Tax Loophole … Tax Credit, or Tax Deduction? Do You Know the Difference?

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One thing that still makes me sad is hearing people talk about “loopholes” as a code word for something dodgy or illegal.

Nothing could be further from the truth! Tax loopholes are consciously and actively created by governments in the US and around the world as a way to stimulate the economy. If they were illegal, immoral or unethical, why would the government create them in the first place?

Most tax loopholes create one of two things: either a tax deduction, or a tax credit. Do you know the difference between the two? More importantly, do you know how to use that difference to your advantage in your tax-planning?

Tax Loopholes

A tax loophole is nothing more than a government incentive to promote some type of public policy. It’s a carrot the government is holding out to you, to entice you to do something the government wants you to do.

An IRA or 401(k) plan is a tax loophole. Every dollar you contribute to your tax-deferred retirement plan goes in without you paying tax on it first. You deduct each year’s contributions from your gross income. The government likes this, because by contributing to your own retirement you are reducing the burden on social assistance in the future. So, deducting those contributions from your gross income is the carrot.

The “principal residence gain exclusion” is another loophole. This says that once you’ve lived in your home for 2 of the previous 5 years you can sell your home and take the first $250,000 in profit ($500,000 if you’re married, filing jointly) tax-free. Yet most other assets that you sell come with a capital gain tax bill of 15% of the sale price.

I believe that most misunderstandings around tax loopholes stem from the fact that governments don’t make loopholes widely known. They’re out there – but they’re up to you to find. And in some ways I can understand why. The IRS Code in the US isn’t just one piece of legislation. It’s actually hundreds of thousands of pages from a number of sources – hardly light Sunday afternoon reading! To make matters worse, Congress often slips tax loopholes into other bills – who would think to look for a tax change in a piece of legislation about how organic food is certified?

So the next time you hear tax loopholes mentioned in a negative light, take what you hear with a big grain of salt. The person making the comment may not really understand what a tax loophole is, or they may have tried to use loopholes improperly and run into IRS troubles.

Tax Deductions

A tax deduction is something you take off your income before arriving at your net taxable income (the figure you’ll calculate any tax on). If you’re a business owner, tax deductions are things like your phone bill, car expenses, packaging and shipping supplies, salaries, utilities, and so on. The more tax deductions you take the lower your net taxable income will be, and, therefore, the lower your corresponding tax will be. Remember, taxes are assessed on a sliding scale, so the lower your net taxable income, the fewer tax rungs you’ll have to climb.

One great example of a tax deduction is health insurance. If you’re a business owner and you operate through a C Corporation, then you actually get two tax deductions. First the business can write off all of the premiums it pays towards health insurance purchased on behalf of its employees. Second, as an employee of a C Corporation (even if you’re also the owner) you don’t have to declare the value of the medical benefits you receive, because they’re considered non-taxable benefits by the IRS. If your monthly premium is $750, the company writes that amount off and you don’t declare it on your tax return. This is one of the biggest reasons many small businesses decide to operate as C Corporations.

Tax Credits

A tax credit is different from a tax deduction. A tax credit is applied against the tax you’ve just calculated from your net taxable income.

Let’s say you took advantage of all of the tax loopholes and found as many tax deductions as you could, and wound up with $25,000 in net taxable income. After you calculate your taxes owing at the federal and state level (if applicable), let’s say you wind up with a tax bill of $3,000. A tax credit will directly reduce that $3,000 amount. So it’s like a tax deduction for your tax!

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