Claudia Wolter, CPA, CVA, is a shareholder with the regional accounting and consulting firm of Katz, Abosch, Windesheim, Gershman & Freedman, P.A. (KAWG&F). She serves on the firm's Construction and Real Estate Services Group and is a Certified Valuation Analyst. Please visit www.kawgf.com for additional information or by phone toll-free at 1.800.989.6432.
How well do you know the tax law?
The "loopholes" of the past have been closed, and it's harder to find "breaks" in the tax law. However, if you have a good accountant, and you plan strategies with their assistance, there are still some opportunities for deductions and deferrals.
"New" Deduction Allowed for Construction Companies
The American Jobs Creation Act of 2004 allows a deduction that is equal to a percentage of the taxpayer's qualified production activities income for years starting in 2005. Qualified production activities income is defined as domestic production gross receipts less direct costs related to those receipts less an allocable portion of costs not directly associated with the receipts.
Domestic production income specifically includes income from construction activities performed in the United States, as well as engineering and architectural services for construction projects in the United States. For this purpose, construction activities include activities that are directly related to the erection or substantial renovation of residential and commercial buildings and infrastructure.
For tax years beginning in 2005 and 2006, the deduction is 3 percent of the lesser of taxable income or qualified production activities income. The deduction increases to 6 percent for years beginning in 2007 through 2009 and further increases to 9 percent for years beginning in 2010 and later. The deduction cannot exceed 50 percent of the W-2 wages paid during the calendar year that ends in the taxable year for which the deduction is claimed.
Writing Off Business Assets-the Quicker the Better
There are many tax planning opportunities when it comes to the acquisition and disposition of your business assets.
The definition of depreciation per the IRS is "the annual deduction allowed to recover the cost or other basis of business or investment property having a useful life substantially beyond the tax year." So, basically anything you purchase for your business that has a useful life of more than a year or so has to be capitalized and a portion of the cost is expensed each year over a certain period of time. The period of time in which you must spread out the expense depends on the type of property.
In addition to normal depreciation, the IRS has a few provisions which allow a larger amount of depreciation to be recognized in the first year, generally on assets other then real property. The first of these provisions is Section 179 expense. Section 179 of the Internal Revenue Code allows a business to fully expense in the year of purchase qualifying capital purchases. The limit for Section 179 for 2006 is $108,000.
There are various limitations that apply to the Section 179 election, two of which we have outlined here. You cannot use the Section 179 expense election to create a loss. For 2006, the deduction begins being phased out once a business places over $430,000 in property in service during the year.
Avoid Recognizing Gains When Selling Depreciated Assets
When planning for asset purchases and disposals, also keep in mind the use of like-kind exchanges. You may be able to defer gain on the sale of property by exchanging it for property that is of the same nature or character.
Like-kind exchanges are available for both real and personal property; the properties must be like-kind (for example, heavy equipment for heavy equipment). The parties to the transaction do not need to exchange property with each other; there can be multiple parties to a like-kind exchange. The like-kind exchange approach allows you to do a delayed exchange with the proceeds going into an escrow account. You must have a qualified intermediary and never take possession of the proceeds. You would need to identify qualified replacement property within forty-five days and have the purchase completed within 180 days of the sale to avoid the tax on the gain from the sale. This is a way for you to dispose of property no longer needed and to acquire new like-kind property which is needed without paying tax on the gain from the sale.
Please keep in mind that the technical requirements of the tax law dealing with like-kind exchanges are very detailed. Therefore, it is critical that you discuss this matter in advance with your tax advisor and/or real estate attorney. Your advisors can also be a valuable resource in helping you structure the deal and perhaps even in finding the appropriate replacement property.
Depreciate Real Estate as Quickly as Possible
Have you purchased, constructed or substantially renovated real estate that you rent or use for business purposes? If so, you may be able to get the depreciation deductions more quickly than usual by having a cost segregation study done.
Most builders and contractors combine expenses like electrical, mechanical, site preparation, drywall and framing in the cost of construction. Breaking down the expenses allows a builder or contractor to reclassify and depreciate certain assets more quickly.
Cost segregation studies defer taxes by carefully breaking down construction and/or acquisition costs and allocating them to specific asset categories, maximizing depreciation expenses for qualifying costs.
The study utilizes engineering and architectural reports to determine what portions of systems installed in a building are not related to building operation and maintenance, and what may be eligible for much faster depreciation (five or seven years instead of twenty-seven-and-a-half or thirty-nine years). The following are some examples of property that may be eligible for faster depreciation:
- Electrical distributions systems
- Air handling and safety
- HVAC and air conditioning units
- Lighting, interior and exterior
- Partitions and walls
- Plumbing and wiring
- Site utilities
Additionally, site work, including site improvements, parking lots and landscaping generally qualify as fifteen-year property.
The benefits of a cost segregation study can far outweigh the up-front cost. Whether constructing, purchasing or expanding a building, a cost segregation study can significantly increase cash flow by maximizing depreciation.
Additionally, the study can also apply to past purchases, which means that adjustments for "missed" depreciation deductions from prior years can be reported as an automatic change in accounting method and deducted 100 percent in the year of the change. So even if you purchased/constructed/renovated a building five or more years ago, you can still take advantage of this accelerated depreciation. In fact, buildings or renovations placed in service between September 11, 2001 and December 31, 2005, would get a more advantageous write-off because of the tax law in effect at that time.
A cost segregation study creates an opportunity not to be missed for real estate investors.
Your Company May Have a Hidden Tax Refund
Close attention should be paid to the look-back interest rules. If you are not currently filing Form 8697, Interest Computation Under the Look-Back Method for Completed Long-term Contracts, and have contracts that that are not completed in the same tax year they are started, you may be targeted as noncompliant by the IRS.
Taxpayers must perform a look-back interest computation in the tax year a contract is completed to compensate for any under- or over-estimation of income from the contract in any previous year the contract was in process. After the calculation of the difference in income recognized is performed, the taxpayer must recalculate their income tax liability in all previous years the contract was in process to determine the difference in the tax liability.
The difference in the tax liability is then considered an under- or over-payment of taxes in the previous years, and the IRS published rates of interest are then applied to the under- or over-payment of taxes. The taxpayer will then either receive a refund of interest or be required to pay interest on the difference in the tax liability.
Form 8697 is the form used to report the under- or over-payment in taxes and the resulting interest. Many contractors are not filing this required form and are not complying with the law. Failure to file this form is considered failure to file a complete return, and therefore, the IRS can assert that the statute has not begun to run on the income tax return. The implication of this is that a contractor that has not filed a Form 8697 for prior years could have that income tax return open for audit by the IRS after the statute would have normally exempted it from being examined.
If your company's contracts often experience profit fade, you could quite possibly be due a refund of interest for taxes "pre-paid" in relation to this look-back computation. Conversely, if the costs are inflated early in the job for anticipated issues that may arise, taxes may be deferred to future years and interest may be due for the deferral of taxes. Our experience has been that more contractors receive refunds than make payments.
Construction Business Owner, December 2006