Most tax planning targets the long-term, tax-beneficial treatment of certain accounts and investments, such as 401(k) plans and municipal bonds. In reality, most investments will have little to no upfront tax benefits for the investor, but some do. Thus, in a year when your income is abnormally high, it might be prudent to consider those specific investments that offer immediate tax benefits.
Before you analyze the tax benefits of an investment, always ensure it’s sound and profitable without the tax benefits. This is because most upfront tax benefits will be lost when the investment is sold, so they only add a little economic value to the deal. This principle is often applied to rental real estate, where investors can defer their taxes indefinitely. But it’s a deferral, not a permanent benefit, and eventually, taxes will be paid on the capital gains.
The following list offers a starting point when looking for investments with upfront tax benefits. Most of these upfront benefits are a result of allowed bonus depreciation.
Active Rentals
The best example of active rentals is Airbnb. The main economic driver is the service provided, not the rental itself. For example, hotels have a significant expense in checking people in/out, cleaning the rooms and providing general hospitality services. The real estate rental component tends to be small, compared to long-term rentals where most of the economic value is derived from the use of the real estate with little day-to-day involvement from the owner.
The same concept applies to other rental businesses: If you rent construction equipment for months at a time it’s passive, but if you rent it for just hours or days at a time it may qualify as active. To get upfront tax benefits, you may need a cost segregation study to identify the components of the investment that qualify for bonus depreciation.
Businesses With Equipment
Unlike service-based businesses, capital-intensive businesses that require a large upfront investment in equipment to operate can offer substantial tax benefits. Like with any other investment, however, there are nuances.
First, the business purchase must be structured as an asset purchase. Second, the equipment is not rented long term but used in the company’s operations. Some examples of this are car washes, laundromats, vending machines, photo booths, trucking and logistics, and machining shops. These businesses have assets that can be depreciated in less than 15 years, thus making them qualify for bonus depreciation.
Real Estate Professionals
Many investors would benefit greatly if they could qualify as a real estate professional. That is because real estate professionals are essentially allowed to turn passive real estate income into active business income. As with the investments above, most of the upfront tax savings come from bonus depreciation.
Unfortunately, for anyone with a separate full-time job, qualifying as a real estate professional is nearly impossible. To qualify, you must spend 750 hours per year performing services for your real estate business, and you must spend more than half your time doing so. For example, an investor with a full-time, 40-hour-per-week job would have to spend more than 40 hours per week on their real estate in order to qualify, which is not feasible.
But if you do qualify, this would allow you to treat your real estate investments as an active business.
Bonus: Financing Your Investment
A big leverage opportunity with these investments is that you can finance them and still take a large tax deduction without using your own money; however, there are restrictions.
First, the investor must at minimum guarantee the loan. You need to have skin in the game to take a tax deduction; otherwise, you will be limited to just what you invest.
Second, the investment must be structured correctly. For example, S-corps limit the loss deduction for a financed investment even with a personal guarantee.
A Few Final Points
Bonus depreciation is only 80% in 2023 and will reduce by 20% each year until it disappears. Section 179 deductions are still an option, but they are limited to business income and thus not as encompassing as bonus depreciation. Be sure to also understand the type of income you are trying to offset since investment or capital gains income might be easier than business income, W2 or dividends.
Source : Forbes
