S Corporation Tax Benefits

ct.wolterskluwer.com writes: Both tax and nontax considerations must be considered when you determine how you want to structure your business. Corporations, both C corporations and S corporations, and limited liability companies (LLCs) provide distinct advantages over operating as a sole proprietorship or a general partnership.

Among these non-tax advantages are

• enhanced credibility, which makes it easier to obtain investment capital,
• protection of your non-business assets from business creditors and
• increased ability to plan for business succession.

However, there are also many tax advantages that can be achieved by incorporating or forming an LLC. These tax advantages vary from entity to entity.  This article discusses the tax benefits ofoperating your business as an S corporation.

C and S Corporations Are Taxed Very Differently

The distinction between a C and an S corporation is purely the way they are taxed.  For business law, compliance requirements, and asset protection purposes, they are identical creatures under state law.

However, with regard to taxation, an S corporation is very different from a C corporation. 

CT Tip: C corporations get that name because they are governed by subchapter C of the income tax provisions of the Internal Revenue Code. S corporations are governed by subchapter S of the same Code.

To transform itself into an S corporation, a corporation files an election with the IRS using Form 2553 (Election by a Small Business Corporation).  See our article “How to Make an S Corporation Election” for more information on when and how to file Form 2553.

This election affects the corporation’s taxes in two major ways:

• Income tax liability (both federal and state)
• Self-employment and employment tax liability

S Corporation Income Is Taxed on Shareholders' Tax Returns

As a result of this election, an S corporation does not pay corporate-level income tax. In an S corporation, all profits, losses, and other pass through items are allocated according to each shareholder based on that shareholder's proportionate shares of stock. This means that a shareholder with 50 percent of the stock must report—and pay taxes on—fifty percent of the corporation’s income, losses, deductions and credits.

This is an important distinction between operating as an S corporation and operating as a limited liability company (LLC). An LLC operating agreement can allocate different percentages (or even changing percentages over time) of different tax items to different members, without regard to their percentage of ownership. So, a member can be allocated 40 percent of the profits and 60 percent of the losses during the first three years of a business, and 60 percent of the profits after the third year.

Operating an S Corporation Can Lower Employment Tax Liability

In addition to paying income tax, everyone must also pay some type of employment tax on his or her earnings over the course of the year.  An employee is liable for FICA (Federal Insurance Contribution Act) tax on one-half of the compensation received. The employer withholds this amount and pays it on behalf of the employee. The employer must also pay the employers’ share of the tax on the other half of the compensation. 

Self-employed individuals—which include those who operate their business as an LLC—must pay SECA (Self Employed Contributions Act) tax on the entire amount of their self-employment income.  When all of the LLC’s income passes through to the owners, self-employment tax is due on the entire amount. There is an offsetting deduction which helps re-establish parity between the employed and the self-employed.

CT Tip: With a pass-through entity—whether it is an LLC or an S Corporation—all the income is considered to be distributed, even if the owners chose to keep it in a business bank account.  For example, if an S corporation with 3 owners has $300,000 in income then each owner will have to report $100,000 on his  or her tax returns. This is true even if $150,000 of it remains in a corporate bank account.  The ability to accumulate income is one hallmark of a C corporation.

Operating as an S corporation provides a way to reduce the amount of self-employment tax that the owners must pay because an owner can also be a corporate employee. This means that owner-employees can receive money from the corporation in two ways:

• Dividends: No employment tax is due on amounts received as dividends.
• Salary: Employment taxes must be paid on amounts received as salary.

By utilizing a combination of dividends and salary, an S corporation owner can reduce self-employment tax liability and generate wages-paid deductions that will reduce the amount of corporate income. 

Warning:  The allocation between salary and dividends must be reasonable. That is the salary must be in line with what would be paid for comparable work performed by an individual with comparable skills and experience. 

The IRS closely scrutinizes transactions between shareholders and their S corporation—especially if those transactions have tax avoidance potential. The more stock you own and the more control you exert over the corporation, the more likely the transaction is to be examined closely.

