In many situations, the IRS does not allow reinvestment of funds generated by a project without an interim tax penalty. This can be important when you compare one long-term investment to multiple short-term investments that are otherwise identical. For example, consider a farmer in the 40% tax bracket who purchases grain that costs $300, and that triples its value every year.
• If the IRS considers this farm to be one long-term two-year project, the farmer can use the first harvest to reseed, so $300 seed turns into $900 in one year and then into a $2,700 harvest in two years. Uncle Sam considers the profit to be $2,400 and so collects taxes of $960. The farmer is left with post-tax profits of $1,440.
• If the IRS considers this production to be two consecutive one-year projects, then the farmer ends up with $900 at the end of the first year. Uncle Sam collects 40% ·$600 = $240, leaving the farmer with $660. Replanted, the $660 grows to $1,980, of which the IRS collects another 40% ·$1, 980 = $792. The farmer is left with post-tax profits of 60% ·$1, 980 = $1, 188.
The discrepancy between $1,440 and $1,188 is due to the fact that the long-term project can avoid the interim taxation. Similar issues arise whenever an expense can be reclassified from “reinvested profits” (taxed, if not with some credit at reinvestment time) into “necessary maintenance.”
Although you should always get taxes right—and really know the details of the tax situation that applies to you—be aware that you must particularly pay attention to getting taxes right if you are planning to undertake real estate transactions. These have special tax exemptions and tax depreciation writeoffs that are essential to getting the project valuation right.

While ordinary income applies to products and services sold, capital gain applies to income that is earned when an investment asset that was purchased is sold for a higher price. Capital gains are peculiar in three ways:
1. If the asset is held for more than a year, the capital gain is not taxed at the ordinary income tax rate, but at a lower long-term capital gains tax rate. (In 2002, the long-term capital gains tax rate is 15 percent for taxpayers that are in the 25% tax bracket or higher.)
2. Capital losses on the sale of one asset can be used to reduce the taxable capital gain on another sale.
3. The tax obligation occurs only at the time of the realization: if you own a painting that has appreciated by $100,000 each year, you did not have to pay 20% · $100, 000 each year
in taxes. The painting can increase in value to many times its original value, without you ever having to pay a dime in taxes, just as long as you do not sell it. In contrast, $100,00 in income per year will generate immediate tax obligations—and you even will have to pay taxes again if you invest the labor income for further gains.
Dividends, that is, payments made by companies to their stock owners, used to be treated as ordinary income. However, the “Bush 2003 tax cuts” (formally, the Jobs&Growth Tax Relief Reconciliation Act of 2003) reduced the tax rate to between 5% and 15%, the same as long-term capital gains taxes—provided that the paying company itself has paid sufficient corporate income tax. However, this will only be in effect until 2008, when dividends may be taxed at the ordinary income tax level again. There is no guarantee that this will not change every couple of years, so you must learn how to think about dividend taxes, not the current details of dividend taxes.
In the United States, corporations holding shares in other companies are also taxed on dividend proceeds. This makes it relatively inefficient for them to hold cross equity stakes in dividend paying companies. However, in Europe, dividends paid from one corporations to another are often tax-exempted or tax-reduced. This has allowed most European corporations to become organized as pyramids or networks, with cross-holdings and cross-payments everywhere. (In effect, such cross-holdings make it very difficult for shareholders to influence management.)

It is important for you to understand the difference between before-tax expenses and after-tax expenses. Before-tax expenses reduce the income before taxable income is computed. After-tax expenses have no effect on tax computations. Everything else being equal, if the IRS allows you to designate a payment to be a before-tax expense, it is more favorable to you, because it reduces your tax burden. For example, if you earn $100,000 and there were only one 40% bracket, a $50,000 before-tax expense leaves you ($100, 000 − $50, 000) · (1 − 40%) = $30, 000 , Before-Tax Net Return · (1 − Tax Rate) = After-Tax Net Return while the same $50,000 expense if post-tax leaves you only with $100, 000 · (1 − 40%) − $50, 000 = $10, 000 .
We have already discussed the most important tax-shelter: both corporations and individuals can and often reduce their income tax by paying interest expenses, although individuals can do so only for mortgages.
However, even the interest tax deduction has an opportunity cost, the oversight of which is a common and costly mistake. Many home owners believe that the deductibility of mortgage interest means that they should keep a mortgage on the house under all circumstances. It is not rare to find a home owner with both a 6% per year mortgage and a savings account (or government bonds) paying 5% per year. Yes, the 6% mortgage payment is tax deductible, and effectively represents an after-tax interest cost of 4% per year for a tax payer in the 33% marginal tax bracket. But, the savings bonds pay 5% per year, which are equally taxed at 33%, leaving only an after-tax interest rate of 3.3% per year. Therefore, for each $100,000 in mortgage and savings bonds, the house owner throws away $667 in before-tax money (equivalent to $444 in after-tax money).