Moore Colson :: News & Resource Center

Borrowing: It’s not all it’s cracked up to be

Feeling a bit overstretched financially? If you are, you’re not alone. American consumers have been racking up debt in record numbers. And with lenders promising low-low interest rates, it’s no wonder we’ve become so credit happy.

While there’s nothing wrong with borrowing money, it’s important to consider the impact of borrowing decisions on your long-term financial goals.

When it pays to borrow

Sometimes the need to borrow is inescapable, such as to cover excessive medical costs. However, borrowing generally should be reserved for appreciating assets or assets that will pay a return on your investment or, at least, hold their value, such as:

A home. The tax-deductible interest expense on home mortgages can significantly reduce your actual borrowing cost. And, with consumer prices rising with inflation, your purchasing power is typically greater if you buy a home with today’s dollars and pay for it with tomorrow’s dollars.

Keep in mind that lenders may paint a pretty picture when it comes to how much home you qualify for, often approving loans well over advisable amounts. The temptation to purchase as much house as possible, consequently, can leave you overextended.

A growing business. Taking out a loan to invest in the growth and improvement of your business increases your ability to build wealth. To help minimize your outstanding loan amount at any given time, consider devising a phased growth plan. For example, you might invest in additional facility space to increase production capacity. Once you’ve paid off that loan, you might finance new machinery and equipment to automate processes and reduce operational costs.

Finally, taking out a loan to pay for education expenses or to otherwise improve your job skills can be a good move because the ultimate goal is to increase your earning power.

When it doesn’t

On the other hand, you should avoid borrowing money, or at least minimize loan amounts, for purchasing “wasting assets.” These include items with a limited useful life that depreciate in value over time. A classic example of a wasting asset is a car, which begins depreciating the moment you drive it off the lot.

Of course, many retailers offer no-interest loans on select wasting assets (for example, furniture and computers). Sometimes, it may make sense to take advantage of those loans because they are giving you free use of their money to make the sale. Just be sure you have the funds to pay off the loan in full at the end of the loan period, or you’ll be hit with a whopper of a finance charge.

3 borrowing traps

When finances are stretched thin, you may be tempted to fall into these borrowing traps:

1. Borrowing against your home. Taking a loan against your home mortgage or taking out a home equity line of credit to pay off nonessential debts is a no-no. Not only will you likely end up paying more interest long-term by extending the payments over a longer period, but you’ll diminish a vital source of funding for emergencies. Plus, if you default on the loan, you may lose your home.

2. Borrowing from your 401(k) plan. When you repay a loan to your 401(k), you’re essentially paying the interest back to yourself vs. to a lender, which may sound advantageous. But keep in mind that you’ll lose any tax-deferred growth you would have earned had you left the money in the plan. And, if you’re unable to pay back the loan within the required time, the “premature” (before age 591⁄2) distribution will be subject to penalty and income tax.

3. Borrowing via credit cards. While low-interest credit cards may appear like a good deal, you can end up paying much more in the long run if you pay only the minimum balance each month.

Admittedly, there may be a time when you have no other option but to use an asset (such as your home) as collateral for a loan. If you find yourself in that situation, take time to familiarize yourself with the loan terms so you don’t exacerbate your financial problems.

Stay focused on the goal

The decision to borrow money essentially comes down to a question of appreciation or depreciation in value over time. So before you borrow, consider your investment return on an asset purchase and how long it will take to recoup your investment relative to your long-term financial goals.

Back to top

A cost segregation study can increase current deductions

Have you recently purchased or built a new building? Or substantially remodeled your existing building? If so, you should consider a cost segregation study. Property that qualifies for faster write-offs — such as decorative fixtures and carpeting — is often lumped in as part of the building and depreciated over 27.5 or 39 years using the straight-line method. A cost segregation study identifies these misclassified property components and their cost, allowing you to maximize your current depreciation deductions by using the shorter lives and faster depreciation rates available for the qualifying parts of the property.

The ins and outs of cost segregation

Real estate can be segregated into four basic categories of property: buildings, land, land improvements and personal property. As mentioned above, buildings are generally depreciated over 27.5 or 39 years. Land isn’t depreciable at all.

But, you can typically depreciate land improvements over 15 years using 150% of the straight-line rate and most personal property over five or seven years using 200% of the straight-line rate. For example, if $400,000 of assets were reclassified as seven-year vs. 39-year property, the depreciation deduction in the first year would increase as much as 10 times, or about $50,000.

Examples of items you can isolate with a cost segregation analysis include:

Land improvements:

• Parking lots,
• Sidewalks,
• Fences, and
• Landscaping.

Personal property:

• Decorative fixtures,
• Cabinets and shelves,
• Moveable wall partitions,
• Carpeting, and
• Security equipment.

Moreover, certain plumbing, wiring, and heating and air conditioning vents and lines — which you would normally think of as part of the building — may be eligible for shorter lives if they are specifically required for equipment that has a shorter life (such as wiring for the security system).

You may also be able to depreciate the allocated portion of certain capitalized indirect or overhead costs — such as architectural fees.

Be aware of inadvertent AMT consequences

You should consider a cost segregation study when you buy, build or remodel — or when you have done so within the last few years. But, be mindful that the overall benefit of a cost segregation study may be limited in certain circumstances, such as when the business is subject to alternative minimum tax (AMT) or is located in a state that doesn’t follow federal depreciation rules.

In addition, the cost of the study is generally warranted only if the building or remodeling expenditures are fairly substantial and were completed fairly recently.

