Business owners often have to make decisions about the offices, warehouses, and other real estate they use. At some point, you may decide that your company should be a property owner. Whether you buy existing real estate or develop a new property, some strategies can make the venture less costly.
With any real estate investment, raw land is not eligible for depreciation deductions. Thus, it's in your interest to have less of your cost allocated to land and more allocated to building and improvements. Additionally, commercial real estate generally has a 39-year depreciation schedule. However, machinery and equipment and other items not part of the base building can be written off more quickly, perhaps over five or seven years. The costs of carpets, linoleum, and window treatments, for example, often can be depreciated rapidly. The same might be true for appliances and communications systems. Our office can help you work with a consulting firm that has engineering expertise, which will be especially helpful in the case of new construction. If tax reduction is a goal, from the beginning of a project more costs can be allocated to shorter-lived items, resulting in accelerated tax deductions. And even if you already are depreciating your building on a 39-year schedule, it may be possible to file amended returns to claim deductions you could have taken in prior years.
What if your company owns a building that is fully depreciated and therefore not providing much in the way of tax deductions? One strategy would be to buy the building yourself, as the company owner, or have a group of owners form a limited liability company (LLC) to buy the building. Most of the purchase price could be borrowed. Then you could lease the building back to the company. What does this accomplish?
A sale-leaseback may be especially attractive if you're about to retire. Lease payments from the company can provide supplemental retirement income. Ultimately, you might sell the building to provide even more spending money in retirement, Alternatively, you can hold on to the building and pass it to your heirs, who may get a basis step-up to market value when they inherit. To qualify for all the benefits listed above, the sale-leaseback must be valid. Among the requirements:
As oil prices climb and the value of the U.S. dollar sinks, inflation might pick up. Higher inflation, in turn, can damage your portfolio. One way to protect yourself is to put some money into investments that will act as inflation hedges. For example, you can buy Treasury Inflation-Protected Securities (TIPS).
TIPS are Treasury bonds, so they are protected against default by the federal government. As is the case with all Treasury issues, the interest income from TIPS is exempt from state and local income tax. You can buy new issues of TIPS with 5-, 10-, or 20-year maturities. They can be ordered, generally with out a fee, at www.treasurydirect.gov. If you don't want to buy and hold TIPS on your own, there are several TIPS funds in which you can invest. They're available from fund families such as Fidelity and Vanguard.
Despite the similarities noted above, TIPS are different from other types of Treasuries. If you invest $10,000 in a standard Treasury paying 4.5%, for example, you'll collect $450 in interest each year. At maturity, you'll get your $10,000 back. With TIPS, the interest rate might be only 2%. Why settle for a 2% yield when you could get 4.5%? Because TIPS increase value, to keep pace with inflation.
Say you invest $10,000 in TIPS paying 2%. Suppose that inflation is running at a 4% rate. TIPS pay interest every six months, and their principal is reset then. If inflation is 4%, the six-month reset would be half that amount: 2%. Now the TIPS you bought for $10,000 would have a face value of $10,200, including the $200 (2%) inflation adjustment. And so on, every six months. Over the years, your principal might grow to $10,500, $11,000, $12,000, or more, depending on the inflation rate. Moreover, TIPS investors enjoy compound growth principal. In our example, TIPS bought at $10,000 were worth $10,200 after six months. If the inflation rate remains 4%, another 2% increase would result 6 months later. This 2% increase would be based on the reset value of $10,200, so the inflation adjustment would be $204, and the TIPS would be worth $10,404 after one year.
In the example above, the fixed interest rate was set at 2%. Although the rate is fixed, the interest payments are not. As TIPS principal increases, that 2% would be paid on the inflation-adjusted principal. Suppose the TIPS you bought for $10,000 reach $12,000 in inflation-adjusted principal. The 2% interest rate would amount to $240 (2% of $12,000) and the semi-annual interest payment would be $120.
Suppose that you bought 10-year TIPS with a 2% interest rate. Further suppose that inflation averages 4% per year for those 10 years. Your ultimate return would be 6% per year: 4% in principal adjustments and 2% in interest payments. You would be better off with TIPS that with a standard Treasury issue yielding 4.5%. In fact, if TIPS pay 2% when Treasuries of the same maturity pay 4.5%, TIPS would be a better choice as long as the inflation rate exceeds the 2.5% difference.
When you invest in TIPS, you will owe tax each year on both parts of your return- the increase in principal value as well as the interest. Thus, you will owe tax on money you might not receive for years. Suppose you receive $200 in interest payments from TIPS this year, while the principal grows by $400. You'll owe tax on $600 of income but have only $200 in hand. One solution is to hold TIPS in a tax-deferred retirement account such as an IRA. You will not owe tax until the money comes out of the IRA, so you'll avoid paying tax on "phantom income." The situation is trickier if you expect to live in a high-tax state when taking money from your IRA. Withdrawals will be subject to state and local income tax, so you'll be losing the benefit of the tax exemption offered by Treasury bonds. Our office can help you determine whether it makes sense to hold TIPS in a tax deferred retirement account.
| Annualized Inflation Rates | |
| 1997 through 2006 | 2.4% |
| 1992 through 2001 | 2.5% |
| 1987 through 1996 | 3.7% |
| 1982 through 1991 | 3.9% |
| 1977 through 1986 | 6.6% |
| 1972 through 1981 | 8.6% |
| 1967 through 1976 | 5.9% |
| 1962 through 1971 | 3.2% |
| 1957 through 1966 | 1.8% |
| 1957 through 1961 | 1.3% |
| Source: Morningstar | |