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MONTHLY TAX NEWSLETTERMarch 2007
Every tax season, there seem to be a few hot tax topics that I make sure to discuss with my clients. So far, this year's winner is the non-deductible IRA.
What happened to cause non-deductible IRAs to become so popular? Last spring, the Tax Increase Prevention and Reconciliation Act, signed into law on May 17, 2006, included a provision that eliminates the income limitation for people looking to convert their IRAs and other eligible retirement accounts to a Roth IRA, effective in 2010.
The beauty of Roth IRAs is that they provide tax-free growth. Assuming the current Roth rules don't change down the road, you will be able to withdraw money from your Roth accounts when you retire without paying a dime of taxes on the money withdrawn.
Most other retirement accounts grow tax-deferred, which means you will owe taxes on distributions taken from these accounts in the future.
One of the drawbacks to Roth IRAs is that high-income taxpayers haven't been allowed to put any money into them since they were introduced back in 1998. In any year that your adjusted gross income (AGI) exceeds $160,000 if married or $110,000 if single, you're not allowed to contribute to a Roth IRA that year.
Plus, you're not allowed to convert your existing IRAs and other eligible retirement accounts to a Roth in any year that your AGI exceeds $100,000. The same $100,000 threshold applies to single individuals and to married couples.
The New Rules
Under the new rules, you still can't contribute to your Roth IRA if your AGI exceeds the $160k or $110k ceiling. But by planning ahead, you can bypass this threshold, and end up contributing a total of $23,000 to a Roth IRA over the next five years.
Here's what you need to do. Starting for 2006, max out your traditional IRA contribution each year if your income is too high for a Roth IRA. You're limited to $4,000 per year for 2006 and 2007, increasing to $5,000 per year after that. Anyone 50 or older can contribute an extra $1,000 per year. This threshold is per person, so married couples can contribute double these amounts. You have until April 17, 2007 to make your 2006 IRA contributions.
Assuming you're covered under a retirement plan at work, or are self-employed and contribute to a SEP, SIMPLE, Keogh, or Solo 401(k), your IRA contribution won't be tax deductible if your AGI exceeds $85,000 if married or $60,000 if single. If you're married, and your spouse doesn't work or isn't covered under a retirement plan, your spouse's IRA contribution won't be tax deductible if your AGI exceeds $160,000.
For every year that you make a non-deductible IRA contribution, make sure to attach a Form 8606 to your federal tax return, since this is how to inform the IRS of your after-tax basis in your IRA accounts. If you've already filed for 2006, that's not a problem since you can send in the Form 8606 to the IRS as a standalone form.
In 2010, after making your non-deductible IRA contribution for that year, convert your IRA account to a Roth IRA. Keep in mind that you will only be taxed by the amount that the value of the account exceeds the non-deductible contributions you made over the years.
Let's say that you currently have no other IRA money, and begin making non-deductible IRA contributions for 2006. You continue to contribute to your IRA each year, and as of 2010 have made a total of $23,000 of non-deductible IRA contributions.
Assuming your IRA is worth $30,000 in 2010, you will only be taxed on $7,000 of income when you convert your IRA to a Roth IRA ($30,000 - $23,000). And if you convert your IRAs in 2010, the new rules give you the option of splitting this income over the subsequent two tax years.
If you currently have other IRA accounts open, including SEPs and SIMPLEs, this strategy may not work so well. That's because your other IRA accounts will dilute your after-tax basis in your IRA.
Let's change the example to reflect that you're sitting on quite a bit of IRA money, and in 2010, the total value of all your IRA accounts is $230,000. You will now need to divide the $23,000 of basis over the full value of your IRAs, which means that you will only be able to allocate $1 of basis for every $10 or IRA converted. So when you convert $30,000 to a Roth, the taxable income to report jumps from $7,000 as in the previous example to $27,000.
The good news is that you might be able to get around this pitfall. If you have money sitting in a "rollover IRA", consider rolling that money into your current employer's 401(k) or 403(b) plan if that plan is set up to accept rollovers. Under the current rules, you only look at your existing IRA accounts when allocating your non-deductible contributions.