Don’t try this at home

Cost segregation studies can be complicated, and some items may be hard to classify because there aren’t clear-cut guidelines for all types of property. Keep in mind that you also must file an accounting method change request to adjust the depreciation to the shorter lives.

Consequently, you’ll need a cost segregation expert who can work with a valuation specialist to provide a report of the assets identified and reclassified and who can prepare the forms and related calculations. In other words, don’t attempt this study on your own. Too much money is at stake.

Back to Top

Making the most of the home-sale exclusion

Changes over the last several years have caused capital gains tax to be a bigger concern for homeowners. If you’re planning to sell your home, you can soften the impact by ensuring you deduct the cost of improvements and other relevant expenses when figuring out your gain.

Why gains are now a concern

Almost 10 years ago, Congress amended the federal tax code to allow taxpayers to exclude up to $250,000 (the limit is $500,000 for married couples) in capital gains on the sale of a principal residence, subject to certain limitations. Previous rules allowed taxpayers to defer capital gains if the proceeds were used to buy a new home. The home-sale exclusion is permanent, so you never pay tax on your gain, even if you pocket the profits.

At the time it was introduced, the home-sale exclusion seemed like a generous gift from the government. But as housing prices have soared over the last several years in many parts of the country, the exclusion has lost some of its punch. Today, it’s not unusual for home sellers to rack up profits well in excess of the exclusion limit — and the resulting tax liability can’t be postponed by using it to buy a new home.

Cut your gains

Simply put, gain is equal to the amount you realize on a sale minus your adjusted cost basis in the home. The amount realized is the selling price less selling expenses, such as commissions, advertising fees, legal fees, and seller-paid points or other loan charges.

To calculate your adjusted basis, start with the amount you paid for your home (including certain settlement and closing costs). You may have to reduce your basis by the amount of any points paid by the person who sold you the home. Special rules apply if you acquired your home by gift or inheritance, or contracted to have it built.

The next step — which home sellers often overlook — is to increase your basis by the amount you spent on improvements, special tax assessments for local improvements (such as streets and sidewalks) and restoring damaged property after a casualty. If your home is a condominium, you can add your share of assessments used for capital improvements.

Generally, improvements such as these add value to your home:

• Additions such as a new garage, bedroom or porch,
• New roofs,
• Swimming pools,
• New heating or air conditioning systems,
• Modernized kitchens and bathrooms, and
• Upgraded plumbing and electrical systems.

For tax purposes, there are many more items that qualify as improvements. Keep in mind, repairs that maintain the home in good condition but don’t increase its value or prolong its life are not considered improvements.

Certain items reduce your basis, such as depreciation related to business or rental use of the home, gains from a previous home sale that you deferred under the old law, and insurance payments.

Cover all the bases

To avoid overpaying capital gains tax on the sale of your home, be sure you take into account all improvements and other expenses that can increase your basis. Most important, keep the receipts and other documents needed to support your calculation.

Back to Top

Marriage of equals
To reduce estate taxes, share the wealth

It’s not unusual for one spouse to own a disproportionate amount of a couple’s wealth. But this type of fiscal imbalance can prove costly when the estate tax bill arrives. Affluent couples that “equalize” their estates can cut their taxes considerably.

A balanced approach

The federal estate tax exemption currently shields $2 million in assets from estate taxes — it increases to $3.5 million in 2009. The estate tax is scheduled to be repealed in 2010, only to return in 2011 with a $1 million exemption.

If the value of your combined estate is less than the exemption amount, the distribution of wealth isn’t a big concern. But if your estate is worth substantially more than the exemption amount, you and your spouse have a lot to gain by equalizing your estates.

Spreading the wealth

Equalizing estates is simple in theory: The “wealthier” spouse transfers at least enough assets to the “poorer” spouse to fund his or her estate tax exemption. (There’s no gift tax on transfers between spouses, as long as both are U.S. citizens.)

For instance, Sally and her husband, Ted, have $4 million in assets, all in Sally’s name. Ted dies in 2006 with no assets, so his estate tax exemption is wasted. When Sally dies in 2008, her exemption shelters $2 million of her estate from taxes — but the remaining $2 million is subject to a 45% estate tax.

An alternative is for Sally and Ted to create an estate plan that provides for their assets up to the available exemption amounts to go into a bypass trust, with the balance going into a marital trust. This would allow them to both take advantage of their exemption amounts and avoid the estate tax altogether.

In practice, transferring assets can be challenging. A significant portion of your wealth may be tied up in, for example, retirement plans, which aren’t readily transferable.

Ideally, you’ll have sufficient assets that are easy to value and simple to transfer, such as cash or publicly traded stock. You can also divide real estate by converting it into tenancy-in-common property.

There may be an advantage to transferring more than the amount needed to fund the poorer spouse’s exemption: A larger transfer may shrink the wealthier spouse’s estate enough to bring it into a lower tax bracket, reducing the couple’s overall estate tax liability.

Control issues

Despite the tax advantages that can be gained by equalizing estates, the wealthier spouse may not want to relinquish control over his or her property. If so, there are other estate planning techniques that can help leverage the estate tax exemption while retaining some control over your wealth.

A qualified terminable interest property (QTIP) trust is one such vehicle. It allows you to transfer property for your spouse’s benefit while retaining control over how the assets are distributed after your spouse dies.

Equal opportunity

Equalizing estates isn’t right for every couple, but for many people it’s a simple, inexpensive technique for reducing and even eliminating estate taxes.

Back to Top