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How to “use” Depreciation and why it’s in your K-1?

Financial Planning Dentist

How to “use” Depreciation:

Basic Definition: Depreciation is a method used to allocate the cost of a tangible asset (like a building, machine, or vehicle) over its useful life. Since assets wear out or become obsolete over time, they lose value. Depreciation is a way to recognize this decrease in value on financial statements and for tax purposes.

Simple Analogy: Imagine you buy a car for $20,000, and you expect it to last for 10 years. Each year, the car loses a bit of its value. So, instead of deducting the entire $20,000 from your income in the year you buy the car, you deduct a portion of it each year over the 10 years. This annual deduction is the depreciation expense.

Depreciation in your K-1:

What’s a K-1?: Schedule K-1 is a tax form used in the U.S. for partnerships, S corporations, and certain trusts. It represents an individual’s share of income, deductions, credits, etc., from these entities. If you invest in one of these entities, you receive a K-1 detailing your portion of the income or loss.

Why Depreciation is Relevant: When a partnership (or similar entity) owns tangible assets like real estate or equipment, those assets get depreciated. This depreciation provides a tax deduction for the entity, thereby reducing its taxable income. If you’re an investor in that entity, your share of that depreciation appears on your K-1. On your personal tax return, this can offset other income, potentially reducing the amount of tax you owe.

In simpler terms, depreciation on a K-1 represents your piece of a tax benefit stemming from the tangible assets the business entity owns and uses. This benefit can reduce your taxable income, which could potentially lower the amount of taxes you need to pay.

 

These are Typical Sources of Depreciation in the expenses of an investment:

Furnishing and Fixtures

Definition: These are movable furniture, fittings, or other equipment that are used in a business or home but are not integral to the building.

Depreciation: Typically, these are depreciated over a 5 to 7-year period using the Modified Accelerated Cost Recovery System (MACRS) for U.S. tax purposes.

Laundry Equipment:

Definition: Equipment specifically designed for cleaning fabrics, such as washing machines, dryers, and ironing machines.

Depreciation: Often depreciated over a 5 to 7-year life using MACRS.

Computers:

Definition: Electronic devices used to process data and perform tasks.

Depreciation: Typically, computers are depreciated over a 5-year period using MACRS.

Automobiles:

Definition: Vehicles primarily designed for on-road use.

Depreciation: Generally depreciated over a 5-year period using MACRS, but there are specific rules and limits, especially for passenger vehicles.

Personal Property:

Definition: This can refer to items that aren’t permanently attached to or part of the real estate. It could include machinery, tools, or other movable properties.

Depreciation**: The period varies but often falls in the 3 to 7-year range, depending on the specific type of property and its use.

Capital Improvements:

Definition: Upgrades made to enhance the value of a property or extend its lifespan. This might include things like a new roof or an added wing to a building.

Depreciation: The depreciation schedule depends on the nature of the improvement and what it’s related to. For example, if it’s an improvement to a building, it might be depreciated over 27.5 years (for residential property) or 39 years (for commercial property).

Buildings:

Definition: Structures like houses, office complexes, or warehouses.

Depreciation: In the U.S., residential rental property is depreciated over 27.5 years, while commercial property is depreciated over 39 years using the straight-line method.

Land Improvements:

Definition: Enhancements to a piece of land, such as landscaping, driveways, walkways, fences, and parking lots.

Depreciation: These are generally depreciated over a 15-year period using MACRS.

 

 

More related articles:

Definitions: Debt

Generally debt is any monies owed. it is broadly defined as “Any negative on your balance sheet.” But we think there are key distinctions in the way debt is owed. This causes us to divide debt into two definitions, erosive and accretive. Erosive Debt – is debt that over the long term does not create a profitable asset on a persons balance sheet. This include any time the debt service outpaces inbound cash flow. Accretive Debt –  is debt that the long term capital gains and cash flow of an assets outpaces the debt service required to purchase said asset. Breakeven – this is the tipping point when debt changes from being erosive to accretive.

