To Capitalize or Not to Capitalize

No, we're not talking about punctuation. The issue is whether or not you can write off that business expenditure this year or whether you will have to take your tax deduction over several years. Depreciation can be a pain in the neck for the small business person because it represents a disconnect between actual cash out of pocket and the resulting tax deduction.

Imagine your business is sitting on $50,000 of positive cash flow going into December. You have a great CPA who helps you estimate your tax bill before year end and she tells you that you're going to owe $17,500 in taxes unless you can generate some big tax deductions before year end. Not a need a new work truck, some additional equipment and new uniforms for employees. You get all of this done by year-end and deliver your records to the CPA with a big smile on your face, expecting not to owe Uncle Sam a dime.

A month later your CPA tells you the new truck earned you a deduction of $3,000, your equipment will get a deduction of $1,500 and all $1,200 for uniforms is deductible. The net result is your $50,000 spending spree earned you $5,700 in deductions lowering your tax bill by only $2,000. Needless to say you're not thrilled. Welcome to the world of depreciation.

Situations like the one above have conditioned small business owners to attempt to write off everything they possibly can and depreciate as little as possible. So what are the rules? Here's a quick summary.

IRS Publication 946 outlines four requirements for identifying property the must be depreciated.

  1. It must be property you own.

  2. It must be used in your business or income producing activity.

  3. It must have a determinable useful life.

  4. It must be expected to last more than one year.

The first two are fairly straightforward. To have a determinable useful life the property must be something "that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes." Land for instance is not depreciable because it doesn't get used up. Fine art and collectibles are other examples of things that do not wear out.

The fourth criteria is the one with the biggest gray area. For instance, a repair shop may depreciate a portable welder because they expect it to last 5 years. A contractor, however, may know the welder will get beat up enough on job sites that it will have to be replaced in twelve months. In the first situation the welder is depreciated, in the second it is written off in the year of purchase as an expense.

Dollar value also plays a part in deciding what gets depreciated. A useful tool for all Small businesses is a capitalization policy with a minimum dollar value for depreciable items. A professional practice may have a capitalization policy with a minimum value of $500 whereas a home builder may have a minimum of $5,000. When establishing such a policy you should base the minimum on a realistic assessment of the average value of equipment and other fixed assets you buy. Don't set the policy minimum so high that you don't depreciate anything (unless you want IRS help in revising your policy later).

If you do get stuck with a large tax bill in a year when you spent big money on fixed assets make sure you discuss a Section 179 election with your CPA. This yearly election allows you to write off fixed assets in the year of purchase up to a maximum dollar amount.

View the Axiom Professional Group, P.A. home page   or visit the Axiom web site articles page (both links will exit the blog site).



Use Net Worth to Measure Your Progress

Your net worth is the result of a simple equation: what you own minus what you owe equals your net worth. In accounting terms we call what you own 'assets' and what you owe 'liabilities'. The difference is known as 'equity' or net worth. I will use these terms here and you should learn them so you can speak intelligently to your banker or accountant about increasing your net worth. There are a couple of ways to do this.

First, you can increase what you own. A bigger bank account, a more expensive house, a larger investment portfolio; these would all increase your net worth. However, it's possible to increase what you own and at the same time increase what you owe so in essence you have taken two steps forward and two steps back. In fact, there are few situations besides winning the lottery or receiving an inheritance that will affect only one side of the net worth equation. Most of the time when you add significantly to the asset side you are also adding to the liability side (think of buying a house, you get a big asset and also a big mortgage to go with it). Smart investors know this is their only choice so they add things to the asset side that will increase in value while taking on liabilities that grow at a smaller rate. In accounting terms this means their assets appreciate at a rate greater than the interest on the loans used to acquire them. Think of your house mortgage. If the interest rate is 6.5% and the housing market in general is appreciating at 9.5% your net worth should increase each year by about 3% of the value of your home.

Now focus on the second side of the equation. Reducing your liabilities (what you owe) will also increase your net worth. Again, the problem is that reducing liabilities in almost all cases means giving up assets so it would seem little is done to increase your net worth. However, smart decisions here can increase your net worth. Think of credit card debt. If you owe $10,000 and the credit card has a finance charge of 12% you can use $10,000 of cash to pay the card off and during the next year you will save $1,200 in finance charges. In this case your net worth went up even though all you did was trade $10,000 in assets for $10,000 in reduced liabilities.

The point here is not an elementary lesson in home economics. The point is the need to focus on net worth when setting financial goals. Too often I hear people set targets for increased savings, a bigger home, a larger bank account, but to focus on these goals to the exclusion of net worth is very nearsighted. Net worth is the only measure that takes a holistic view of your situation. Therefor it is the tool you should use to measure long term progress toward your goals.

