It is possible to report a positive cash flow ‘on the books’ and still claim losses to reduce or eliminate your US income tax liability.
You may have seen or heard about property owners paying little or no taxes on their property income while a positive cash flow was reported on their US income tax returns. At first glance, this proposition may seem like tax evasion; but it’s possible to report losses on your property, even if you have a profit ‘on the books’.
It’s important to remember that gross profit is just that. There are many deductions for which you qualify as a property owner. These deductions can reduce your actual income and, therefore, reduce your taxable income. This article reviews the expenses you can use to adjust your US income tax return and minimize your tax liability.
The first thing you need to decide is whether you will use a cash basis accounting method or an accrual accounting method. An accounting method of cash basis will mean less detail throughout the year, but the accrual accounting method allows you more access to claiming non-cash expenses.
Before reviewing the deductions that can be used to reduce your property tax liability, we will define the difference between cash basis and accrual.
With a cash basis accounting method, income and payments are documented when they are received or paid. For example, using the cash basis accounting method, a credit card payment is recorded when it’s paid rather than when the expense was incurred. While this accounting method is the easiest, there are less opportunities to take non-cash deductions. A cash basis income statement will closely resemble a tax return, except when it comes to deductions such as depreciation.
With an accrual accounting method, expenses and payments are tracked and documented at the time they occur. Using the same example as used above, this means that expenses paid with a credit card are documented at the time they’re incurred rather than the time at which they are paid. While this accounting method requires more documentation, it leaves the taxpayer the option of taking advantage of more non-cash deductions, such as the expense of bad debt.
In order to help you understand the difference in these accounting methods, we have provided the following example. It’s important to note that only one accounting method may be used during a given year.
ABC Properties, Inc., uses an accrual accounting method. It received an invoice for work done in December, but it doesn’t plan on paying for the bill until January. Using the accrual accounting method, this expense is recorded when it was incurred in December. Since the expense was recorded in December, it is deductible on the tax return for the tax year including December.
If a cash basis accounting method was being used, ABC Properties would have to report the expense when it was paid in January. Therefore, it couldn’t be claimed as a deduction until taxes were filed in the following year.
If you are using an accrual accounting method, you cannot change your method during the taxable year. If you are interested in changing your accounting method, you must be proactive in letting the IRS know and making required adjustments to change from one to the other.
There are a few non-cash expenses that can be claimed on your US income tax return to reduce your tax liability. The most common non-cash expense is depreciation. Depreciation is calculated by taking the value of property which is subject to depreciation and divided by 27.5 (the amount of years allowed to determine depreciation). You may deduct depreciation amounts whether you use an accrual accounting method or a cash basis accounting method.
Assume you own a piece of residential rental property. The total value of the property is $150K and $20K is the cost of the land. Since land does not experience depreciation, you have a depreciative property value of $130K. Divide $130K by 27.5 for a total of $4727. If you had a rental income of $12K, the total of depreciation would reduce your taxable income to $7273. This deduction is available to both accrual and cash basis taxpayers.
The next non-cash expense is that of prepaid expenses. Cash basis taxpayers may only deduct prepaid expenses if payment was incurred during the taxable year. If there are pre-paid expenses for following tax years, they cannot be claimed by cash basis taxpayers until taxes are filed for those specific years.
There are situations in which pre-payment for services is required. This is often the case with insurance premiums – which sometimes need to be paid six months to one year in advance. If you use the accrual accounting method, you would deduct a prorated portion of the cost each month as the cost is incurred. Since the entire amount was paid in advance, there will be no reflection of each prorated amount in the cash flow statement. It will, however, be a deductible expense.
If you are using a cash basis accounting method, you will only be able to deduct the portion of the payment which will be utilized in the current tax year. You will not be able to deduct pre-payments for services rendered in the following tax year.
The final expense we will discuss is the bad debt expense. When using the accrual accounting method, an invoice is issued and is immediately reported as income – even when the invoice hasn’t yet been paid. There are times in which an invoice will never be paid, and the amount needs to be written off as a loss.
As we discussed earlier, the accrual accounting method calculates profit and loss when they are created instead of when they’re incurred. When invoices with net terms are created, they immediately count as income when using the accrual accounting method. It’s possible to have calculated income in 2013 for a net invoice which wasn’t due until 2014. In this case, an amount which was counted as income in the previous tax year can now be deducted as a loss in the current tax year on your US expat tax return.