Tax Deduction

Taxes. Love ‘em. Hate ‘em. You can’t leave ‘em. But you can lower ‘em. Legally. By being thoughtful about how you spend your earnings.

Let’s start with the largest tax deduction in America: the home mortgage. And you. You...the dentist who makes 150 grand a year. Remember that for individuals (vs corporations), we pay a graduated or "progressive" tax rate, like…almost nothing on the first $15k we earn, then about 10 percent from $15k to $30k, and then about 20 percent from $30k to $60k, and so on. So, on the last 20 grand of earnings you make, you might pay, say, 40 percent in taxes. And yeah, we know the numbers aren’t exact. We’re just illustrating a point here.

You have a mortgage of $300,000 on a home you bought for $400,000. The mortgage costs you 6% per year in interest, or $18,000. Before you owned the home, the IRS thought of you as a 150-grand-a-year earner. But 100% of the interest on the mortgage is fully tax-deductible.

So what about that last 20 grand, i.e. the money you earned from $130k to $150k? Well, as far as the IRS is concerned, you get taxed as if you earned just 132 grand, not the 150k you actually earned. Why? Because that $18k comes right off the top of your earnings. As if you didn’t earn that money. If you’d had no deductions, on that last 20k of earnings, you’d have paid 40%, or $8,000 in taxes. But now, on that last $20k, thanks to your mortgage deduction, you only have taxable income of $2k. And yes, you pay 40% on that $2k, or 800 bucks. And you mumble, "Thank you, government, for largely splitting the cost of my mortgage with me. The American Dream is alive and well."

There are other deductions beyond home mortgages, of course, but you get the gist. From a taxpayer's perspective, deductions like those from home mortgages are a good thing, and this is how they work. Common personal deductions also include things like prepaid health care costs and the cost of feeding dependent children, i.e. those noisy things sleeping in your spare bedrooms until they're 18.

Okay, so those are personal deductions: things that individual citizens take. But what if you‘re a corporation? Well, it’s kinda easier. Think of most corporations as having a flat 30 percent tax from the first dollar they make, just to keep things simple. Participation Trophy Company, Inc. made $100 million last year and paid $30 mil in taxes. They netted $70 million after tax. The company really needs a new trophy smelting machine, because with so much demand for participation trophies of late, the old one is running…dull.

The company spends $40 million on the new machine, knowing that it’ll be worthless in 10 years, either because it wears out, or because the country gets real, or simply remembers to...have a nice day. They depreciate the $40 million in equal parts of $4 million each year over ten years, so that in the next year, when they again earn $100 million, they now get to deduct $4 million in depreciation from their smelting machine against their $100 million in earnings.

So again, as far as the IRS is concerned, they didn’t earn $100 million. They earned "only" $96 million. And they still pay their 30% tax, only now instead of being on $100 million, it’s on $96 million of earnings, or 0.3 times 96, or $28.8 million in taxes. They deducted from their taxes the $4 million in expected value decline from their smelting machine, but received essentially a credit on their taxes of $1.2 million.

So instead of that year’s depreciation costing the company 4 million bucks, it really costs them more like $2.8 million, if you ignore a bunch of other things, like the original capital cost of the machine, and what else they might have done with that money other than buy a smelting machine.

Think...corporate jet: Those G6s are surprisingly tasteful.