One final point, when we work with clients who are struggling to increase either their personal net worth or the equity in their business there is one rule we spend a lot of time drilling into their heads.  More money will not fix the problem! People don't believe me when I tell them this but it is true. The person who is financially secure on a $30,000 salary will be financially secure on a $210,000 salary. But a person who cannot survive on $30,000 will have just as much trouble making ends meet when he's making seven times as much. Businesses that can't make it on $1,000,000 in sales will not be able to make it on $2,000,000. The reason is that financial security and success requires discipline and discipline is a function of spending and investment. Don't get caught in the trap of thinking more money will fix your problems, business or otherwise. It will only reveal another set of issues that mask the real problem, your lack of discipline.

View the Axiom Professional Group, P.A. home page   or visit the Axiom web site articles page (both links will exit the blog site).


Vehicles - actual expenses vs standard mileage rate

When deducting business vehicles you can deduct the actual expenses or use the standard mileage rate. Actual expenses are just that, the expenses associated with operating the vehicle. You calculate your tax deduction as the sum of depreciation, repairs, maintenance, tires, gasoline, oil, insurance, license and registration fees.

The standard mileage rate is probably the only area of the entire US tax code that actually makes the taxpayer's life easier instead of harder. You simply take the number of business miles driven and multiply that number by an IRS determined amount. The result is your tax deduction. Each year the IRS hires an outside consulting firm to survey all the costs associated with operating a vehicle and boil them down into a standard mileage rate. The current and preceding standard mileage rates for business use are as follows:

  • 2005-Jan through Aug = 40.5 cents per mile

  • 2005-Sep through Dec = 48.5 cents per mile

  • 2006 = 44.5 cents per mile

If you want to use the standard mileage rate instead of actual expenses you must use it in the first year the vehicle is placed in service. You can switch to actual expenses later if you account for the depreciation component of the mileage rate (a calculation and explanation beyond the scope here). However, you cannot switch from actual expenses to the standard mileage rate.

It pays to sit down with your CPA when you buy a new vehicle and discuss the strategy you are going to take toward tax deductions. Usually high mileage taxpayers are better off with the standard mileage rate where trucks and heavier vehicles can benefit from much higher initial first year depreciation deductions. Watch for a more thorough treatment of vehicle expenses in the March newsletter.

View the Axiom Professional Group, P.A. web site  or return to the Axiom web site articles page (both links will exit the blog site).


What makes tax deferred (1031) exchanges work

There seems to be some misconception, especially among international property investors, about what constitutes a section 1031 exchange (often called a like kind exchange). These are transactions in which the seller of a piece of property turns around and reinvests the money into a second property. In order to encourage capital investment Congress established a set of rules that if followed allow the seller to defer paying tax when the first property is sold.

For a sale to qualify under these rules the new property must be equal or greater in value AND have an equal or greater equity investment. It's not enough to simply buy a property that is worth more than the old one. For instance, you sell a property for $500,000 on which you have a $300,000 mortgage. You pay off the bank and have $200,000 to reinvest. Your replacement property costs $600,000 and you obtain a mortgage for $400,000. Assuming other requirements are met this exchange is totally tax free.

However, let's assume only $150,000 was put down on the new property and the mortgage is for $450,000. This is now a taxable transaction since the equity investment went from $200,000 in the old property to $150,000 in the new property. The taxable amount will be the gain on the original sale or the reduction in equity, whichever is less.

The goal here is not to give you an overview of 1031 exchanges. There are many other factors to consider that are not even mentioned here such as depreciation, cash received during the transaction, the use of qualified intermediaries and several other elements common to all such exchanges. The purpose here is to highlight the role that changes in equity and debt position play in these types of deals. Too many people assume they can pull equity out at a 1031 exchange, pocket some cash and defer taxes. This just is not the case.

We are very experienced in helping clients accomplish 1031 exchanges. If you have questions or are contemplating an exchange please give us a call to run through the numbers.

View the Axiom Professional Group, P.A. web site  or return to the Axiom web site articles page (both links will exit the blog site).


Great resource for international real estate agents

I work with international buyers and sellers of US property and that brings me into contact with a lot of real estate agents. More than a few have become clients themselves and as with all clients we're constantly looking for ways to make them more successful. Toward that end I have started sending them to the website of Thomas C. Roberge & Co. Tom Roberge bills his firm as "the only Certified Public Accounting firm in the state of Florida that practices international taxation exclusively." I know Tom and have immense respect for his professionalism and experience. His company issues short newsletter memos about once a week that contain really good information specific to non-residents. There is a section of Tom's website where these newsletters are archived and you can add your name to his mailing list there.

View the Axiom Professional Group, P.A. web site  or return to the Axiom web site articles page (both links will exit the blog site).