Capital

Article Dean Dorton

Investment interest — interest on debt used to buy assets held for investment, such as margin debt used to buy securities — generally is deductible for both regular tax and alternative minimum tax purposes. But special rules apply that can make this itemized deduction less beneficial than you might think.

Limits on the deduction

First, you can’t deduct interest you incurred to produce tax-exempt income. For example, if you borrow money to invest in municipal bonds, which are exempt from federal income tax, you can’t deduct the interest.

Second, and perhaps more significant, your investment interest deduction is limited to your net investment income, which, for the purposes of this deduction, generally includes taxable interest, nonqualified dividends and net short-term capital gains, reduced by other investment expenses. In other words, long-term capital gains and qualified dividends aren’t included.

However, any disallowed interest is carried forward. You can then deduct the disallowed interest in a later year if you have excess net investment income.

Changing the tax treatment

You may elect to treat net long-term capital gains or qualified dividends as investment income in order to deduct more of your investment interest. But if you do, that portion of the long-term capital gain or dividend will be taxed at ordinary-income rates.

If you’re wondering whether you can claim the investment interest expense deduction on your 2016 return, please contact us. We can run the numbers to calculate your potential deduction or to determine whether you could benefit from treating gains or dividends differently to maximize your deduction.

Article Dean Dorton

With most of 2016 behind us, you may want to consider some year-end tax-saving ideas. Before acting on these, note the following:

  • Most strategies do not apply universally, but only in specific circumstances.
  • Many strategies should take into account not just the current year’s impact, but future years’ projected impacts as well.
  • Strategies that reduce your current year regular federal income tax may not reduce your overall federal income tax due to the alternative minimum tax.

Section 179 and bonus depreciation — Businesses should consider these tax breaks related to fixed asset acquisitions:

  • Section 179 depreciation deduction. In 2016, individuals and business entities can elect to deduct up to $500,000 of qualifying business property cost in the year the property is placed-in-service. The deduction is reduced dollar-for-dollar for qualifying property cost greater than $2,000,000. Note that this deduction is available only to the extent of positive business taxable income.
  • Special “bonus depreciation” allowance. For 2016, an additional depreciation deduction is permitted for qualifying property in the year it is placed in service. This bonus depreciation is a deduction of 50% of the qualifying property’s cost.

Capital gains and losses — If you have realized net capital gains during 2016, consider realizing capital losses before the end of the year to offset the gains. Remember that net long-term losses can be used to offset net short-term capital gains which otherwise would be taxed at ordinary rates. Also, be aware of the “wash sale” rules if you are inclined to reinvest in a security you sell at a loss.

Self-employed retirement plans — If you have self-employment income and don’t have a retirement plan in place to shelter any of it, you may qualify to use a Self-Employed Plan (SEP). A SEP contribution deduction is allowed for 2016, even if the SEP is created and funded at any time up to the due date, including extensions, of the 2016 income tax return in 2017.

Charitable contributions — Consider funding charitable gifts with appreciated marketable securities held for more than one year, resulting in gains being untaxed and deductions being allowable at the securities’ market values. You may also charge charitable contributions on your credit card; contributions posted to your account before year-end are deductible this year, even if you do not pay the charges until next year.

Annual gifting — You may give your children and others up to $14,000 each in 2016 without any gift tax consequences. This annual exclusion is calculated on a per donee basis and no carryover is allowed for the unused exclusion. Consider making year-end gifts to fully utilize this year’s annual exclusion, and consider making your 2017 annual exclusion gifts (also at $14,000 per donee) early next year.

Required minimum distributions — Individuals with retirement plan accounts (employer qualified plans or IRAs) generally are required to take minimum annual distributions upon reaching age 70 ½. Steep penalties apply to noncompliance, and not all IRA custodians or plan sponsors actively communicate the applicability of the rules to account holders and plan participants.

S Corporation and partnership losses — If your S Corporation will generate a tax loss this year, consider whether you have enough basis in the stock (or in loans you’ve made to the corporation) to take the full loss. If you don’t, additional investments should be considered. Similar considerations can arise in some situations with partnerships expecting tax losses.

Possible elimination or reduction of valuation discounts for family-owned businesses — As reported in an earlier newsletter, the U.S. Treasury has proposed regulations which, if finalized, will have the effect of increasing valuations of noncontrolling interests in family-owned businesses and investment entities for gift, estate, and generation-skipping tax purposes. The proposals are attracting much criticism. A hearing on the proposals is scheduled for December 1. Subsequent courses of action include at least the following:

  • The regulations being finalized as proposed
  • The regulations being finalized with modifications
  • Withdrawal of the proposals followed by further study

Once finalized, the regulations would become law after 30 days. If you are interested in transferring an interest in a family-owned entity, you may want to consider conducting such transactions before the end of the year.

If you have any questions, contact your Dean Dorton advisor or Matt Smith at msmith@deandorton.com.

