[The following article by Diane Kennedy appeared on her website at www.TaxLoopholes.com from a link in a free ezine called "What's Hot". For a few dollars each month you can also gain access to a membership subscription site with some very valuable information - knowledge that would cost you a lot if it came from your professional accountant, lawyer, or tax advisor.]

Tax Loopholes: The Government's Carrot

One thing that made me sad after attending eBay Live last week and reading the message boards is the amount of people who believe a tax loophole is 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?

In this week's What's Hot, we're going to take a look at tax loopholes, tax deductions and tax credits. What they are, what the difference is between them, and how you can use them to your advantage.

• Tax Loopholes
• Tax Deductions
• Tax Credits

Tax Loopholes

As many long-time readers and Tax Loopholes seminar attendees know, 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 and paying less tax up front is the carrot.

Another great tax loophole the government has made available to everyone (or at least to homeowners) is the "principal residence gain exclusion" rule. 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. The regular capital gains tax rate is around 15% right now. So if you sold stocks or other securities worth, say, $250,000 you'd pay 15% tax on the money you earned. But if you live in a high-appreciation area like California or New York, you may be better off to keep the stock and sell your house!

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 it's up to you to find them. 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. Whatever you do, don't let their experiences and comments stop you from taking all of the legal tax loopholes available to you to reduce your tax bill.

Tax Deductions

Do you know the difference between a tax deduction and a tax credit?

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 – the first $7,300 of your net taxable income is taxed at 10%, the next $22,400 is taxed at 15%, and so on, until you hit the maximum 35% bracket, when your net taxable income tops $326,450 (these are the 2005 numbers for a single person). 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 benefits. First the business can write off all of the premiums it pays towards health insurance purchased on behalf of its employees. That includes you if you're a employee-owner, and eligible dependents or family members, just as it would at any other job. 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, for example, 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.

S Corporations aren't quite as lucky here. In an S Corporation, employee-owners do have to declare that benefit. So while your company can still write off that $750 monthly premium you have to add all those premiums to your income each year and pay taxes on the money.

Sole proprietors don't fare as well as C Corporations, either – even though a sole proprietorship can deduct health-care costs. That's because the IRS recently clarified where the deduction goes on your personal return.

Currently, sole proprietors must deduct health care premiums from the gross income reported on their Form 1040s. Taxpayer advocates had been pushing to have this deduction moved to the Schedule C instead, which would allow sole proprietors to reduce their business income before self-employment tax was assessed. In other words, taxpayer advocates were trying to have health-care costs treated as a business tax deduction, just the same as C and S Corporations.

Sadly, the argument that health-care costs are business-related and not personal, fell on deaf ears at the IRS. Even though it is standard practice in the business world to offset expenses earnings the IRS continues to insist that health care costs are not deductible from self-employment earnings.

If you're wondering whether to incorporate, consider this: if you pay $750/month for health-care, you're paying almost $1,400 in self-employment tax on that money. What other use could you find for that money?

Tax Credits

A tax credit is quite 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!

Here's a great example of a tax credit that's available to everyone: the tax credit available for those who purchase a hybrid vehicle. This is new for 2006 – up until December 31, 2005, you received a $2,000 tax deduction when you purchased a hybrid vehicle. But now you are eligible for a tax credit of up to $3,150, depending on the type of hybrid vehicle you purchase, and how many the manufacturer has sold (the credit starts to phase out once the manufacturer has sold more than 60,000 hybrid vehicles).

That's up to $3,150 you can apply directly against your taxes due at the end of the day. I think that's a pretty nice loophole myself. I'm also glad I didn't buy a hybrid last year – a $2,000 tax deduction is nice, but a $3,150 tax credit is even nicer!

Here's another example of a great tax credit for those of you who have residential real estate rentals: if you invest some money into your properties to make them more energy efficient you can get a tax credit of up to $500 each year you make improvements. That means you're getting a tax credit to make an improvement to your property that will increase its future value!

At the end of the day my question to you is two-fold:

1. What's not to love about tax loopholes, tax deductions and tax credits?
2. Are you taking all the tax loopholes, tax deductions and tax credits you're entitled to?