Use these strategies before year-end to maximize deductions.
Though many people associate tax time with April 15, the time to implement your business tax strategy is now, before the calendar year comes to an end. Just as location is the key to real estate, timing is the key to taxes. Commercial real estate professionals can take the following steps to reduce their own tax burdens — as well as their clients’ — before the new year begins.
Timing Is Everything
Attempt to defer any sales that will result in taxable income or gains until after the first of the year, as well as the collection of rents if possible. If it is not possible to defer the entire sale, consider structuring the transaction as an installment sale. Using this technique, sellers can lock in the contract price, close on part of the deal before year-end, and prorate the remaining gain over the future tax years in which payments are received.
If a sale is of an asset or activity that has been generating losses in recent years and has not been deducted on tax returns, the entire accumulated loss may be deductible in the year of the disposal. However, if the sale results in a significant gain, be aware that the accumulated loss might not be sufficient to offset other unrelated taxable income.
For stocks or other investments that have substantially declined in value, realizing losses on sales of these assets may be a good strategy to offset taxable gains for the year. By selling these assets, taxpayers may be able to minimize or eliminate a significant tax liability. Beyond offsetting those gains, each year taxpayers are entitled to offset up to $3,000 of ordinary income with realized capital losses.
As for business expenses, attempt to pay as many bills as possible before year-end. For cash basis taxpayers, taxable income is a function of cash receipts less cash expenses as of the last day of the year. Thus, it is better to pay a bill in the last week of December than the first week of January. One strategy is to use a credit card to pay expenses, as they are deductible as long as the charge is made before year-end, regardless of when the credit card bill is paid.
Along the same lines, taxpayers are allowed to write off up to $125,000 of capital expenditures this year. This deduction is phased out if the total cost of new assets exceeds $500,000. Capital expenditures include investments in tangible property, equipment, and vehicles, which are actively used in a trade or business. If taxpayers are planning large investments, they should consider making them before the end of the year to obtain the write-off on this year’s taxes. This deduction can be especially useful for taxpayers who are obtaining zero or low interest financing on the purchase, thereby creating a positive cash flow from the tax savings.
Some motor vehicles also qualify for expensing under this rule; however, there is a $25,000 maximum deduction for sport utility vehicles and certain trucks and vans. These are vehicles that are built on a truck chassis and have a gross vehicle weight greater than 6,000 pounds. Smaller passenger cars are not eligible for expensing and must be depreciated.
Lastly, accelerating some personal expenses can reduce commercial real estate professionals’ tax burdens as well. Examples of this include payments for property taxes and fourth-quarter state income-tax payments, which are typically due in January. If these payments are made before year-end, they are deductible in the current tax year as itemized deductions. However, take note that itemized deductions can be limited as a result of the alternative minimum tax rules.
Transferring funds to retirement accounts is a quick, easy way to reduce income tax burden. Most taxpayers have individual retirement accounts, simplified employee pension plans, and/or 401(k) accounts, yet most never fully fund them. Deposits into these accounts reduce taxable income dollar for dollar, the same way deductible business expenses do, only the cash still belongs to the taxpayer.
These accounts can invest in real estate; however, certain factors should be considered. The qualified account is segregated from other investments and thus it must be sufficient to purchase, carry, manage, and maintain the real estate investment it owns. While the profits and gains from transactions within the account grow tax deferred over a long investment horizon, the eventual distributions are taxed at ordinary tax rates, not as capital gains. Distributions typically cannot begin before age 59½.
Because Congress has increased the maximum contributions to these accounts, some additional financial flexibility may be needed to max out. Individuals over age 49 are eligible to make even greater contributions, known as catch-up contributions. Fortunately, some qualified accounts may be funded as late as the extended due date of the return, which can be as late as Oct. 15, 2008.
Active vs. Passive Participation
Those involved with rental real estate may want to investigate whether they qualify under the Internal Revenue Service’s definition of a real estate professional. The tax treatment between those who qualify and those who don’t is significant.
