your taxes, would easily be able to lie on their tax return and get away with paying far fewer taxes.

And yet, Minogue says most Americans don't cheat on their taxes. And maybe one reason why, other than sheer patriotism, is that you can save a lot of money just by playing by the rules. That's what buy, borrow, die is all about. It takes advantage of how we tax income from buying and selling assets, stuff like real estate and stocks. And the rule is, you only pay taxes after you sell something. Like, say you made a big profit on the stock market. You bought some stocks and they went up. You don't have to pay taxes on those profits until you actually sell the stocks.

That sounds fair. You don't have the money until you do the selling. Right, so you're stuck. You can't sell your stocks without getting hit with taxes, but you also want to spend your profits. So what do you do? Manoj says, well, there is a way to avoid paying taxes and to spend some of your new wealth. You can go to the bank. Go to the bank. You can say,

listen, I'd like to borrow some money. They say, well, what do you got? That's collateral. He'll just give you money. It's like, well, I've got this portfolio of stocks that's worth a million dollars. I'm willing to put that up as collateral if you let me borrow $500,000. So the bank gives you a $500,000 loan and you say, well, if I don't pay it back, bank, then you can just take my stocks, which are worth a million dollars. That's right. A couple years ago, the investigative news outlet ProPublica got the tax returns of some of the richest people in America. And what they found was a lot of billionaires weren't paying very much in income tax.

One likely reason why is this buy, borrow, die business. If I have a lot of valuable stocks, I can easily borrow money to fund my lavish lifestyle. When do I pay taxes on it then? Maybe never. What? You would pay tax, maybe never. You might never pay taxes because you could live on borrowed money

for the rest of your life. If you have enough stocks, you can just get new loans or the bank will extend your old loans. And here comes the final piece of the strategy. When you die, all those taxes on your stock market profits get wiped away. It's called a step-up in basis. Your basis is like what you originally paid for your stocks, and it's how you calculate your profits. That gets stepped up when you die. And so the people inheriting your

stuff, they get a clean slate. They don't have to pay any federal income tax on all of your stock market profits. Why? Why do we do this? It's just easy to do. That's the argument. If you bought the stock a long time ago, maybe it's hard to find records of what you paid for it. If I have like billions of dollars in stock, the argument is I might have forgotten how much I paid for it. That's right. The step up in basis is a time honored, well-known way that the tax system works. It's been around since before the 1920s. And it's like the cherry on top of this buy, borrow, die strategy. In theory, you and your descendants can just keep borrowing and dying and avoid paying income taxes forever. Okay, that does sound pretty good. I honestly

was skeptical. I thought that 1031 was really strong, but yours sounds like it might be bigger. Is that right? It's an infinite money glitch, Mary. And you know, it's not just for stock market profits. Regular people can use buy, borrow, die and the step up in basis to save money when they inherit homes from their parents. It's a big giveaway to anybody who has stuff to inherit. Buy, borrow, die. Not just for billionaires. I will be trying that when I die. Me too. Can't wait.

Thank you, Jeff. Thanks, Mary. So by now we have heard fun, easy ways to save money on taxes when you have a lot of stuff that can be taxed. And what about whales? We have a bunch more to go, including a loophole that's a bit more democratic, but one that can also backfire very easily. That's after the break. Hi, Planet Money. My name is Dominic. I'm in Denver.

My eldest daughter was born with a pretty significant mobility challenge. So then we looked and waited and found a beautiful ranch. The cool thing is the architect designed the house to meet that accommodation. So it's a beautiful house, it's completely ADA accessible. Then when you go through and you build the house or renovate the house, that all turns into a qualifying medical expense. And so that qualifying medical expense you can write off on your taxes. So great place to live. Hello, Planet Money.

This is Gannett. I live in Shenzhen, China, and I make my money in China. And I am still responsible to pay taxes in the U.S. in a file every year. But luckily, there's this form called the F-E-I-E or good old form 2555. And basically, it says that if you're an actual resident living abroad, then you don't have to pay federal taxes, which has gotten me out of a lot, seeing as how, you know, for three years of my life, I was living in China and definitely not in the U.S. Hey, Planet Money. I'm an expat living overseas and I've been overseas for over 13 years,

and it is a real pain in the bum to have to do two tax returns every year. I am so glad to only have to file one taxes. Okay, so we have heard how to roll our profits from the apartment complexes we definitely own into new, bigger, better apartment complexes without paying taxes possibly forever. Amazing stuff. We heard about the very favorite loophole among billionaires. We are now down to our last few loopholes. Next up, Kenny Malone. What do you got, Kenny? Well, Mary, you know, we've been talking about loopholes for the rich,