Conclusion

It is unwise to select a business structure based solely upon tax considerations, but it is also unwise to neglect to consider the tax impact of your decision. The combination of pass-through taxation, which eliminates any risk of double taxation, and the ability to receive both salary and dividends can make the S corporation the best choice from a tax perspective. However, it is wise to discuss all your options, including your long-range growth plans, with your business advisors before making the S corporation election.

Over 100 Microsoft Dynamics GP Companies and Partners Unite at SalesPad PANELS / SalesPad team members will lead sessions that examine in depth how the full line up of SalesPad products integrate with Intuit QuickBooks to improve business communications, inventory management, customer service, and business intelligence.

For the first time, SalesPad, LLC and Microsoft® Dynamics GP™ partners and users will come together in Grand Rapids. Their goal is to collaborate on enterprise resource planning (ERP) and customer relationship management (CRM) in order to improve efficiency and customer service at SalesPad PANELS. SalesPad will be hosting the event downtown at Grand Valley State University’s Eberhard Center August 4-5.

SalesPad team members will lead sessions that examine in depth how the full line up of SalesPad products integrate with Microsoft Dynamics GP and Intuit QuickBooks to improve business communications, inventory management, customer service, and business intelligence. Two of the key sessions will consist of a panel of customers and a panel of partners which will be available for each respective group to pose questions to and have an open discussion with. In these sessions, all attendees will be at liberty to address topics they are passionate about and collaborate with each other to discuss business issues brought forth by the group.

Jeremy Boogaart, the General Manager of SalesPad, highlights the opportunities the community event offers SalesPad customers, partners, and employees, “PANELS is a really exciting event for the SalesPad family. Customers get to share their SalesPad success stories, and we get to present new features and products to the customers who have requested them. It should be an energizing event for everyone involved.” The company plans on making PANELS an annual event, and expects the 2015 conference to be even larger.

SalesPad, LLC specializes in developing software, with the primary goal being to provide a better interface to both Microsoft Dynamics GP and Intuit QuickBooks through enhancing sales entry, customer service, inventory management, warehouse management, and business intelligence. It is dedicated to increasing business productivity, while decreasing the cost of operation, by providing software that aids in eliminating areas of inefficiency throughout the customers’ business processes. For more information on SalesPad, LLC, please visit their website at http://www.salespad.net.

Startups leverage Xero’s APIs as part of their growth hacking strategy

OmnyApp writes: There’s no doubt that accounting is getting smarter in the 21st century as vast amounts of information, transactions and complex business processes move into the cloud to further trim workplace efficiency.

More importantly however is the arrival of a platform called an API that has accounting software giants like MYOB and Xero implementing their own versions of this highly versatile tool. An API is a digital foundation which allows accounting software clients to transform their business into a gateway to the world market by building custom apps or add-ons on top of the proprietary accounting software.

Confused? We feel your pain. Think of it like Facebook as the Xero or MYOB. A user uses Facebook to conduct their everyday business – chat to friends, message friends, share posts, stalk exes, etc. If the user wants to grow this connectivity further, they have the option of creating their own pages, apps, sponsored content, and games on the Facebook platform to interact with people of the same interests or even their favourite brands. The API then is the Application Programming Interface that allows the user to do this.

Riley James, Developer Relations at Xero explains that on a technical level, an API allows data to be viewed, created and modified by an external application. An API can also allow actions to be triggered from an external application.

This can include anything from having your contacts added to Xero when they are created within your CRM, to sending a thank you email to a customer who pays an invoice early. On the more operational level, it can have your POS system export the day’s transactions to Xero ready for reconciliation when the funds are deposited in the bank. Time management an issue? A time tracking application on the API can calculate the time spent on a job and create an invoice within Xero when you’re ready to collect payment.

This all sounds like a huge leap in the right direction in theory, but how effective is the Xero API in actual startup practice when it comes to business growth potential?
David New, Managing Director at ReceiptBank tells us that there is no question that Xero’s API platform has been integral in contributing towards Receipt Bank’s growth.
“As our first accounting software partner in Australia, Xero’s open API has continuously resulted in new possibilities emerging for Receipt Bank which we have always tried to embrace,” he said.

“Typically it has allowed for tighter integration and the ability to provide additional product features.”It is these additional product features that seem to make an API a viable application for building on a client base and user experience.

