The Hidden Tax: Transaction Costs

Living a frugal lifestyle sometimes lends to a false sense of security. We take all the financial precautions to increase our savings rate and invest in broad-based index funds. Before long the net worth starts reaching for the stars and we feel good about ourselves.

Now, we decide, might be a good time to get a second car or trade for a new one. Moving to a smaller home, across town or to another state or country, sounds tempting and easy to do with your nest egg growing faster than you are spending.

Your habit of caution is well defined. There will be no stupid tax in your future! Careful planning leads to good decisions. You look before you leap.

Then it happens and you never even saw it coming. You paid a stupid tax without even realizing it was there.

How the Government Robs Smart People

Smart people know how to avoid spending half their income on taxes. They fill their retirement accounts and use index funds for non-qualified accounts to keep the tax burden low. Using the tax code can really put a dent in your income tax liability. But the government has insidious ways to pry your hard-earned cash from your wallet.

Selling an old car and buying a new or newer vehicle has an obvious hidden cost: sales tax. When you sell your current vehicle the government collects some coin from the buyer; when you buy a replacement vehicle the government collects sales tax from you. In Wisconsin, where your favorite accountant lives, the sales tax is 5% with most counties tacking on a ½% or more. (I am aware a few counties have a 5.6% rate, but we are trying to keep this discussion clean.) If you buy a $10,000 car you are required to pay at least $500 in sales tax, more in most counties. The value of the car hasn’t changed, but your net worth took a 5% ding on the purchase price. New vehicles are even worse with the higher selling price and non-tax fees crammed down your throat by the dealership.

Buying a piece of real estate is the worst. We will use your favorite accountant’s state in our illustration.

Sales tax isn’t due on the purchase of a home, rental property, land or commercial property. (Can you imagine paying sales tax on a $400,000 home?) There are far worse things than sales tax when it comes to purchasing/selling real estate.

Local governments love when real estate changes hands. In Wisconsin there is a $3 per $1,000 transfer tax. Don’t forget title insurance and both the buyer and seller get a bill.

As a seller you pay realtor fees or pawn your property pro se. If you go it alone you will invest time and money advertising the property and running to show the property. You still need an attorney (and last I checked they still invoice for their time) to handle the legal documents when you have a buyer.

Rather than bore you with the myriad fees associated with real estate I will stop here. All you need to know is real estate, as the buyer or seller, has lots of fees/taxes connected to the transaction.

The transaction fee is the most voluntary tax of all. The more you spend the more you pay.

Reducing spending and saving/investing a majority of your income has many financial benefits. We hear plenty about reduced taxes based on retirement accounts. What none of this savings rate considers is the amount of money wasted on merely the transaction.

Taxes are not the only culprit! Sure, the government has its hand out whenever an asset transfers. But so do sales reps, attorneys, and (gulp) accountants. Everybody gets a piece of the action. You have no guarantee on how the new asset will perform for you. The rental property could sit vacant; the new car could be a lemon. But all the, ahem, professionals are getting paid. If you ask me to consult on a transaction know up front I am the only guy in the room guaranteed a profit.

Reducing the Tax Grind

Taxes will consume over half of everything you earn in a lifetime if you are not careful. Income and sales taxes are only the beginning. Payroll taxes take a bite and realized capital gains put a grin on Uncle Sam’s face. Before you blink, when is the last time you filled the tank on the car and thought, “Oh yeah, I just paid an excise tax.” Excise taxes are everywhere and hard to spot for a reason. It makes it easier for the government to get more of your wealth.

Property taxes are relentless. If you rent the landlord adds the property taxes to your rent; it’s built in. If the landlord didn’t include this major expense she would be broke quickly and the new landlord will not be so lax.

And did you forget you pay corporate taxes, too? You do. Corporations include their tax liability in their cost structure and pass it along to customers. The end user get stuck holding the bag.

Even when you die the government takes a slice in the form of the estate tax. It never ends even if you do!

You can fight back and regain control of your financial future. We have discussed visible (income, et cetera) taxes at length in the past. Now we want to gut the terror of the hidden tax: the transaction fees.

Fee’d to Death

When a simple phone bill has more individually listed fees than you actually make phone calls it is time to consider fees, transactions fees and how they affect your wealth.

We will focus on the two big ones: real estate and vehicles. Of course you already know if you increase your savings rate you will automatically reduce the transaction fees chewing into your life. Buy less stuff; pay less sales tax. You understand the concept.

Cars are a different story. Transportation is a necessary part of life. Even people who bike and walk everywhere they can frequently also own one or more vehicles. And each vehicle owned is a wasting asset.

The more often you buy a vehicle the more often you pay the stupid, ah, hidden tax. If you buy from anyone other than a “for sale by owner” there will be a profit built into the price. This doesn’t make the seller a bad person, just a business person who will survive.

No matter who you buy from you will pay a sales tax. Every sales tax paid is an instant reduction of your net worth. I have a powerful allergic reaction to any event that molests my net worth. There are times I come out swinging it is so bad.

There are two things you can do to massively reduce the transaction costs with vehicle ownership: buy as few vehicles as possible over a lifetime and pay less for the vehicles. Finding the lowest priced reliable vehicle to get the job done for the longest period of time creates the greatest savings. When I buy a car it will be in the family for a very long time. Most of my vehicles are purchased 2-5 years old and I run them for another 15-20 years. I don’t care what they look like! They only leave the family when they no longer can do their job.

A typical sale of an auto in my household is purchased by a local kid looking for a vehicle to enter into the local demolition derby. “Gi’me five hundred bucks kid and this beauty is all yours.” They buy it every time.

You may also consider forgoing vehicle ownership. Ride sharing and public transportation coupled with a good bike can keep transportation costs low. For those few times you need a vehicle for a longer trip I suggest renting. There are still transactions costs, but they tend to be minor in these situations compared to auto ownership.

The other big purchase that chomps a serious chunk out of your net worth is real estate. It drives me crazy when I see clients think they can trade houses like day-traders trade stocks. Of course you can make money flipping houses, but the transactions costs will kill you. Remember who is always guaranteed to turn a profit: the professionals (sales rep, et cetera). One bad deal and it all goes south quick.

Before someone points out I flipped a few houses over the years I want to point out I never went into an investment property with the intention of doing a quick sale for some easy greenbacks. We bought many properties and improved them all. If a rundown property cleaned up nice and we were offered a price we couldn’t refuse, we didn’t refuse.

I own homes like I own cars: for a very long time. I’ve lived on my current farm for 22 years. Before that I owned a home in town and before that I owned a mobile home because I didn’t want to live with my parents anymore. As far as I’m concerned, the mobile home was a vehicle (it has a license and everything) and is a wasting asset. The home in town was nice, but I always wanted to move back to the country where I could raise animals and till some land.

Warren Buffett still lives in the home he bought in 1958. Smart man. Bet he has money.

I’m not telling you you can’t buy a car or a property. If you want to own income property you have to buy it first. There is also nothing wrong with owning your residence. All I am pointing out is that you want to own as few of these big assets for personal use over your lifetime. Doing this one simple lazy thing (not buying/selling/trading your car/house on a regular basis) could increase your net worth by a million dollars or more over a lifetime if invested in an index fund.

Or, you can keep doing what you always do. My brethren in the legal and sales fields are happy to take you money.

So am I.