for the 1%, for the monocled and top-hatted. Yes? Yes. Well, the tax shelter I want to talk about. The thing I love is not for the 1%. This is the Working Joe's tax break. It is actively encouraged by employers in the United States. It is the health flexible spending account. Ah, the FSA. The FSA. Yes, I have dabbled in an FSA. This is a way to set aside some of your paycheck for a special, flexible account that lets you pay for health stuff. Yeah, that's right. So it would cover stuff that isn't covered by insurance. So I don't know, like Excedrin migraine, ACE bandages, even your co-pays, for example. like Excedrin Migraine, Ace Bandages, even your co-pays, for example, you can pay for all of this stuff with pre-tax money. That's the sell. And they are the best, but also the worst. To help us understand why, allow me to introduce you to Regina Achempong.

So I'm a senior director for global operations for a cybersecurity tech firm. And of course, we can't say anything beyond that. Very high, very hush hush. A little bit, a little bit. Now, a few weeks ago at work, Regina says HR sent out this company-wide email. And they sent out a reminder of, hey, don't forget you have money in your FSA

and if you don't use it, you lose it. And then it was like the light bulb went off for me. That light bulb being, oh crap, I did sign up for an FSA this year, didn't I? And Mary, you probably know this, but FSAs have this stipulation, of course. Yes, use it or lose it. Use it or lose it, right.

Now, depending on your employer's rules, you might have to spend all of your money by the end of the year, which Regina says was her case. The problem was she totally forgot how much she had put into her flexible spending account. Yeah. I logged in and it showed my balance of like, it was a little over $2,000? Yeah. No. So. Yeah. So Regina had to figure out how to spend $2,000 on health stuff in like a month. But Mary, I do want to step back here for a second because the FSA traces back to a pretty incredible period in American history, in American tax dodgery history, if I may. Oh, you may.

Okay. I figured you would be enticed. Okay. So in the 50s and 60s, corporate execs would do this thing where they would say, hey, hey, a company that I run, don't pay me with more money, which gets taxed. Maybe just throw me some perks, a company car, stock options, cover all my family's health-related expenses. Basically, instead of money, pay for my lifestyle. Right. Classic. Reduce the taxable income, get compensated in other ways. Yeah, that's exactly right. And in 1978, there was this big tax code overhaul that addressed this by taking those executive perks and allowing all of us to get those. It put them in writing that any of us are allowed to do it.

In fact, it explicitly says those kinds of perks aren't just for C-suite folks. Wow. That is the American way. It is the democratization of tax avoidance. That's right. And so, you know, the FSA sort of evolved from that milieu. And it can be a useful thing, of course. Like if you have predictable health expenses or God forbid, if you end up in the hospital unexpectedly, like it can be a huge relief to know that you have this pool of untaxed money to help you out. But this gets to the reason I have a love-hate relationship with FSAs.

What if you find yourself in the same situation as Regina at Shempong? Yes. If you have just one month to spend $2,000 on exclusively IRS-approved healthcare crap. That's right, yes. So I literally solicited some guidance on Twitter. What am I going to do with this? With this $2,000. At one of the first responses on Twitter, Regina's brother, actually. My brother was like, hey, I need another massage gun

because I don't know what happened to mine. Sure, why not? That goes in the shopping cart. Then my mom said she wanted to try using a body pillow because I used them, got her one. And then some heel cream, put that in the shopping cart. To make sure my feet are nice and soft. So they had some of that. This is probably overpriced to be fair, but again, need to spend the money. All right. So we got that. What else we got? And then, so I love Black Girl Sunscreen. It's really great. Is it 10 of them? It says 10 of them? It's 10 because I figure, I do believe for the things that you use all the time, buy them in bulk. So this will last me probably like two to three years. And by the way, sunscreen is supposed to last three years,

according to the Mayo Clinic. So this is good to know if you are ever in this situation. But anyway, six jars of multivitamins, two bottles of contact solution, two massage guns, two body pillows later. Total was $1,062.29. Now, of course, that does still leave roughly $1,000, right? It does. It does. Could you do 40 bottles of sunscreen or that would probably not last three years? 40 bottles, I definitely would not use that in three years. That's a lot of sunscreen. That is too much sunscreen, Kenny. It's just too much.