What are some of these features? James says that there are now over 300 add-on cloud-based software applications that can be seamlessly integrated with Xero. Applications that claim to deliver all the business software functions one might expect: point of sale, CRM, job management, inventory and tools such as advanced reporting and benchmarking.
“This provides great choice for the business owner. We are about linking all the stakeholders in a business and streamlining the workflow to make small businesses very efficient,” he explained.

“As these companies rebuild their products for the cloud, they’re reaching out to Xero to leverage our accounting solution rather than rebuilding their own general ledger. They are focusing their resources on the features that their customers get value from.”
Emma Petroulas from Nudge Accountingutilises both MYOB and Xero Live Accounts. She agrees with most of Jame’s claims but adds that her one gripe with the software is Xero payroll. “Many of our small business clients have found it difficult to use Xero payroll,” she says.

“Setting up payroll in Xero is easy when clients have staff who are on annual salaries, but when our clients have lots of casual staff working different shifts or irregular hours, they find it hard to navigate their way around the different payroll calendars.”
In saying this, Petroulas says that they still use Xero and “love it”.

Further to Petroulas’ point is how this API technology is being used to direct the growth of a business. When a client knows their numbers, they can make the best decisions for their business. Nudge Accounting says that they use Xero to process clients’ numbers each month, which means that they have almost real time financials at their fingertips.
“The thing about numbers is that they don’t lie,” she says. “What we generally find with startups is that they tend to overstate the financial health of their business, but when they have their numbers in front of them it forces them to make some difficult decisions.”
This is a vital tool in the startup environment and could very well prove an early indicator for founders that things are going pear-shaped long before that ‘closing down’ sign rears its head. Based on the numbers in a management report, clients can recognise inefficiencies in their business and improve many parts of their operations process.

“Using the tracking function in Xero, they have also been able to isolate and understand the most profitable product lines of their business, and change their strategic direction based on this,” adds Petroulas.

“In terms of APIs, there are loads in Xero and we have found that in most cases our clients have found an API which suits what they are after. From time tracking to quotation add-ons, they’re all saving time for our clients.”

As business changes, the methods of growing must also follow suit. For the moment, Xero’s APIs is helping to accelerate this growth albeit without the complacency and sluggishness of traditional accounting and marketing practices.

Disclosure: Emma Petroulas is part of Shoe String Media Group’s advisory board.

Tax Alpha®: What Sophisticated Counselors & Advisors Needs to Know

Robert S. Keebler for Ultimate Estate Planner writes: In the world of finance, “Alpha” is often referred to as the value a money manager generates by exceeding a particular benchmark. In the world of financial planning, Tax Alpha® is best defined as the value financial advisors add by reducing the tax burden on portfolio income – “After all, it is what you keep not what you earn that counts.” A thorough knowledge of the intersection between tax and finance will allow an advisor to substantially reduce a client’s overall tax burden. The heart of Tax Alpha® for most clients is bracket management, IRA and other deferral strategies, DrawDown strategies, and “asset location.”

Bracket Management

With the introduction of the 3.8% net investment income tax (NIIT), the 20% capital gains rate, the 39.6% income tax rate, and the PEP and Pease limitations in 2013, America shifted overnight from a two dimensional federal tax system to a five dimensional system. Virtually every financial decision now needs to be analyzed through the lens of the regular income tax, the AMT, the NIIT, the new additional brackets for high income taxpayers (the “supertax”), and the PEP and Pease limitations. The complexity of going from a two dimensional system to a five dimensional system is exponential, not linear, and requires a quantum leap in tax analysis methodology, tax strategy and tax planning software tools.

2014 Federal Income Tax Rates and Brackets

There are now seven different ordinary income tax brackets – 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%, and three different capital gains tax brackets – 0%, 15%, and 20%. Furthermore, if you combine these tax brackets with the new 3.8% NIIT, there are even more possible tax brackets; i.e., high income taxpayers will be subject to a 43.4% tax rate on ordinary investment income and a 23.8% tax rate on long-term capital gains. Lastly, when taking into account the phase-out of personal exemptions (PEP) and limitations on itemized deductions (Pease) as income rises above the applicable threshold amounts, the tax rates increase even further.

