Here’s an old post I placed elsewhere, years ago:
WARNING: This post will cure insomnia�sadly, I can only do so much to make the Internal Revenue Code decipherable, much less entertaining. A decent tax advisor CAN use this post- really a rehash and consolidation of prior posts on this subject- to save you money.
Good news, bad news: Lonnie Deals can be (and for me, usually are, bone-headed moves notwithstanding) tremendously profitable. Bad news: Uncle Sugar has to pay for Presidential interns, among other vital things- so he wants his hard-earned (by you, that is) cut and he wants it NOW. In fact, the WORST aspect of Lonnie Deals is the tax bite�…typically, Lonnie Dealers get their money over time, but pay the taxes on their gain immediately. For example:
You put $3000 into a MH in December of 2000. You sell it in February of 2001 for $1,000 down on a $7,000 note, $239.24/month, 14% interest over 36 months. The federal income tax consequences are generally as follows, assuming that you are in the 28% bracket:
� You have a $6,000 gain in 2001. The $1680 in tax is due in three months at the most if you are on the Fed�s quarterly installment plan.
� You must pay tax on the interest portion of your payments. This number declines as the portion of each payment attributable to principal increases over time. For example, the tax on your first payment’s interest would be $25.32, while the tax on the final payment’s interest would be $.86.
Your pre-tax uncompounded return (using Excel’s IRR function) is approximately 150%. Your after-tax uncompounded return, given the numbers described above, is approximately 68%. Heck of a difference! It is also illustrates what your government is REALLY costing you.
Wouldn�t it be nice to defer paying some of the tax? We’d have our money longer�…and would be able to invest it at high rates before eventually forking it over to fund the Presidential harem, err, I mean, worthy federal projects. What if some up-front tax-planning got us up to about 90% after-tax return on the deal outlined above?
The tax-planning in question involves getting on the “cash method of accounting”. Until recently, mobile home dealers HAD to apply the "accrual method of accounting"�.which resulted (and for many STILL results) in the kind of insane tax bite that I described above. Revenue Procedure 2000-23 now permits businesses with less than $1 million in annual gross revenues to use the cash method of accounting�…a good (if somewhat boring) thing, as I shall demonstrate in the following paragraphs.
What IS a “method of accounting”? Without getting into the exciting (YAWNNNNN!) details, it is the set of rules that determine HOW you keep your books. There are three basic methods of accounting: Governmental, Accrual and Cash.
� Governmental: The rules are VERY different. If we used this method of accounting for our businesses, we’d be broke and in jail. Come to think of it, the government is broke and sends plenty of it members to jail��…
� Accrual: Income is counted when it is “earned”, and it is often “earned” before it is received. Applied to Lonnie Deals, it means paying taxes based on the face value, as opposed to fair market value, of the note created, creating the huge up-front tax bite that I described above. Accrual method also means �inventorying� expenses�.so if you paint your mobile home, the cost of the paint becomes part of the basis of the mobile home. That means the cost of the paint is deducted when you sell the home- always AFTER you paid for the paint.
� Cash: Income is counted when actually received based on the fair market value of what is received. So a cash method Lonnie Dealer would report gain based on the fair market value of the note created (which is usually MUCH less than the face value of such notes), plus on any subsequent payments that are not a return of capital (capital being “taxes-paid” principal on the note in this case). In addition, the cost of inventory (that is, the mobiles and any improvements made on them) is treated as a �supply expense�, deductible when the supply is �used�, as opposed to when sold. Guess which comes first?
So what�s all this mean? Going back to the example above, under the cash method:
You deduct $3,000 in 2000, due to the �supplies� you bought. So all other things being equal, you have a $840 tax savings in 2000 when compared to the original example.
In 2001, you pay taxes on $1,000 cash received plus on the fair market value of the $7,000 face-value note. Based on what investors will pay for the entire brand new note (NOT for a partial) on a used mobile home, I figure the note is currently worth about $3850 (55% of face value). So you have a gain of $4850 in 2001, for a tax of $1,358 on the gain. In addition, as your payments are made over the term of the note, you pay tax on interest and untaxed principal (similar to an installment sale). You ultimately pay the same amount of tax as under the accrual method, but pay it later. Your after-tax return is approximately 80%- that�s 12 points better than the accrual method! The greater up-front cash flow (including your initial investment and taxes) under the accrual method accounts for the difference in after-tax rates of return under each method. Just compare the annual cash flows in the above example:
2000 2001 2002 2003
Accrual: -$3,183 $2,638 $2,723 $2,582
Cash: -$2,301 $2,344 $2,429 $2,313
Just in case this little post isn�t technical enough, the above treatment is contingent on three �grey� positions- moderately aggressive positions but based on a VERY supportable reading of the Code. A good tax person should spot the three issues fairly quickly. I�ll not bore you with the details nor do your tax advisor�s work for him. If your tax advisor cannot, after being spoon-fed this post and a copy of Rev. Proc. 2000-22, figure out what to do, get a new tax advisor!
Hopefully you are still awake,