Archive for the ‘Tax Planning’ Category
November and December is when I normally start sitting down with my clients to talk about what they can do at the end of the year to minimize or defer their taxes. Everyone’s tax situation is going to be different so the meetings are tailored to the clients but here are some general themes that will come up and that you can use in a discussion with you tax professional. Keep in mind that a lot of this could change depending on which way the elections go.
1) Do you pay less now or potentially more later? Right now, the long term capital gains rate is 15% for those in the top tax brackets. If Congress does nothing, that rate is going to go up to 20%. If you’re looking to sell a long term asset, you have a decision to make. You can sell now and pay the 15% rate, or you can hold off, pay later but pay at the higher 20% rate.
2) What should I do with my dividend paying stocks? Right now, dividends are taxed at the long term capital gains rate which maxes out at 15%. If nothing is done, that rate could go up to as high as 39.6% depending on your marginal rate. While this could affect what corporations do, if you have large holdings in dividend paying stocks, you’re going to see your tax bill go up if you don’t make any adjustments. Also keep in mind that you’re going to have to pay medicare tax on unearned income if you’re over a certain threshold ($200,000 if you’re single, $250,000 if you’re married) so you also have to take that into account.
3) What if I have my own C-Corporation? If you have your own C-Corporation and you have some excess cash you might want to consider flushing out as a distribution. You’re probably not going to see rates any lower then 15% and you might even combine this with an S-Corporation election in 2013. This would also apply if you have an S-Corporation and you have some C-Corporation earnings and profits that you want to get out before rates go up.
4) Expect your payroll taxes to go up. A big deal last year, it looks like the payroll tax cut isn’t going to be extended. If you have your own business where you pay yourself a salary, it might be worth looking into whether you can justify a lower one.
As always, this is general information and you should be discussing these matters with a professional.
Enacted in 2011, employees and self-employed people alike received a temporary 2% cut in their payroll taxes. Mired in Congress, the extension of this tax cut was given some odd treatment because the two sides of the aisle couldn’t agree on how to pay for it so for a while, there was just a two month extension. At the end of February, a full year extension was finally passed but as we get closer to the end of the year, it’s unclear what the fate of this tax cut is going to be.
If you’re an employee (of a company you don’t own), there’s not a lot you can do to plan. Either the cut will be extended and you’ll get or it won’t and you’ll see your pay check take a hair cut. For the self-employed who pay SE tax, you fate is about the same. If you’re an employee of your S-Corporation, there is a little bit you can do. In December, if the political winds are telling you that an extension isn’t going to pass, it might be a good time to push some salary (maybe a one time bonus or an advance) from 2013 into 2012. Other than that, this one is a big “wait and see.”
If you’re a regular to this website, you’ll notice something new. At the top of the sidebar by entering your name and email address, you’ll be able to receive my new monthly special reports. These will include timely summaries of new tax legislation as well as checklists and lists and you can’t beat the price because these will be sent to you inbox for no charge. Expect the first on in the first week of June and until then, be sure to enjoy the updates on the site.
Last week we talked about capital gains and this week, we’re going to talk dividends. This year, most dividends will be taxed at the capital gains rate which maxes out at 15%. If nothing is done, that special rate goes away and dividends will be taxed at your marginal tax rate which could go as high as 39.6%. If you thought the 5% increase on capital gains is big, managing your dividends if you’re able to is an even bigger deal.
For a lot of people with stock investments, there is no control over the dividends. You can opt to move to stocks that pay no dividends and you might see some of that. Where this rate change will really see an effect is if a person owns a C-Corporation or has an S-Corporation that has some C-Corporation earnings and profits. If you do and you have some cash sitting around, you might want to look at pulling it out as dividend. I wouldn’t do it until after the election although you can get an idea on what the political climate is going to be like, but until then, you have some time to assess the situation.
Last month, a pretty important Revenue Procedure came out. In Rev. Proc. 2011-34, we get some updated guidance on fixing making a late election to aggregate your rental real estate activities when determining whether you qualify as a Real Estate Professional or not. To qualify, you must meet a three pronged test (I’ll probably dedicate an entire blog post to the rules here but in the meantime, I took part in a conference call on this subject a few months ago that’s worth listening to). One of those tests is that you materially participate in each real estate activity. By making an election, you can choose to aggregate your activities so all of them are effective used in total to determine whether you meet the test or not.