2013+ Adjusted Federal Tax Rates

The tax increases that went into effect at the beginning of 2013 highlight the growing realization among investors that it isn’t what you earn that counts, but what you keep after taxes. The prudent investor carefully plans to reduce the drag of taxation on investment performance by analyzing financial decisions through the lens of the new dynamic.

The first step in tax planning is to estimate the amount of taxable income over a five to fifteen year horizon. This longer time frame is desirable given the increased progressiveness of the tax code. Once the amount of taxable income is estimated, planning to avoid the higher tax brackets and the NIIT can begin. There are many different specific tax planning strategies that can be implemented depending on the situation. Some of these include:

1. Harvesting losses in high income years;
2. Harvesting gains in low income years;
3. Contributing to traditional IRAs in high income years;
4. Contributing to Roth IRAs in low income years;
5. Investing in tax deferred annuities;
6. Creating different types of charitable remainder trusts;
7. Creating charitable lead trusts;
8. Engaging in installment sales;
9. Engaging in life insurance strategies;
10. Implementing Roth IRA conversions;
11. Creating family trusts.

While some of those tax planning strategies may be quite complicated, the basic idea is simple – use income smoothing to obtain the maximum benefit of tax rate arbitrage. Basically, income smoothing strategies involve: (1) reducing taxable income in high income years by maximizing deductions and shifting income to lower income years; and (2) increasing income in low income years by deferring deductions and increasing taxable income to fill-up the lower tax brackets. Put another way, the idea is to “fly below the radar”; i.e., to keep taxable income below the 3.8% NIIT applicable threshold level, and if that is not possible, to keep taxable income below the PEP and Pease applicable threshold, and if that is not possible, to keep taxable income below the 39.6% tax bracket.

Many these income smoothing strategies also create tax deferral – which is also quite powerful in of itself. The longer the period of time that tax can be deferred, the smaller the present value of the tax owed. Below is a chart showing the present value of a dollar of tax paid for various deferral periods, assuming a discount rate of 5%:

Unfortunately, deferring the entire amount of tax for a certain period of years as shown in the chart above may not be possible. Even if the full amount of tax payable cannot be deferred until the end of the period, impressive tax savings can still be achieved by spreading the payments out over the applicable time period rather than paying all the tax at the beginning of the period.

The types of securities and accounts used in the tax aware investor’s portfolio will shift according to the level of the investor’s tax burden. As the income level increases, the complexity of the tax         strategies increases accordingly.. Investors in lower brackets enjoy income from bonds under priced for their tax burden and, furthermore, capital gains are tax-free to the extent the of the 15% bracket. Medium bracket investors, who expect their rates to decline will shift income to later years and achieve tax deferral. Taxpayers in the highest brackets will seek statutory tax shelters, even if it means accepting a lower pre-tax return. The following chart shows the type of income or statutory tax shelter taxpayers will seek depending on their marginal rate:

Deferral and IRA Strategies

Gain is taxable only if it is both realized and recognized. There is a realization event if a taxpayer receives or loses something of monetary value. Realized gains or losses are also recognized unless they are subject to a non-recognition provision in the Tax Code. One such non-recognition provision applies to a sale of assets inside a qualified plan or IRA. Although gain is realized, it isn’t recognized. No tax is payable by the taxpayer until distributions are received.. .

To illustrate the value of managing recognition events and creating tax deferral, compare a taxable investment account with 10% turnover to a taxable account with 100% turnover:

Assumptions:

• Beginning Age: 30
• Ending Age: 65 (i.e. retirement)
• Annual Contribution (Age 30 – 65): $5,000
• Long-Term Capital Gains Tax Rate: 15%
• Short-Term Capital Gains Tax Rate: 25%
• Annual Income/Growth Rate: 6%

Now, to illustrate the value of the lack of tax recognition events within a Qualified Plan or IRA and to calculate the value of tax deferral, compare a taxable investment account with 10% turnover to a Roth IRA account with 100% turnover:

Assumptions:

• Beginning Age: 30
• Ending Age: 65 (i.e. retirement)
• Annual Contribution (Age 30 – 65): $5,000
• Long-Term Capital Gains Tax Rate: 15%
• Ordinary Income Tax Rate: 25%
• Annual Income/Growth Rate: 6%

Clearly the savings afforded by certain sections of the tax code offer significant opportunity for the tax-aware investor. Deferral is powerful when growing a portfolio. However, its power is even more impressive when retirees carefully manage distributions from retirement plans.

