Tax Loopholes for All Classes That Could Save You Big Bucks

A tax loophole is an acceptable and efficient way to reduce the taxes you owe to the government.

In a nutshell, a loophole in tax rules is a set of unforeseen conditions and circumstances that negate or nullify the scope and perimeters established in implementing a particular tax provision.

The good thing about tax loopholes is that there are several examples and workarounds that low, middle, and high-income earners can each benefit from.

So if you want to learn all about tax loopholes, how they work, and how to apply them, read on!

Key Takeaways

• A tax loophole is a discrepancy in the legislation of taxes that creates a leeway for taxpayers to reduce their tax liability.
• The most common examples of tax loopholes are Carried Interest Loopholes, Backdoor Roth IRAs, and Foreign Derived Intangible Income (FDII).
• American opportunity tax, saver’s tax credit, and earner income tax are tax loopholes for low-income taxpayers.
• Capital gains tax, high-income mortgage interest deduction, and carried interest loophole are loopholes ideal for high-income earners.
• Middle-income earners can take advantage of mortgage interest deductions, lifetime learning credits, child tax credits, retirement savings accounts, etc.

What is a Tax Loophole?

A tax loophole is a legally acceptable ‘method’ of reducing tax liabilities. It results from a discrepancy in existing tax legislation or provisions. As a result, corporations use loopholes to reduce their taxable earnings.

The majority of tax loopholes are unintentional. Most of these flaws were unanticipated at the time when the policies were drafted.

Once the discrepancies are detected, federal, state, or local governing bodies amend the legislation and resolve the loophole. In comparison, tax deductions are deliberately prepared systems to help taxpayers regulate their taxes due and save more.

Tax Loophole Examples

The following are the most common tax loophole examples:

#1. The Carried Interest Loophole

This tax loophole involves a carried interest or the percentages of profits earned by general partners from overseeing private equity, venture capital, and hedge funds. At least 20% of returns from funds are earned by general partners as incentive compensation.

Since general partners earn carried interest only when the trust reaches a specific return amount, the said interest is often categorized as a return on investment. This also means that the carried interest is not taxed as regular income but rather as capital gains.

If an investment’s carried interests are held for over three years, the interest qualifies for a maximum tax rate of 20% on capital gains.

#2. Backdoor Roth IRAs

Roth IRA is a highly preferred type of retirement savings account because it potentially paves the way for tax-free earnings. There are two ways in which you can prepare for a backdoor Roth IRA.

The first one is to contribute to a traditional IRA before converting to a Roth IRA. It is important to ensure you do not incur balances in your traditional IRA account and wait for the requisite holding period. This is to ensure taxation will not be levied on your conversions.

Converting a traditional IRA to a Roth IRA entails filling out IRS Form 8606.

Aside from your traditional IRA, you can also set up a backdoor Roth IRA using your 401(k). However, this will depend on your 401(k) plan, as some plans do not allow the automatic conversion of contributions into Roth IRAs.

#3. Foreign Derived Intangible Income (FDII)

Exported goods linked to or associated with copyrights, trademarks, patents, and other forms of intangible assets are taxed at lower rates. The reduced tax rates were part of the Congress’ Tax Cuts and Jobs Act of 2017, wherein the taxes were lowered from 21% to 13.125%.

Now, how does FDII work as a tax loophole? Given that the tax rates for FDII are 13.125%, corporations whose income is related to the exportation of goods and services can subtract up to 37.5% of their foreign-derived intangible income from their taxable earnings.

Tax Loopholes for Low-Income Earners

Contrary to popular belief, tax loopholes are not reserved for corporations and high-income taxpayers alone. Low-income earners may also take advantage of the following tax loopholes:

#1. American Opportunity Tax Credit

The American Opportunity Tax Credit (AOTC) is designed for eligible students enrolled within the first four years of higher education. This tax credit applies to qualified educational expenses, such as tuition, school fees, and learning materials used for the student’s course.

Eligible students can receive a maximum of $2,500 worth of annual credit.

If the annual credit reduces a student’s taxes to zero, then they may have 40% of any remaining credit amount refunded. Before claiming the American Opportunity Tax Credit, taxpayers or dependents must possess a valid Taxpayer Identification Number (TIN). They must also receive Form 1098-T, “Tuition Statement,” from a qualified educational institution.

The form is issued by either foreign or domestic institutions to help students assess their tax credit. Students are also required to fulfill Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits).

A modified adjusted gross income (MAGI) of $80,000 or less qualifies for claiming the credit in full. If married and filing jointly, MAGI should be a minimum of $160,000.

#2. Saver’s Tax Credit

Saver’s Tax Credit is a non-refundable credit meant to help low-income earners who contribute a portion of their income into employer-sponsored 401(k), 403(b), SEP, and SIMPLE retirement plans. Taxpayers who also contribute to governmental 457 plans, traditional, or Roth IRAs are also eligible for the Saver’s Tax Credit.