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December 11, 2020 No Comments
1031 Exchange Alternative
Articles
Peter Locke

An Alternative or Back-up for the 1031 Exchange

The Delaware Statutory Trust (DST) is a trust that is structured as a pass-through entity and can hold passive Real Estate. It can function as a 1031 Exchange Alternative. All of the debt is nonrecourse and the income, net of expenses, is distributed to the investor.  What are the advantages?   1031 Exchange compatibility Passive investment with no management responsibility Estate planning tool – pass DST on to your heirs, tax deferred Who benefits from them? Investors no longer wanting to manage real estate Retiring real estate investors Backup/ alternative option for 1031 exchanges Investors looking to diversify into properties typically unavailable to them A Delaware Statutory Trust is a legal entity used to arrange for the co-ownership of property. DST’s are a great vehicle when constructing real estate offerings as co-owners are entitled to profits earned from the property, like rent, without the management responsibilities. For many it can be a 1031 Exchange Alternative. So why do people use DST’s? Let’s say you have an investment property that you’ve held for a long time and because you’ve depreciated the property for a number of years your basis is very low and the property has grown considerably simultaneously. Well you’d have a large capital gain on your hands if you sell it. You could do a 1031 exchange (1031 Exchange)  but that means getting another investment property, following a number of rules, and doing it in a short amount of time. Although very doable, looking at a more passive strategy may benefit you.  If you want your capital to be invested from your home without losing a majority of it to capital gain taxes and are accustomed to cash flow from your rentals then deferring your gains and reinvesting your capital into like-kids real estate can be done through a 1031 exchange. You may also decide to hire a third party management company to take the day-to-day responsibilities away as well which although cuts into your income, saves you from the downside of being a landlord. If you’re the one being a landlord, want to expand your investment portfolio, and want cash flow then the DST is the best of both worlds alternative where you don’t have to choose between paying taxes now or being a landlord. With the DST, you get passive income, capital grows free of capital gains tax, you avoid being a landlord, and you get diversification. Let’s walk through how you’d do this. First, you’d make use of the 1031 exchange by swapping the proceeds from your real estate sale of your investment property for interest in a DST. By doing this, you become co-owners/investors in a diversified portfolio of properties and pass the management responsibilities on to the sponsor who acts as the trustee for the DST. This satisfies your IRS responsibility of finding a “like kind” property and enabling you to defer capital gains.  DSTs provide you limited liability protection, regular (at least quarterly but often monthly) cash flow income, high-quality assets, and 1031-compatibility. Since with any trust there is a trustee (takes legal title for purposes of management) and a beneficiary (takes equitable title). DSTs are pass through entities, so as a beneficiary, this structure entitles you to a fractional share of income, appreciation, and tax benefits from the properties.  This structure is key for 1031 eligibility as the acquiring property must be “like kind” to your sold real estate and even though you don’t hold legal title, for tax purposes, you’re treated as owning that property. Since the DST is a separate legal entity, beneficiaries have limited liability and therefore any debts incurred by the DST won’t put the investors personal assets in harm’s way. It also protects personal assets from the liabilities of other owners and the DST itself.  DSTs are the only statutory trusts to be explicitly recognized by the IRS as legal entities that can facilitate a 1031 exchange.  What are the risks of DST’s? Macroeconomic risks Economic downturn can mean lower returns and income Liquidity risks Most DST’s have an investment period of 7 to 15 years Although you get cash distributions your principal is off limits during this time Management risks A bad sponsor may pick overvalued properties when compared to peers  A low yield while the investor is still collecting fees for management and organizing the investment Do your due diligence to check the sponsors history, background, and how similar deals have done in the past to see if projected return rates were met and problems due to bad management didn’t occur High vacancy rates and unforeseen costs hurt cash flow Financing Risk DSTs are managed differently but if the trustee uses high loan to value offerings there is a higher risk of foreclosure Fully amortized loans need to be paid by the end of the loan agreement so that could affect your cash distributions Eligibility The DST needs to be structured to facilitate your 1031 Exchange Alternative In conclusion, DST’s when done properly, are a great way of getting away from being a landlord or paying a large sum of capital gains taxes while simultaneously giving you the passive income, limited liability, 1031 compatibility, and high quality asset diversification. However, just because it does all these things doesn’t make it a great investment. They require proper due diligence to review the sponsors reports, loan documents, appraisals, underwriting data, etc prior to investing.

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December 12, 2020 No Comments
New
Kevin Taylor

How to Prepare your company for the Close of the Plan Year and Welcome the New Year in Your 401(k) Plan