The first step in managing draw down years is to make a 5-15 year tax bracket projection. This is critical because it establishes a benchmark to weigh options. Knowing future potential marginal tax rates allows for informed decisions about when to take distributions and when to make Roth Conversions. To demonstrate how to estimate a taxpayer’s future marginal rate consider the following example:

Assumptions:

• Projection Age Range: 65 – 80
• Single
• State Tax Rate: 0%
• 2014 Traditional IRA Balance: $3,000,000
• IRA Growth Rate: 5%
• 2014 Interest Income: $50,000
• 2014 Social Security Benefits: 25,000
• Real Estate Rental Income: $20,000
• Annual Inflation Rate: 2%

Compiling and projecting the data reveals that, despite the client’s modest investment and social security income, required minimum distributions drive the marginal rate up to 33% during retirement.

Now it’s clear that accelerating income into the early years of retirement, by making Roth Conversions for example, will likely be very effective provided it does not cause the applicable rate to exceed the 33% bracket.

Drawdown Strategies

The more applicable question for most is, however, which account to draw annual living expenses from– a Traditional IRA, a Roth IRA, or a taxable account. Moreover, some will have the exponentially more complicated decision of having to consider life insurance, annuities, deferred compensation, and stock options.

Tremendous value can be added by carefully analyzing the tax implications of the various options. For many clients, the key will be to minimize income exceeding the 15% tax bracket and prevent large fluctuations in income from year-to-year. Income can be minimized by, for example, delaying distributions from pre-tax qualified plans and instead selling high basis capital assets for cash flow. In early retirement years, such strategies can be overwhelmingly effective.

To demonstrate the effectiveness of the distribution management strategy cited as an example, consider a 60 year old retiree in the 25% marginal tax bracket who requires an additional $7,500 for living expenses. The retiree has the choice of: (1) distributing $10,000 from a Traditional IRA to meet the shortfall or (2) selling stock in a taxable brokerage account with a basis equal to its fair market value of $7,500. The following chart shows that keeping the funds in the IRA will result in less taxation than even a taxable equity investment with completely deferred taxation of the growth.

Assumptions:

• Projection Age Range: 60 – 80
• Filing Single
• Stock/IRA Growth Rate: 5%
• State Income Tax Rate: 0%
• Federal Ordinary Income Rate: 25%
• Federal Capital Gains Rate: 15%

Note that this chart compares the after-tax value of each account if allowed to grow rather than being liquidated.

However, the opportunities to give such long-term strategic advice to clients rarely presents itself compared with opportunities to provide tactical advice about how to manage draws in a particular tax year. Nevertheless, such tactical advice can be equally, if not more effective. For example, balancing retirement draws from accounts which generate taxable income and those which do not, can significantly decrease the amount of wealth consumed annually or allow for greater spending. Consider a retired single taxpayer who has not yet started social security and is comfortable drawing $80,000 from savings for living expenses, but is unsure which accounts to draw from. Note the tremendous amount of tax saved by balancing draws in order to avoid the higher income tax bracket:

Tax-Aware Investing

Taxes are often a bigger drag on performance than management fees or commissions and over time can dramatically inhibit wealth accumulation. In my next article I will focus on tax-aware investing.

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RELATED EDUCATION & PRODUCTS

Below is a list of a number of educational programs and products that relate to this topic that you might be interested in:

• The Advisor’s Guide to The Top 25 Tax Planning Ideas for 2014 – By Robert S. Keebler, CPA, MST, AEP (Distinguished)
• Personal Exemption Phaseout & PEASE Impact (PEP-PEASE) Chart
• Bracket Management Chart
• DrawDown Strategies Chart

To contact the author Robert S. Keebler, CPA, MST, AEP , CGMA click here Keebler & Associates, LLP

Vacation Home Rentals, Taxes & Deductions

If you rent a home to others, you usually must report the rental income on your tax return. But you may not have to report the income if the rental period is short and you also use the property as your home. In most cases, you can deduct the costs of renting your property. However, your deduction may be limited if you also use the property as your home. Here is some basic tax information that you should know if you rent out a vacation home:

• Vacation Home.  A vacation home can be a house, apartment, condominium, mobile home, boat or similar property.
• Schedule E.  You usually report rental income and rental expenses on Schedule E, Supplemental Income and Loss. Your rental income may also be subject to Net Investment Income Tax.
• Used as a Home.  If the property is “used as a home,” your rental expense deduction is limited. This means your deduction for rental expenses can’t be more than the rent you received. For more about these rules, see Publication 527, Residential Rental Property (Including Rental of Vacation Homes).
• Divide Expenses.  If you personally use your property and also rent it to others, special rules apply. You must divide your expenses between the rental use and the personal use. To figure how to divide your costs, you must compare the number of days for each type of use with the total days of use.
• Personal Use.  Personal use may include use by your family. It may also include use by any other property owners or their family. Use by anyone who pays less than a fair rental price is also personal use.
• Schedule A.  Report deductible expenses for personal use onSchedule A, Itemized Deductions. These may include costs such as mortgage interest, property taxes and casualty losses.
• Rented Less than 15 Days.  If the property is “used as a home” and you rent it out fewer than 15 days per year, you do not have to report the rental income.
• Use IRS Free File.  If you still need to file your 2013 tax return, you can use IRS Free File to make filing easier. Free File is available untilOct. 15. If you make $58,000 or less, you can use brand-name tax software. If you earn more, you can use Free File Fillable Forms, an electronic version of IRS paper forms. Free File is available only through the IRS.gov website.

Publication 527 is available on IRS.gov. You can also call 800-TAX-FORM (800-829-3676) to get it by mail.

Additional IRS Resources:

• Tax Topic 415 - Renting Residential and Vacation Property
• Rental Income and Expenses - Real Estate Tax Tips

E-Tech Offers QuickBooks Multi-Currency Removal Service

E-Tech, a third-party QuickBooks data recovery and conversion provider, now offers a QuickBooks multi-currency removal service for Intuit customers who no longer need the multiple currency feature enabling them to convert to QuickBooks Online or QuickBooks for Mac.

QuickBooks Online does not support multiple currencies. This is frustrating to users of QuickBooks who turned on the multi-currency feature and now want to convert to QuickBooks Online or QuickBooks For Mac. The Quickbooks multi-currency removal service will enable customers to convert their data file to QuickBooks Online or QuickBooks Mac. "This service is perfect -- it let me effortlessly convert my QuickBooks file to QuickBooks Online" said Sheryl Matheson of Glendale, California.

Until now, once the multi-currency feature was turned on in QuickBooks, it was impossible to revert back to a single currency. "Most users simply turned on the multi-currency feature without even using it" stated CIO John Rocha of QuickbooksRepairPro.com. "Now they have a way to undo this change and convert to QuickBooks Online". E-Tech guarantees no loss of data and also offers a full money back guarantee. So far, hundreds of users have taken advantage of this service to move to the Online version of QuickBooks.

Using the multi-currency removal service is simple and quick. The user uploads a backup of their QuickBooks company file via a secure upload link. After the conversion of the file is complete, the user simply downloads the converted file and opens it in QuickBooks. The entire process takes 24 to 48 hours. This service works for both QuickBooks US and Canadian company files. Users of QuickBooks can get more details about this service at http://quickbooksrepairpro.com/Quickbooks-Multi-Currency-Removal-Service.aspx.

For media inquiries regarding this or any other tech-related stories, those interested are encouraged to contact Media Relations, Melanie Ann directly via email at pr@e-tech.ca. To learn more about E-Tech, individuals are encouraged to visit http://www.e-tech.ca for more information.

To get more information about E-Tech Canada, please feel free to visit http://www.e-tech.ca.

4 Depreciation Tax Mistakes Investors Need to Avoid

AMANDA HAN for BiggerPockets If you are someone who invests in long term rentals, you probably already know how depreciation can be your best friend when it comes to paying less taxes.

What you may not know is that as investors, we can also make some pretty big mistakes when it comes to taking depreciation for our real estate. In today’s blog, I wanted to go over some of those common depreciation mistakes that real estate investors make.