Article Dean Dorton

Investing in mutual funds is an easy way to diversify a portfolio, which is one reason why they’re commonly found in retirement plans such as IRAs and 401(k)s. But if you hold such funds in taxable accounts, or are considering such investments, beware of these three tax hazards:

  1.  High turnover rates: Mutual funds with high turnover rates can create income that’s taxed at ordinary-income rates. Choosing funds that provide primarily long-term gains can save you more tax dollars because of the lower long-term rates.
  2. Earnings reinvestments: Earnings on mutual funds are typically reinvested, and unless you keep track of these additions and increase your basis accordingly, you may report more gain than required when you sell the fund. (Since 2012, brokerage firms have been required to track — and report to the IRS — your cost basis in mutual funds acquired during the tax year.)
  3. Capital gains distributions: Buying equity mutual fund shares late in the year can be costly tax-wise. Such funds often declare a large capital gains distribution at year end, which is a taxable event. If you own the shares on the distribution’s record date, you’ll be taxed on the full distribution amount even if it includes significant gains realized by the fund before you owned the shares. And you’ll pay tax on those gains in the current year — even if you reinvest the distribution.

If your mutual fund investments aren’t limited to your tax-advantaged retirement accounts, watch out for these hazards. And contact us — we can help you safely navigate them to keep your tax liability to a minimum.

Article Dean Dorton

Question:

If you spend money to change a capital asset used in your business this year, then is the expenditure a capitalized improvement or an expensed repair?

Answer: 

Under the new Tangible Asset Regulations (TARS), you must capitalize all betterment, restoration, and adaptation expenditures as improvements to the unit of property (UOP). The regulations define these three terms as follows:

  1. A betterment is an expenditure that:
  • Corrects a material condition or defect that existed prior to acquisition or arose during production of the UOP,
  • Results in a material addition to the UOP, or
  • Results in a material increase in strength, capacity, productivity, efficiency, quality or output of the UOP.
  1. A restoration is an expenditure that:
  • Replaces a component of a UOP,
  • Repairs damage to a UOP,
  • Returns UOP to its ordinarily efficient operating condition if it deteriorated to a state of disrepair and is no longer functional for its intended use,
  • Rebuilds UOP to a like-new condition after the end of its ADS class life, or
  • Replaces major component or substantial structural part of UOP.
  1. An adaptation is an expenditure that adapts a UOP to a new or different use that is not consistent with the taxpayer’s intended ordinary use of the UOP when originally placed in service by the taxpayer.

Otherwise, the expenditure is a repair, and you can expense it in the current year.

Contact your Dean Dorton advisor or Faith Crump at fcrump@deandorton.com or 502.566.1025 if you have any questions.

Article Dean Dorton

Question:

If you renovate a building used in your business this year, then is the expenditure a capitalized improvement or an expensed repair?

Answer: 

It is important to understand how the “unit of property” concept has changed regarding buildings. Before the new rules, only the building in its entirety was considered one unit of property. Now, as many as nine building systems can make up one building, and each system is its own unit of property.

The nine systems that can make up a building are as follows:

  1. Heating, ventilation and air conditioning (HVAC) systems
  2. Plumbing systems (pipes, drains, sinks, toilets, etc.)
  3. Electrical systems (wiring, outlets, lighting fixtures, etc.)
  4. All escalators
  5. All elevators
  6. Fire protection and alarm systems (sensing devices, computer controls, sprinkler heads, etc.)
  7. Security systems (window and door locks, security cameras, recorder, monitors, motion detectors, etc.)
  8. Gas distribution systems
  9. Other structural components (roof, walls, floors, etc.)

To follow the new Building Systems rules, you may have to plan more carefully before you renovate and keep detailed records during each project. However, these rules may also provide more certainty that an expenditure appropriately expensed as a repair will pass IRS scrutiny.

Contact your Dean Dorton advisor or Faith Crump at fcrump@deandorton.com or 502.566.1025 if you have any questions.

View Faith Crump’s Bio

Article Dean Dorton

As you close out 2015, take a look at the following key electric co-op performance indicators in Kentucky. Dean Dorton analyzed 11 of the larger electric co-op financial statements as provided to the Public Service Commission.

The industry looks stable with equity as a percentage of total assets climbing from 37% to 43% and an increase in current ratio from 1.18 to 1.25. Accounts receivable and accounts payable continue to turnover about every 12th day. Operating margin dipped from 6% to 5% and the group continues to reinvest in itself at the rate of 8% of revenue.

The industry is highly leveraged to fund its capital with debt exceeding its equity. The purchase of energy sits at 74% of revenue and represents one of the main risks going forward as highlighted in Dean Dorton’s top 10 electric co-op list for 2016.

2014

2013

Debt to equity

1.39

1.46

Equity to total assets

43%

37%

Current ratio

1.25

1.18

Accounts payable turnover

12.65

11.82

Accounts receivable turnover

12.59

12.82

Operating margin

5%

6%

Cost of purchase %

74%

74%

Plant additions %

8%

8%

 

For more information, contact Bill Kohm at bkohm@deandorton.com or 859-425-7625.


View Bill Kohm’s Bio