As the current year draws to a close, plan sponsors overseeing 401(k) plans have several essential tasks to complete to ensure a smooth transition from the old plan year to the new one. This guide provides insights into what you can expect and how to prepare effectively for the upcoming year. With InSight, plan years align with the calendar year, making January 1 the starting point for the new plan year. Before Year-End Some elements of your tax mitigation and 401(k) planning strategy must be completed before the Dec 31st deadline. Consult your AIF®, CPA®, and CFP® today to make sure these are noted and can be completed by year-end: Elect Final Contributions For individuals with self-employed income, confirming owner’s draw elections by the December 31 deadline is essential, and this requirement extends to more than just owner’s draws.  It also encompasses bonuses and other spot compensation that employees want to count in this year’s contributions. This deadline is significant because it impacts how these additional forms of income are allocated within the 401(k) plan. Even if participants intend to allocate these contributions to the following year for the current plan year, adhering to the December 31 deadline ensures that these funds are correctly accounted for and accounted for in the appropriate tax year.  Bonuses and spot compensation, often received at year-end or sporadically, should not be excluded from 401(k) contributions. It’s crucial to communicate to plan participants that they have the opportunity to temporarily adjust their deferral rates via their dashboards before payroll processing, allowing them to make informed decisions about their retirement savings in light of these variable income sources.  Timely compliance with these deadlines ensures transparency and accurate accounting of all forms of income within the 401(k) plan, promoting financial security for participants and regulatory compliance for plan sponsors. Verify or Update Company Information Begin by confirming that InSight and the recordkeeper have the most up-to-date and accurate information about your company’s owners and officers. You can achieve this by completing the company information task on your dashboard. If you’ve switched or plan to switch payroll providers, it’s crucial to inform us promptly. Make sure to review your employee roster, ensuring it includes any new hires and employees who have left your organization. Monitor Your Compliance Dashboard Access your compliance dashboard to review projected compliance results via the Compliance Status section on your administrator dashboard. More on Compliance testing is found here. It’s important to note that Safe Harbor 401(k) plans automatically meet most non-discrimination testing requirements. More on Safe Harbor 401(k) plans can be found here. Understand End-of-Year Payroll and Annual Limits Keep in mind that bonus payments cannot be excluded from 401(k) contributions, even if they are paid separately from regular payroll. If participants are due to receive a bonus, inform them that they can temporarily adjust their deferral rates via their dashboards before payroll processing, if desired. Employer nonelective contributions and matches will apply to bonus pay as usual. All payrolls with a payment date on or after January 1 will count toward the next plan year’s contributions, regardless of when the work was performed. In the context of 401(k) plans, compensation is recognized when it’s actually paid, not when it’s earned. If any employees reach annual contribution limits before the year-end, their contributions may be capped by either your payroll provider or recordkeeper to prevent exceeding these limits. When the New Year Begins At the onset of the new plan year, you can expect to receive tasks within your administrator dashboard, guiding you on essential actions to take. Here are some tasks you may need or want to complete: Report Compensation and Self-Employment Income Reporting compensation and self-employment income in 401(k) plans holds paramount importance as it forms the foundation for fair and accurate retirement savings. This crucial step ensures that participants’ contributions and benefits align with their actual earnings, fostering equity within the plan. Accurate income reporting not only helps employees maximize their retirement savings but also aids plan administrators in complying with regulatory requirements.  By meticulously documenting compensation and self-employment income, employers and plan sponsors can confidently navigate the complexities of 401(k) plan administration, contributing to the financial well-being of both the workforce and the organization as a whole. Make Additional Employer Contributions with Profit Sharing Making additional employer contributions with profit sharing is a strategic move that can significantly benefit both employers and employees within a 401(k) plan. This practice allows employers to share their company’s success directly with their workforce, fostering employee loyalty and motivation. It serves as an attractive incentive for employees to participate in the retirement plan, increasing overall plan engagement.  From an employer’s perspective, profit sharing provides flexibility in contributing to retirement accounts while potentially enjoying tax advantages. It aligns the company’s prosperity with the financial well-being of its employees, creating a win-win scenario that strengthens the employer-employee relationship and enhances the long-term retirement security of the workforce. Consider making additional employer contributions with profit sharing, enhancing the retirement benefits offered to your employees. Explore the advantages of profit sharing. Address Required Nondiscrimination Test Failures Addressing required nondiscrimination test failures in a 401(k) plan is a crucial step to maintaining fairness and compliance within the plan. These tests are designed to ensure that retirement benefits are distributed equitably among all employees and not skewed in favor of highly compensated individuals or business owners.  When failures occur, it’s imperative to take corrective actions promptly as outlined by the IRS. By rectifying these issues, plan sponsors not only avoid potential penalties and legal complications but also uphold the core principle of retirement plans – providing a fair and equal opportunity for all employees to save for their future. Proactive resolution of nondiscrimination test failures not only safeguards the plan’s integrity but also fosters trust and confidence among plan participants, reinforcing the plan’s commitment to equitable retirement savings for everyone. If your plan fails any mandatory nondiscrimination tests, be prepared to make the necessary corrections as outlined by

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November 15, 2023 No Comments

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