The saver’s tax credit reduces the tax rates of qualified individuals, dollar for dollar. Depending on the taxpayer’s income, the maximum credit amount could range from $1,000-$2,000 (that’s approximately 10% to 50% of their contributions.)

In 2022 and 2023, different scales of adjusted gross income (AGI) influenced how the saver’s tax credit was measured:

#3. Earned Income Tax Credit (EITC)

Low-to-moderate income earners, taxpayers with children, or qualifying dependents qualify for Earned Income Tax Credit. Persons with disabilities qualify and are also eligible for EITC. As for clergy and military workers, they must follow special EITC rules.

Another basis for determining whether a taxpayer qualifies for the earned income tax credit is whether they have investment income. Qualified taxpayers should not have investment income; otherwise, the amount they earn from investments should be no more than $11,000.

Primarily, the Earned Income Tax Credit minimizes the impact of Social Security taxes on the wages of low-income taxpayers. The credit amount and percentages for EITC are based on each taxpayer’s filing status. At the same time, the number of dependents will also factor in evaluating the phaseout range for EITC.

Filing a tax return is possible if the amount of EITC is greater than the tax to be paid.

Tax Loopholes for the Middle Class

Now, let’s move on to the tax loopholes for taxpayers who belong to the middle class:

#1. Mortgage Interest Deduction

Homeowners will likely find the mortgage interest deduction a most beneficial tax loophole example. Deductions in mortgage interest are applicable to loan interests used to fund the repairs, renovations, and construction of residential properties.

It is important to note that only mortgages with a land contract or a duly fulfilled deed of trust are deemed eligible for the tax break. Aside from mortgage interests, property interests can also be reduced as long as homeowners itemize all their taxes and check all the requirements before subtracting their mortgage interest rates.

As for co-owned properties, the deductions will be based on how the property is divided among the homeowners.

Form 1098 is used to report the deductible mortgage interest rate.

#2. Lifetime Learning Credit (LLC)

Lifetime learning credit offsets up to $2,000 worth of expenses on higher education for students and parents. LLC may be used to cover the taxes owed, but it may not be filed for a tax refund.

Students who qualify for LLC can be enrolled in either an undergraduate or graduate course. Professionals enrolled in degree courses or courses designed to help develop and attain new knowledge and skills related to their job may also qualify.

There are specific income limitations for Lifetime Learning Credibility. Qualified students and parents whose MAGI ranged from $80,000 to $90,000 for single tax filers and $160,000 to $180,000 for those filing a joint return.

On the other hand, single filers with a MAGI worth more than $90,000 or joint filers with over $180,000 in Modified Adjusted Gross Income are not eligible to claim an LLC.

The Lifetime Learning Credit may not be claimed within the same tax year as the American Opportunity Credit.

#3. Child Tax Credit (CTC)

By definition, the Child Tax Credit is a form of tax benefit for taxpayers in the US with qualifying children or dependents. A taxpayer’s child or dependent must be at least 17 years of age or younger by December 31st of the tax year.

The child or dependent may be biological or adopted, must have lived with the taxpayer for over half of the tax year, and must not be covering over half of the living expenses in the household within the year.

Child Tax Credit is worth $2,000 per qualifying child or dependent of taxpayers who are filing jointly and have a MAGI of $400,000 or lower. The same CTC rate applies to single filers, married filing separately, and heads of household whose MAGi is $200,000 or below.

When claiming the Child Tax Credit for 2022, use either Form 1040 or 1040-SR. The credit must be claimed on the federal tax return and filed either on April 18, 2023, or October 16, 2023.

#4. Retirement Savings Accounts

There are no income limits on withdrawing IRA contributions as long as you are not covered by any employer-sponsored retirement plan. Also, contributions to a traditional IRA must range from $6,500 to $7,500, with the latter amount applicable to contributors aged 50 and older.

Taxable income has also been reduced for the 2023 tax year. Specifically, 401(k) and 403(b) contributions amounting to $22,500 are qualified for reduced tax rates. If you are enrolled in a workplace retirement plan or if your spouse is enrolled in one, you can only deduct a specified amount from your traditional IRA contributions.

IRA contribution deductions are significantly higher compared to the rates in 2022. However, determining the deductible amounts is still heavily dependent on the taxpayer’s filing status. Adjusted gross income and enrollment in more than one retirement account also affect how you can use your retirement savings accounts as a tax loophole.

#5. Cash Charitable Deductions

You can use charitable deductions to reduce your taxes, as long as these are in cash form and are given to qualified nonprofit organizations. Some of the key criteria provided by the IRS in assessing whether an organization is qualified for charitable donations are:

• An organization established in the US meant to fight cruelty against animal cruelty or child abuse
• A US-based foundation or trust created to fulfill educational, scientific, or religious purposes
• A group comprised of war organization veterans
• Religious organizations, including churches, mosques, and synagogues

While non-cash donations are not eligible for tax deductions, certain adjustments and considerations may be made if the donation or gift is worth over $5,000. For example, deductions may be applicable to property donations, with the fair market value used as the basis for the deductible amount.

