Income taxes are a substantial burden for business owners and real estate investors. There are few actions which can reduce your 2006 taxes after December 31, 2006. This article summarizes four options for reducing your 2006 federal income taxes during 2007. These include reducing revenue, increasing real estate depreciation, increasing expenses by conducting a fixed asset audit and increasing expenses by converting capital expenditures into operating expenses.
The basic process for calculating income taxes is simple:
Revenue - expenses = net income, or taxable income,
Taxable income x tax rate = income taxes
Two options for reducing income taxes are to reduce revenues or increase expenses. It is not possible to change the tax rate except through congressional action. It may be possible to reduce revenue for taxpayers on an accrual accounting system. Taxpayers may be able to increase expenses by increasing real estate depreciation, personal property depreciation or operating expenses. One of the benefits of increasing operating expenses by increasing depreciation is ti does not require a cash expenditure. Virtually all other deductions require spending an amount equal to the amount being deducted.
Accrual accounting recognizes revenue when it is earned. Cash basis accounting recognizes revenue when payment is received. Accrual basis taxpayers can review revenue which has been booked but not yet received. In some cases, it may be appropriate to increase the allowance for bad debt. There is little cash basis taxpayers can do to reduce revenue (after the end of the year). However, reasonable people can disagree about the bad debt allowance with an accrual accounting system. It clearly involves judgment regarding the timing and probability of receiving payment.
Most real estate owners can sharply increase depreciation by obtaining a cost segregation study. Real estate depreciation schedules are typically established by simply separating land and long-life property. Long-life property is depreciated over 27.5 years for rental residential property and 39 years for commercial property. However, a subtantial portion of the depreciation schedule should be established as short-life property. It is usually possible to allocate 20% to 40% of the cost basis to short-life categories. Cost segregation can usually increase depreciation by 50% to 100% during the first five to seven years of ownership by allocating a portion of the cost basis to 5, 7 and 15 year property. In addition, real estate owners can "catch-up" depreciation under reported in prior years without filing amended tax returns.
Fixed asset audits can be a cost effective means to increase operating expenses by removing phantom assets, removing operating expenses mistakenly coded as capital expenditures and correcting the depreciable life for incorrectly coded items. Phantom assets can include assets which have been lost, stolen or disposed of without removing them from the accounting records. It is likely that phantom assets exist if a fixed asset audit has not occurred within the last several years. The undepreciated basis of these assets can be converted to an operating expense after the error is discovered. In some cases, substantial operating expenses are incorrectly added to the fixed asset listing as capital expenditures. This could include items such as substantial roof repair or parking lot repair. The undepreciated basis of these items can be converted to an operating expense and written off when the error is discovered. The fixed asset listing is massive for many companies, sometimes exceeding 1,000 pages. With so many assets, it is difficult to ensure all are accurate. For items added with an incorrect and excessive depreciable life, it is possible to revise the asset life and "catch-up" depreciation under reported in prior years without filing an amended tax return. Instead, a form 3115 is filed with the tax return.
The difference between capital expenditures and operating expenses is often subjective. Another example is replacing 10% of the sanitary sewer system at a 40-year-old apartment complex; is this a capial expenditure or an operating expense? Are substantial roof repairs a capital expense or an operating expense? Reviewing disbursements which were listed as capital expenditures in 2006 may uncover items which can be converted to operating expenses.
Federal income taxes are a substantial expense for successful businesses. Tax planning is less glamorous than purchasing a new company or developing a new division. However, a modest effort focused on reducing federal income taxes can sharply increase net income.
Patrick O’Connor, MAI is president of O’Connor & Associates, a 180-person real estate services firm in business since 1974. Further information on reducing income taxes is available at:
http://www.poconnor.com/federal_tax_reduction_overview.asp. O’Connor can be reached at 713 686 9955 or poconnor@poconnor.com.