It’s fairly common to miss the election and the consequences can be severe. With this Rev. Proc., it’s not a lot easier to make a late election to help cover yourself.
I’ve had a blog since 2003. Over eight years ago I started my Tigers fan site, Tigerblog and since then, my life hasn’t been the same. I’ve been in books, been on the radio and I even had the chance to interview Ernie Harwell. I place it as one of my most important life decisions I’ve ever made. Another good thing is, it’s made me some money. I’ve sold ads throughout the years and it’s forced me to treat it as a business. That’s why I did this interview back in back in 2005 on accounting for bloggers. Once money starts coming in, it’s time to take it a little more seriously.
If you read through the interview (which is focused more on baseball blogs), not a lot has changed since then. One thing you always have to keep in mind is the general rule for a business deduction and that’s that it has to be ordinary and necessary. If you start a movie review blog and you write a review on every single movie you see and you only deduct the price of the ticket for you and not everyone in your family, you’ll probably be in good shape. If you write a review for every fifth movie you see and you try to deduct the price of your ticket, the price of the tickets for everyone in your family and then a family dinner on top of that, you might be in trouble.
Also be cognizant of the hobby loss rules. Eventually you should turn a profit and if you don’t, then your losses may not be allowable. While the hobby loss rules have some general guidelines (this may warrant a post of it’s own), even if you meet the requirements, the IRS could still deem you a hobby under audit so nothing is bullet proof.
Yesterday I gave the ins and outs of cost segregation studies. Today, I’m giving you some of the research resources attached to it. One good place to start, if you don’t mind the investment is CCH’s U.S. Master Depreciation Guide (2011). This guide book will give you the ins and outs of the depreciation rules like nothing else will and it comes with CCH’s top notch explanations.
If you don’t want to spend the money, then I’d recommend Publication 535 which has a section on capitalizing assets in it. I’d also highly recommend the Audit Technique Guide on Cost Segregation. Between those two things, you should have the tools to at least get started.
A while back, I wrote a column for the Oakland County Real Estate Investors Association on cost segregation studies, or the abbreviated cost seg studies. Here’s that column in its entirety.
Get More Money Out of Your Real Estate Investment by using a Cost Segregation Study
“Accounting and tax rules allow me to depreciate my property, which means I am making money but it looks like I am losing money, I am making money because I am legally allowed to pay less in taxes, So this is money coming in because less money is paid out in taxes. It is also known as phantom cash flow.” Robert Kiyosaki, The Real Book of Real Estate
“In recent years, increasing numbers of taxpayers have submitted either original tax returns or claims for refund with depreciation deductions based on cost segregation studies. The underlying incentive for preparing these studies for federal income tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods for computing depreciation deductions.” Internal Revenue Service Cost Segregation Audit Technique Guide
There are several tax advantages to rental real estate but near the top of the list is the ability to depreciate the purchase price of your investment and utilize that as a tax deduction each and every year. The current rules allow you to depreciate residential rental real estate over 27 ½ years so if you bought a house for $100,000 and do the standard allocation of 80% going to the house and 20% going to the land, you end up with nearly $3,000 in tax deductions each and every year. In a lot of cases, this can turn an investment with a marginally positive cash flow into a tax loss allowing you to escape paying taxes. Even better, it’s not like a typical expense, such as interest expense, where money is coming out of your pocket. As Robert Kiyosaki described in his quote, it’s like phantom cash flow. With that, it can’t get much better then that, can it?
Actually it can. By utilizing what’s commonly referred to as a cost segregation study, you can significantly narrow the window used to depreciate your investment. While you’re robbing the future to pay for the present, in a lot of cases you’re giving yourself tax deductions in the current year that you might be not be able to normally utilize until over 20 years in the future. We all know that a dollar in our pocket now is worth more then a dollar 20 or 30 years from now so let’s take a look at how this is done.
What Is a Cost Segregation Study?
When depreciating both real and personal property, it’s necessary to classify each asset so a useful life has been determined. Computers are depreciated over five years while non-residential real estate is depreciated over 39 years. The shorter the useful life, the better the depreciation deduction is in the early years of the asset. Sometimes, you can’t break down each and every asset (like for a house), so the Internal Revenue Service let’s you use estimates to segregate or allocate costs to various buckets of assets. A house or apartment building consists of a structure, but there’s also wiring, personal property (cabinets and lighting fixtures as an example) and even furniture. This allocation estimate is what a cost segregation study provides for you.