Individuals not meeting the definition are subject to a limitation on rental real estate passive losses of $25,000, which is phased out if the taxpayer’s income exceeds $100,000 and completely eliminated for incomes greater than $150,000. However, persons meeting the IRS definition of a real estate professional are not limited to the amount of loss they can take in the course of the rental real estate business in which they materially participate.
To qualify, an individual must spend more than half of the personal services performed in trades or businesses during the tax year in real property trades or businesses. A minimum of 750 hours is required. A hurdle often occurs when an individual holds a fulltime job that does not include real property activity.
Given the vast number of deductions associated with cost segregation, this tax strategy must be on any commercial real estate professional’s year-end checklist. In short, commercial real estate typically is depreciated over a 39-year life. However, owners may opt to segregate the cost basis — often the purchase price or cost to build — into various asset classes, with five-, seven-, 15-, and 39-year asset life spans. Depreciating the property in this fashion accelerates non-cash depreciation expenses and significantly reduces taxable income in the near term.
Applying the time-value-of-money concept, many investors prefer to depreciate their buildings faster, enjoying the deductions now rather than 30 or more years from now. In addition, the study does not need to be performed by year-end; rather it can be completed prior to filing. Besides the annual tax benefits from accelerating depreciation expenses, there is another advantage to cost segregation. In the year in which the change in asset life is adopted, the tax forms re-compute what a taxpayer’s accumulated depreciation should have been for the previous years. In the year of adoption, the taxpayer is entitled to a catch-up expense. Even if the asset only has been in service for a year or two, the catch-up can be very significant.
For example, a group of office buildings had been in service for a couple years and together had a value of about $30 million. After completing a cost-segregation study and computing what the depreciation could have been, the taxpayer received an extra $2.3 million dollars in catch-up expense for that year. Because the taxpayer was in the 35 percent tax bracket, the cost-segregation study saved him roughly $805,000 in cash on his fiscal-year tax return.
Paying Your Kids
Consider putting investments in your children’s names or paying them for work they do with the business. A dependent child may pay zero tax on his first $850 of net investment income and only 10 percent tax on income less than $1,700. Wages paid can be exempt up to the amount of the standard deduction. Further, though subject to limitation, a dependent child’s earned income will be taxed at their lower marginal rate versus a parent’s higher rate.
Taking advantage of these tax laws may provide a lower overall family tax burden, but beware of gift tax and “kiddie tax” limitations. The transfer of an investment valued in excess of $12,000 may require the filing of a gift tax return. The kiddie tax comes into play when the child has not reached age 18 by the end of the year and has unearned income greater than $1,700. At this point, the income is reattributed to a parent and taxed at the parent’s highest marginal rate. The recently passed 2007 Small Business Tax Act extends the reach of the kiddie tax for tax years beginning after 2007 by raising the age limit to include all children under age 19 and students under age 24.
Consider a Donation
Cash and non-cash contributions to qualified charitable organizations are an economical and humanitarian way to reduce taxable income. Though Congress has enacted a series of new laws in recent years tightening the rules on non-cash charitable contributions, these donations still provide excellent non-cash means of lowering tax burdens.
For donations of motor vehicles, boats, and airplanes, the deduction is limited to the amount the property is sold for by the charitable organization. In the event the charity uses the property, the deduction is limited to the amount the charity indicates on a required contemporaneous receipt. Clothing and household goods now are deductible only if the property is considered in good used condition or better.
The recordkeeping rules for cash contributions have changed as well. Beginning Aug. 17, 2006, no deductions are allowed for any contribution unless the donor maintains a bank record, receipt, letter, or other written communication from the donor indicating the donor’s name, contribution date, and amount.
As the year comes to a close, commercial real estate professionals still have time to execute strategies that will lower their tax burdens. With the right timing and knowledge of how to maximize deductions, savvy taxpayers can kick off the new year with extra cash in their pockets.