Maybe it's too much. Maybe it's too much. I don't know. But listen, this is your warning to everybody out. It's just too much. Maybe it's too much. Maybe it's too much. I don't know. But listen, this is your warning to everybody out there with health FSAs. The IRS did let us carry over our entire balance during the pandemic if your employer was on board. But that is over. It's back to basically use it or lose it again. And Regina, she is determined to use it, all $2,000. And she's thinking like, I don't know, maybe some eyeglasses, maybe that'll get her there. She's open to suggestions from listeners if you have any. And I will also say that Regina did just go through open enrollment again at work, which meant she had another chance to sign up again for the old health FSA. No, no, thank you. I will just spend as I go. I think you just got to have a

strategy going in and I absolutely did not. And so that's, that's my fault there. Yeah. So have a strategy and remember, spend your FSA if you've got it, do it. Now is the time. That's great. Thank you so much, Kenny and Regina. Thank you. Hey, Planet Money. My favorite part of the tax code is explained by IRS topic number 415, titled Renting Residential and Vacation Property. A big TV show came by our house and asked if we would rent it out to them to film in. And my wife and I were planning to set aside a portion of the money they were going to pay us to pay our taxes.

But then we found out that this rule explains that if you rent your house out for fewer than 15 days per year, you don't have to report any of the rental income. Tax-free income. Tax-free income. To me, what all this shows is we're doing all these backbends to get tax breaks, to make sure we're getting every last incentive, thinking we're being really clever and taking advantage of the tax code. But also, the tax code is changing us. It's distorting our behaviors and making us jump through all of these loopholes. So now for our last contributor, Sarah Gonzalez, thank you for joining. We're doing this show, as you know, on our favorite tax loopholes. And I wanted to know yours. What is your favorite tax loophole? I don't think I know any tax loopholes. I definitely don't look. I

don't seek out tax loopholes. Yeah, I like paying taxes. I'm a tax girl. You're a tax girl. I like genuinely think we should pay for the things that tax dollars go to. But like I do. There is a reason. There is a reason why I think this. And this comes from a fire in my apartment in New York City one year. I was on the top floor and like 14 firefighters showed up. They were on the roof.

They were climbing up everyone's balcony. It was like a huge ordeal. And after the firefighters put out my fire, I was like, are you guys going to like send me a bill? Do I owe you guys something? And the firefighters went, no, you were right to call us. This is what we're supposed to do. And after that, I was like, I will like forever be grateful that I can like tap into these resources. So that's part of it. But the other part is that I just personally don't want to spend my time learning about the loopholes to avoid paying taxes. Like I would genuinely

rather pay money to avoid having to learn about the loopholes. Well, I'm glad that you took advantage of public services and that they delivered, that it worked out really well. That's a scary story, and I'm glad that it turned out not scary. Okay, Sarah Gonzalez, tax girl, thank you so much. Of course, anytime. You can email us. We are planetmoney at npr.org. Or find us on TikTok, Instagram, all of the socials.

We are at Planet Money. Our show today was produced by Sam Yellow Horse Kessler with help from Willa Rubin. It was mastered by Natasha Branch, fact-checked by Sierra Juarez, and edited by Jess Chang. A huge thank you to all the scores of listeners who wrote in. We listen to all of them and we treasure each one. Thank you also to professor and tax law specialist Stephen Bank at UCLA. I'm Mary Childs. This is NPR. Thanks for listening. But okay, if you were counting, you might have noticed that we promised you 11 loopholes and delivered 10. Because Sarah didn't believe in the conceit, which is within her rights. So here is an 11th.

It is extra close to our hearts and our wallets. I call it up. TikTok person Jack Corbett. There's this kind of like this organization that you can donate to. It's called National Public Radio. And donations are tax deductible. Ah, the classic exemption for a 501c3 nonprofit. So when did you make your first donation to NPR?

I got to be honest. I've never. You haven't. I've never donated to NPR. I'm a long-time listener, zero-time donator. Should we do it right now? Let me see. Let me donate.

Oh, my God. It says there's like a little button with a heart on it. Ooh, select donation type monthly or one time. Got to be honest. It's going to be one time. All right. I'm going to donate now. $1,000.

Jack, be careful. $10. So, and there's a little box. I just said, it says, tell us why you think it's important to support public radio. All right, what am I going to put right here? Because I work for you, exclamation.

That's so nice. Okay, thank you, Jack. Yeah, for sure. You mind if I like CC you on my like expense, when I expense this? Absolutely, put my name down. It'll be my honor. Okay, thanks, Mary. And a special thanks to down. It would be my honor. Thanks, Mary.

And a special thanks to our funder, the Alfred P. Sloan Foundation, for helping to support this podcast.