How to offset W2 tax

This post is for knowledge sharing only. It is not intended to be tax or investment advice.

1. Contribute to pre-tax 401K and HSA

As well known, pre-tax 401K and health saving account (HSA) are the only a few tax shelters for W2 workers. 

2. Tax-loss harvesting

If your total capital losses exceed your capital gains in a tax year, you can deduct up to \$3,000 (married filing jointly) from your ordinary income. If your losses are more than $3,000, you can carry over the remaining amount to future years, continuing to offset your income until all the losses are used up.

A popular method to generate these deductible losses is tax-loss harvesting. This involves selling a security at a loss to offset gains or reduce ordinary income, and optionally purchasing a similar, but not "substantially identical", security to avoid missing out on the market. However, be aware of the wash-sale rule, which disallows claiming a loss if you buy the same or a substantially identical security within 30 days before or after the sale.

3. Real estate professional status

Rental owners are allowed to deduct rental losses (including depreciation) against their W2 income if they are qualified as real estate professionals.

The IRS categorizes a rental activity as a passive activity . Consequently, both rental income and rental losses are considered as passive income and passive losses. The implication here is that rental losses can NOT be deducted against W2 income, given that W2 income is considered active income. It is also NOT possible to deduct rental losses against dividends, interest or capital gains, as these fall under the category of portfolio income.

However, IRS makes an exception that "if you qualified as a real estate professional, rental real estate activities in which you materially participated aren’t passive activities". In other word, the so-called real estate professional status enable individuals to deduct rental losses against active income, such as W2 income.

Both of the following requirements must be met for the real estate professional status:

1. "More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated. 
2. You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated."

Therefore, in practice, in order to deduct rental losses against W2 income, one must

• Have a spouse who does not have a full time job.
• This is because the first rule of real estate professional status requires that the time spent on rental services should be longer than that of any other W2 work. 
• Have at least 3-5 long-term rental properties. 
• This is because the 750 hours of services in the second rule of real estate professional status only include activities of rental property operations and management. Do not include the time of real estate investment activities.

4. Short-term rental tax loophole

Short-term rental owners can deduct rental losses (including depreciation) against their W2 income if they materially participate in the activity. This strategy does NOT require the real estate professional status as in the above section.

Recall that there are two kinds of passive activities as defined by IRS:

1. "Trade or business activities in which you don’t materially participate during the year".
2. "Rental activities, even if you do materially participate in them, unless you’re a real estate professional".

The short-term rental tax loophole is that the IRS also makes six exceptions that an activity is NOT a rental activity, which includes:

• "The average period of customer use of the property is 7 days or less."
• "The average period of customer use of the property is 30 days or less and you provide significant personal services with the rentals".

That is, a short-term rental, as long as the average stay period is 7 days or less (or 30 days or less with significant services), is NOT a rental activity, and thus does not belong to the second kind of passive activities.

A short-term rental does not belong to the first kind of passive activities as well if the rental owner can pass at least one of the seven materially participation tests. The second test is the easiest test to pass in practice: "You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year."

In summary, in practice, in order to deduct short-term rental losses against W2 income, one must 

• Run a short-term rental whose average stay period is 7 days or less.
• Spend more than 100 hours and no less than that of any other individual. 

5. Oil and gas general partnership

The IRS lists five activities that aren’t passive activities including "A working interest in an oil or gas well that you hold directly or through an entity that doesn’t limit your liability (such as a general partner interest in a partnership). It doesn’t matter whether you materially participated in the activity for the tax year."

This exception opens up tax advantages for investors through general partnership. For example, investors in general partnership are able to deduct intangible drilling costs in the year occurred against their active income. See this article for a more detailed summary of tax advantages associated with oil and gas investment.

I am still in learning the details of this topic.

6. Contribute to donor-advised fund

Charity donations are one of the itemized deductions to the taxable income. The so-called donor-advised fund allows one to contribute a substantial lump sum in a single tax year, taking advantage of the highest income tax rate for an immediate deduction. Subsequently, the donor can "advise" the fund to distribute portions of the contribution to designated IRS-qualified charity organizations over multiple future years.

It is preferred to donate long-term appreciated assets to maximize the tax benefits including: 

• An immediate deduction in the mount of the fair market value of the appreciated assets.
• No capital gain taxes on the asset appreciations. 

Remarks:

• Avoid donating short-term appreciated assets as the deduction is based on the cost basis rather than the fair market value.
• Avoid donating cash directly. Instead, consider donating appreciated assets and using cash to repurchase the donated assets from the market. While this is functionally equivalent to a cash donation, it raises the cost basis of the held assets.
• When donating ESPP stocks, even though there is no capital gains tax, income tax is still applicable on the 15% discount.

Be aware that the investment options within the donor-advised fund are limited to predefined portfolios. Regardless of the assets donated—be it individual stocks, ETFs, or cryptocurrencies—they will be liquidated and converted into the pre-selected portfolios.

BTW, wealthy families often establish a private family foundation instead of a donor-advised fund as a strategic tool for wealth transfer:

• Family members are appointed as board members of the foundation, granting them control over the decision-making process and receive compensation through the foundation.
• While the IRS mandates that foundations must donate at least 5% of their assets each year, the assets held within the foundation can grow sustainably due to an investment rate significantly exceeding 5%.