Non-cash gifts worth more than $5,000 will require an appraisal to verify the item’s value.

Tax Loopholes for the Higher Class

Even taxpayers belonging to the upper class also have their fair share of tax loopholes, such as:

#1. Capital Gains Tax

Capital gains tax is remarkably lower compared to regular income taxes. The tax rates for capital gains are 0%, 15%, or 20%, depending on annual income.

The key to reducing capital gains tax rates is to hold on to the earned investments for over a year. Otherwise, it will be identified as a short-term gain and will be taxed by the IRS as a form of regular income.

Losses in investments worth as much as $3,000 may also be claimed as a tax return. Any investment losses that exceed $3,000 may be carried out in the following tax years to continuously reduce your capital gains taxes.

What makes capital gains an appealing tax loophole method for the higher class is how it cancels the possibility of double taxation. When a taxpayer or a business owner purchases stocks or bonds, the money used to purchase their shares is already taxed at regular income rates.

Hence, if the IRS imposes taxes on the capital gains earned from the investment, then that also means the business or taxpayer is taxed twice. Capital gains taxes are great for business expansion, cutting costs, and long-term investments.

It is also important to note that monitoring relevant and qualified expenses in regulating investments is a must. Doing so gives you an idea of the adjustments needed to reduce the taxable amount of your earned income.

#2. High-Income Mortgage Interest Deduction

High earners get higher tax breaks with mortgage interest deductions. Regular or low-income earners tend to claim zero to low returns on mortgage interest, given the expensive tax rates imposed by federal authorities.

In contrast, high-income earners may claim as much as $750,000, provided their income is high enough to exceed their mortgage rates. Mortgage interest deductions apply to qualified homes only. Qualified homes include your main and second homes. Your second home is any property that is not rented out or made available for resale and that you consider your second place of residence.

A house that is under construction also qualifies for a deductible mortgage for a period of 24 months.

It is recommended that all deductions related to mortgages be itemized in federal income tax returns to increase the possibility of deducting higher interest. The combined value of all your itemized deductions should be greater than the standard mortgage deduction.

Mortgage insurance premiums, late payment fees, and discount points are also qualified mortgage interest deductions. The points used to pay off interest in mortgages and home equity loans, and the points used by the seller to pay as you purchase a residential property, may be deducted from your taxable income.

If you are eligible for a mortgage tax loophole, you may claim your return by filling out Schedule A of your Form 1040 or 1040-SR. You can also check IRS Form 1098 to calculate the grand total of mortgage interest that you have paid within the tax year.

#3. Roll Forward Business Losses

Successful businesses are experts at transforming their losses into opportunities to maximize their gains. The method of rolling business losses forward, or as the IRS would call it, ‘net operating loss carryforward,’ enables businesses to carry any incurred losses within the year to a succeeding tax year.

Then, they may use the said losses to deduct their taxes whenever they see it most suitable for their business. It is an effective way to fix any inequity in business gains and expenses.

Primarily, businesses were allowed to carry forward significant operational losses indefinitely. On the other hand, these losses may only be used to deduct up to 80% of taxable earnings. But, in 2018 and 2020, the IRS allowed NOL carrybacks provided that businesses had these losses forwarded for a maximum of five years.

If, after the five-year limit, there are still losses, then business owners may continue rolling the diminishing returns into the succeeding years.

#4. Hiring Within the Family

Unlike small businesses and enterprises that do not employ relatives to fill in positions within the company, wealthy businessmen are more likely to transfer ownership of their company or employ within their immediate family.

The reason behind this could be due to an IRS provision stating that Social Security and Medicare taxes are not imposed on services rendered by the business owner’s child to the company.

Startups and mid-sized companies would use a payroll tax table to calculate the correct tax rates to withhold from each of their employees’ salaries. Conversely, large-scale corporations effectively reduce the need to use a payroll tax reference by hiring their offspring to do part of the job in their operations.

As long as the child is under 18 years old and the business structure is either a sole proprietorship or a partnership where the parent is the owner or a key partner, this arrangement could prove to be an effective loophole in taxes.

A child’s contributions to their parents’ business operations may be itemized as a business expense. Be wary when hiring your child as an employee. The work must still be within reasonable arrangements and lawful practices.

At the same time, if their income does not exceed the standard deductions, then the IRS cannot impose any taxes on their earnings. The standard deductions for the tax year 2023 are $13,850.

Final Thoughts

Tax loopholes may not be intentionally present in tax legislation, but that does not make it illegal to maximize them for your benefit. With prices for basic goods continuously rising, finding ways to regulate your expenses is a smart move.

On the other hand, it is also a must to be mindful of your limitations and qualifications for any of the loophole examples enumerated in this article. In this manner, you continue to exercise complete compliance with IRS provisions as you calculate the number of deductions in your taxable earnings and pay your taxes accordingly.

Furthermore, expanding your background on possible tax loopholes could potentially unlock more opportunities to reduce your taxes and increase your disposable income.