Who Performs Cost Segregation Studies?
There are no requirements to do cost segregation studies but in my experience, the best combination is to have a certified public accountant (CPA) and an engineer work together. This way, you have both the tax side (CPA) and the structural/construction side covered. A CPA could do a cost segregation study by himself but without the proper experience that an engineer could bring to the table, things usually get missed. Of course an engineer could do it by himself, but they usually lack the necessary tax knowledge to fully take advantage of the study. In addition, a cost segregation study that doesn’t utilize an engineer is usually going to be more closely scrutinized by the IRS if there’s an audit because a CPA isn’t a construction expert.
When’s the Best Time to do a Cost Segregation Study?
The best time to do a cost segregation study is when you buy the property. It’s a lot easier to do it on day one when all of the paperwork is fresh and the CPA and engineer can get in there before any work is done on the house. It also establishes all of the useful lives associated with property on day one and doesn’t require any additional paperwork.
What if I bought my a rental property five years ago? Can I still do a cost segregation study?
You can still do a cost segregation study if you have a house that you bought several years ago although the benefit could diminish over time. There is additional paperwork because you have to provide the Internal Revenue Service documentation to show them you’re changing your method of account. This involves filing Form 3115 (Application for Change in Method of Accounting). The good news is, for cost segregation studies, the change in method of accounting is automatic (some changes need IRS approval) and you also get to take advantage of the depreciation benefits entirely in the year that you apply for the accounting method change.
How Much Money Can I Save by Doing a Cost Segregation Study?
The short answer is there will be no savings, at least over the useful life of the asset. If you have a $100,000 depreciable asset, the total depreciation expense will be $100,000 over its useful life. What a cost segregation study can do is give you more of your depreciation deductions now so you have more money to put to use here in years one through five rather in year 20 or year 28.
Here are a few simple examples of what a cost segregation study can accomplish (note: I have spreadsheets that provide more detail on the numbers I’ve provided. These are available upon request by emailing firstname.lastname@example.org).
Example 1 – Assume you buy a rental property for $100,000. A quick and easy calculation has 80% going to the building ($80,000) and 20% going to the land ($20,000). Say you bring in a cost segregation study expert and he’s able to determine that 15% ($15,000) should actually go to the land, 50% ($50,000) should go to the building, 15% ($15,000) should go towards land improvements and then 20% ($20,000) should go towards what’s called distributive trade or service property (these are items like wiring, lighting fixtures and personal property). In the first five years, this would result in an increase of $19,545 in depreciation expense when you use the cost segregation study versus a traditional allocation.
Example 2 – Assume you buy an apartment building for $500,000. A traditional allocation would have 20% ($100,000) going towards land and 80% ($400,000) going towards the buildings. With a cost segregation study, you might get 17% ($85,000) going to land, 56% ($280,000) going towards the building, 10% going towards land improvements ($50,000) and 17% ($85,000) going towards distributive trade or service property. This would give you an increase of $79,128 in depreciation expense when you utilize the cost segregation study.
This sounds great, but how much money am I going to save?
This is where I get to hedge with my favorite answer, “it depends.” If you can use all of the extra depreciation deductions and you’re in a high tax brackets, example 2 could save you in excess of $30,000 in the first five years. On the other hand, if the extra deductions put you in a loss situation and you can’t take advantage of those losses because you fall under the passive activity rules, it might not benefit you at all. As always, you should consult with your personal tax advisor as to whether a cost segregation study is good for you.
This sounds fishy. What is the IRS going to do if you do a cost segregation study?
The IRS not only acknowledges that cost segregation studies are valid, but they also told everyone how they’re going to audit them. If your cost segregation expert knows what he’s doing, he’s read the IRS’ cost segregation study audit technique guide to know exactly what the hot spots are and how to protect the client as much as they possibly can.
Cost segregation studies aren’t for everyone, but if you buy and hold real estate, whenever you buy a property you should at be thinking about doing a cost segregation study. I know some cost segregation study experts will analyze the property to see whether you’ll benefit or not before they even do the work so finding someone who will give you a quick review would limit your risk. Cost segregation studies are just one of the many tools that a real estate investor can keep in their tax planning toolbox.