In the good old days of American politics, there always seemed to be a push for presidential candidates to release their tax returns.
The media would put out the notion that it was somehow noble for a candidate to pay a lot in taxes. And that’s why the candidates who were savvy businessmen never went along with it. Then the media would speculate about why they refused to show the American people their tax return, seeking to paint them in a bad light.
Ahh, the good old days.
That’s back when presidential debates revolved around meaningless political topics and good old-fashioned mudslinging… rather than assassination attempts and arguments over who’s a he, who’s a she, and who’s an it.
Nostalgia aside, the reason certain presidential candidates didn’t release their tax returns was that they weren’t paying any taxes. Or if they were, their tax rate was minuscule.
The mainstream belief is that the tax code is all about raising revenue for the government to fund civil services. But that’s just not the case.
The federal tax code consists of over 70,000 pages. Yet, less than five percent of those pages are about paying taxes. In other words, less than five percent of the US tax code pertains to collecting revenue for the government.
The other 95 percent of the code is all about how to avoid paying the taxes that the first five percent says we owe. That’s the whole point underlying such a complex code.
So the US tax code is actually about how not to pay taxes. It was written to show “those in the know” how to legally avoid paying taxes. But regular folks can follow it too. We just have to know what the code says.
Now, the Internal Revenue Service (IRS) classifies income in different ways. When it comes to mortgage notes, we need to ensure that the income they generate for us is considered ‘active’ income per the IRS definition.
The easiest way to accomplish this is to invest in mortgage notes through an LLC established specifically to buy mortgages. This unlocks the tax code and allows us to shift a lot of personal expenses to the business… and create some phantom expenses to boot.
Tax-Free Passive Income
Once we have an active LLC up and running, we can shift existing expenses related to business and investing to the LLC. This includes any subscriptions we have that are related to finance, business, investing, or general self-improvement in some way can also become tax-deductible business expenses for us.
Then if we go out to dinner and talk about our business plans, that can become a business expense. If the person we go to dinner with is our business partner who is also on the LLC, we should be able to write off 100% of the meal. If we go out to dinner with someone who isn’t a partner, typically we can only expense 50% of it.
Now, you would likely run your mortgage notes investing LLC out of a home office. If that’s the case, you can also expense a proportionate amount of home office-related expenses. Things like the interest on your mortgage, your power bill, your cable and internet bill, and any home improvements that benefit the office.
The rule is that you can only write off a percentage of these expenses relative to the size of your home office. If your home office makes up 20% of the house, you can write off 20% of these expenses.
That may seem like a small amount at first… but it applies to anything.
For example, I installed a whole-home generator with a 500-pound propane tank several years ago. It was a considerable expense – but I was able to write off a portion of it as a business expense because the generator keeps the home office running when the power goes out – enabling me to continue my work.
So this can be a powerful tax deduction for you. And the key is – these are expenses you would likely incur anyway. With proper tax planning, you can write them off for tax purposes.
Then there are items that you can write off completely as a business expense.
Any office supplies your business uses – they are a full write-off. And if you set up an ‘Accountables’ plan, you can begin deducting personal health & wellness-related expenses as well. That could be huge.
Then there’s the Augusta strategy. It’s a way to create a phantom loss for your mortgage notes investing business.
Creating Phantom Losses
The Augusta strategy involves having your LLC rent out your home for meeting space one day each month at market rental rates. In my area that’s about $1,600 per day.
So the LLC pays you that rent each month, which is an expense to the business. But that income is not taxable to you personally as long as you do this less than 14 times a year. I think once a month is a good cadence.
The rule is that you must have a signed contract for each rental agreement, and the LLC must actually have a business meeting – even if it’s just you in the meeting. But that’s easy. Your meeting can consist of going over the LLC’s books and perhaps analyzing a few mortgage note listings.
Put it all together and you could likely create tens of thousands of dollars in tax deductions each year with these strategies. Those deductions can offset the income your mortgage portfolio generates – potentially making your passive income tax-free.
And if you have enough of them, those deductions can also offset other sources of income as well. Whether that’s income from a job, another active business, or withdrawals from a retirement account – this approach could potentially work wonders for you.
Again, all we’re talking about here is utilizing the US tax code as it’s written. That’s how we make our passive income bulletproof.
The key is to do everything by the book per the tax code. This includes keeping records and receipts to justify our tax deductions in case of an IRS audit.
Of course, an audit is unlikely as long as you do everything by the book – especially after they cut the IRS employee count by 25% earlier this year. But we still need to keep documentation to justify our tax deductions… just in case.
All this is to say that we can create tax-free passive income with mortgages notes… with the right strategies in place. It’s just a matter of understanding the tax code.
-Joe Withrow
P.S. Don’t forget about our The Secret of Mortgage Notes strategy session tomorrow. We’ll kick off at 7:30 pm Eastern, and we’ll cover the ins and outs of how anyone can build tax-free passive income with this asset class.
If you’re interested, you can register to join us right here: https://phoenicianleague.com/session