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It's interesting that an investor in the "communist" Peoples' Republic of China can make millions tax-free… while investors in the United States – the supposed bastion of free enterprise and capitalism – have to pay, in some cases, a near-50% tax on investment gains.
If trading and investing is all about weighing risk and reward, then the tax code itself makes Uncle Sam the ultimate trader. He gets a nice chunk of your reward, even as he avoids your risk.
Now, I don't mind having Uncle Sam as a silent partner, but like any good partner, he should stick around to help shoulder losses during bad times as well as participate in the good times.
Unfortunately, this isn't what happens….
"Heads I Win… Tails You Lose"
Currently, short-term capital gains get taxed as ordinary income.
But, short-term losses – above a miniscule $3,000 per year – are not deductible against ordinary income.
If you are going to tax trading gains as ordinary income, then shouldn't trading losses also be fully deductible against ordinary income as well? Logically, the answer is yes. But that's just not the reality here in the United States.
This situation is basically akin to Uncle Sam flipping a coin and saying, "Heads I win… tails you lose."
Just ask my friend Dan…
The Warren Buffett of China
My friend and money manager Dan Bin has been called the "Warren Buffett of China."
As you'd expect with a nickname like that, Shenzhen-based Dan has enjoyed great success by applying Buffet's methodology to Chinese stocks. Between 2005 and 2007, Dan made over $300 million investing in Chinese companies for his clients and himself.
I recall a conversation I had with Dan in 2007 regarding Buffet's buy-and-hold approach to stocks. At the time, we both saw the Chinese equity market topping, and I advised Dan to abandon his Buffett-like buy-and-hold methodology.
It certainly wasn't because of any flaws in Buffett's – or Dan's – strategy. It was because of the "Uncle Sam" factor.
Long-term buy-and-hold is Buffet's strategy to reduce tax liability – a problem not faced by China stock investors, or those in other major Asian markets. When Dan realized this, he was actually shocked by how high the capital gains tax in the United States is… and how this rigs the game in Uncle Sam's favor.
But what's a handicap for investors can be downright terrible for entire economies.
The Real Job-Killer
Now, because investing entails significant risk, this asymmetrical tax construct actually reduces investment in the country. And that hurts job creation and puts limits on economic growth. Basically, the unfairness of an asymmetrical tax regime makes investing less attractive.
And the worst part is investors have no choice…
You see, in this arena of low interest rates and high inflation, we have to put our money to work for us just to stand our ground. We must play this rigged game.
And, since we've no choice but to step in and play, it's absolutely vital that we fully reckon with the tax efficiency of our investing strategies.
Fortunately, this is where the sheer variety of securities available swings the game back in our favor.
Trade Smarter, Pay Less
One way to optimize your investing strategy so that it's as tax-efficient as possible is to own "pass-through" securities.
We've discussed pass-through entities such as master-limited partnerships (MLPs), real estate investment trusts (REITs), business development companies (BDCs), and private equity firms.
Because many of these partnerships own depreciable assets such as oil wells, buildings, and natural gas pipelines, much of the taxable income is reduced by depreciation.
The best part is that even though many of these assets actually appreciate in value over time… they can be depreciated for tax purposes.
These types of securities are structured to pass through most of their earnings to shareholders, or unitholders, in this case.
And unitholders get dividends – distributions – passed through directly, without Uncle Sam taking a big bite at the corporate level.
For income-oriented investors, these pass-through securities are a great way to swing the game back in their favor… and away from that ultimate trader, Uncle Sam.