The reason I'm telling all my high income clients about non-deductible IRAs this winter is that this strategy makes a lot of sense for them. High income taxpayers who plan ahead finally have the opportunity to get some money into a Roth IRA while paying just a minimal amount of taxes to do so.
There's more than one way to depreciate a building. By taking advantage of an increasingly popular tool known as a "cost segregation study", you're allowed to depreciate a portion of the money spent to purchase or improve your building much quicker than over 39 years as prescribed by the IRS.
39 Year Life
My clients are generally very surprised to discover that the depreciable life of commercial real estate is 39 years. Twenty years ago, the Tax Reform Act of 1986 extended the depreciable life of a non-residential building from 19 years to 31.5 years. Then, in 1993, the prescribed useful life was extended once again, this time to 39 years. Residential real estate has a depreciable life of 27.5 years.
To further limit the tax break allowed, owners of real property generally aren't allowed to calculate depreciation on their buildings and improvements using "accelerated" methods. Instead, the thirty-nine year depreciation tables call for "straight-line" depreciation.
Let's look at an example where you purchase a commercial property for $1 million, of which $220,000 represents the cost of the land. (Remember, land is not depreciable.) On the remaining cost-basis of $780,000, you get to claim a depreciation deduction of just $20,000 per year. That's not much of a tax break at all.
Furniture, fixtures, carpeting, and other components of your building can be considered "personal property", and qualify for advantageous tax treatment. First off, the depreciable life of personal property is generally 5 or 7 years. Plus, you get to claim depreciation on this type property using accelerated methods - allowing for a larger tax break in the earlier years of owing the property.
With personal property, you also have the option of expensing the cost of the property in the year of purchase. Known as the Section 179 Election, you can write-off up to $108,000 of personal property purchased and put into business use the same year, annually, through 2009.
Land improvements, including landscaping, driveways and parking lots, fences, and drainage facilities also qualify for beneficial tax treatment. The prescribed life for land improvements is generally 15 years, and you can calculate depreciation on them using accelerated methods as well.
How Cost Seg Studies Work
According to our friends at MS Consultants, LLC (www.costsegstudies.com), a leader in this field, "the overall purpose of Cost Segregation Studies is to help you maximize the depreciation benefits for Federal and State income tax purposes by classifying the total acquisition and other related costs for the buildings in accordance with the applicable cost recovery system for Federal and State income tax purposes."
"The basis for developing and supporting this classification of cost components is a detailed cost analysis. Using a team of engineers and CPAs, we examine your site survey, architectural plans, floor plan layouts, cost data, and internal cost ledgers for the projects. We also inspect the properties during the course of our analysis and secure photographs to document those components that qualify for a more rapid depreciation."
Basically, you save taxes due to the "time value of money". Even though you'll ultimately fully depreciate the property if you own it for 39 years, a tax break today is generally much more valuable than a tax break down the road.
Any pitfalls to cost seg studies? Of course there are, since whenever you sell business property there are tax ramifications to consider. Generally, any appreciation realized on the property is taxed as a capital gain, so the appreciation isn't an issue.
The pitfall arises since you're also required to pay taxes on any depreciation claimed over the years. While the maximum federal tax rate on depreciation recapture of real property is currently 25%, the deprecation recapture on personal property is taxed as ordinary income. And today, the top federal tax bracket is 35%.
Since cost seg studies reallocate certain costs from real property to personal property, there is a good chance your taxes might be higher in the year you sell the property. For that reason, cost seg studies make more sense the longer you plan to hold the property.
It's Never Too Late
If you haven't yet completed a cost seg study for an acquisition made in a prior year, don't despair. According to MS Consultants, "the IRS allows a taxpayer to go back as far as 1987 to reclassify personal property items that have been incorrectly depreciated. This change in depreciable lives is prospective and no amended returns are required."
Instead, you will need to prepare a From 3115, Application for Change in Accounting Method, and submit the completed form to the IRS. As part of the service they provide, MS Consultants prepares this paperwork for their clients.
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