Before we get to the mistakes however, let’s take a step back to discuss what depreciation is.  Simply put depreciation is a paper write-off. What this means is that we are taking a tax deduction on our rental properties when we may not have suffered any actual loss on the property.

Depreciation, under the IRS definition, is “a tax deduction that allows a taxpayer to recover the cost of a property over time. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.”

So if you purchase a property for $100,000, and assuming the depreciable building is 80% of the purchase price, then you are generally able to depreciate $80,000 of the purchase price over the life of the rental. This results in a tax deduction each year that can be used to offset your rental income.

What we as investors love about depreciation is that this deduction is available to you regardless of whether the property actually increases or decreases in value. This means that even if your property appreciated in value and is now worth $130,000, you are still able to write off your depreciation based on what you purchased it for.

Another important thing to understand about depreciation is that the amount you write off is not dependent on how much money you put down to purchase the property.

Rather it is based on the purchase price of the contract. For example, on a $100,000 property, you take the same depreciation expense whether you put 20% down or if you put zero money down. This means that it is possible to use depreciation to get tax write-offs without any cash out of pocket.

Now that we talked about how depreciation can be used to help us save on taxes, let’s talk about the four most common depreciation mistakes that we need to watch out for a real estate investors.

1. Depreciation is Not a Choice

Very often we come across taxpayers who either chose not to take depreciation (due to bad advice) or simply didn’t know they can take depreciation (again, due to bad advice).

It is important to know that depreciation is not a choice and if you are eligible to take it, you must take the tax write off. If your rental is eligible for depreciation but you choose not to take it or forget to take it, the IRS will still assume it has been taken and when your property is sold you may end up paying taxes on depreciation recapture that you never received a benefit for previously.

The good news is that if you have not taken your allowable depreciation in the past, there are ways to rectify that problem with amended tax returns to claim what you have previously lost.

2. Recapture is Not the Enemy

Now you may be thinking why in the world would someone choose not to take depreciation?

Well, one of the more common reasons I hear is that people are afraid of depreciation recapture. So what exactly is depreciation recapture? Let’s go over an example: if you take a depreciation deduction for $5,000 today, you may need to pay taxes on that $5,000 if you were to sell your property at a gain down the road.

Sometimes people are afraid of taking depreciation simply because they don’t want the possibility of having to pay taxes on it later. Here are three reasons why this thought process is flawed:

1. Depreciation is required and not a choice. Choosing not to claim depreciation does not protect you from recapture down the road.
2. If you ultimately sell your property at break-even or at a loss then you generally do not need to worry about recapture taxes.
3. Even if you do sell your property at a gain and need to pay recapture taxes, doesn’t it make sense to pay taxes years down the road rather than to pay taxes today? You would not want to prepay the next 20 years’ worth of taxes today would you?

3. Maximizing Your Depreciation

There are lots of different ways to calculate depreciation and it is somewhat rare that I see a tax return with depreciation done in a way that accelerates the depreciation deduction strategically.

Most of the time what I see are investors who depreciate their rental property with two components: land and building. Depending on the investor’s tax profile, this could hurt the investor when it comes to depreciation write-offs.

Most rental properties have many more components than this. There may be appliances, parking structures, landscaping, furniture, fixtures, and much more.

These items can be depreciated much faster than land and building. This concept of identifying the different components and accelerating the depreciation write off is known as a cost segregation.

So if you have made improvements to your property or if you purchased a recently rehabbed property, be sure to provide these break-outs to your tax advisors to accelerate your tax deduction.

4. Something Better than Depreciation?

Believe it or not there is actually something that is even better than depreciation and cost segregation, and that is a “repairs expense”.

Repairs are even better than depreciation because rather than writing off your money over 5, 7, or 27 years, you are able to write off 100% of the repairs cost in the year you incur that expense.  If you are looking at making some improvements to your rental property, here is where strategic planning can really help.

For example, rather than spending $30,000 to change out your entire roof and then having to depreciate that $30,000 over multiple years, why not consider repairing part of the roof over  time so that each repair cost can be deducted on the  year you spend the money?

A slight shift in how your repairs and improvements are done can mean writing off your costs today rather than in the future.