Tax and Business Alert - May 2004

Benefiting from the 50% Bonus Depreciation

The Jobs and Growth Tax Relief and Reconciliation Act of 2003 increased the bonus depreciation rate from 30% to 50% of the adjusted basis of qualified property. The bonus depreciation is determined without any pro-ration based on when during the tax year the property was placed in service. So, even property placed in service on the last day of the tax year is eligible for the full 50% bonus depreciation amount. Bonus depreciation is also available for qualifying vehicles via an increase in the first year luxury auto depreciation limit.

The 50% bonus depreciation is claimed after any Section 179 deduction (allowing you to expense, subject to limitations, certain otherwise depreciable assets), but before calculating the regular depreciation with respect to the property. Bonus depreciation is allowed for both regular tax and Alternative Minimum Tax (AMT) purposes. Capital expenditures to recondition or rebuild acquired or owned property satisfy the original use requirement (next paragraph), but purchases of reconditioned or rebuilt assets do not qualify.

To be eligible for 50% bonus depreciation, the property must be qualified property, its original use must commence after May 5, 2003, and it must be acquired and placed in service after May 5, 2003, and before January 1, 2005. However, the placed-in-service period is extended to December 31, 2005, for certain longer-lived property and transportation property.

Otherwise qualified property that was subject to a binding written contract for acquisition in effect before May 6, 2003, does not qualify for the 50% bonus depreciation deduction, but may qualify for the 30% bonus depreciation provision of the 2002 Tax Act.

An asset is qualified property (meaning it is eligible for bonus depreciation) if it is one of the following:

a) Tangible personal property with a recovery period of 20 years or less.

b) Depreciable computer software.

c) Water utility property.

d) Qualified leasehold improvement made to the interior of a nonresidential building, by
or for the benefit of a lessee or sub-lessee and placed in service more than three years
after the building was placed in service.

Please call us to discuss the possible tax-saving benefits of the 50% bonus depreciation for your business property purchases.

Treasury to End Series HH Savings Bonds

The U.S. Treasury will put an end to a popular tax deferral technique when it stops issuing Series HH Savings Bonds after August 31, 2004. As a result of this action, owners of Series E and EE Savings Bonds will no longer be allowed to exchange their bonds for Series HH Bonds. The ability to exchange Series E and EE, including all of the accumulated and untaxed earnings, for Series HH Bonds allows Series E and EE Savings Bond owners to defer their accumulated earnings for up to an additional 20 years.

The Treasury has been issuing Series HH Saving Bonds since January 1980 as a successor to the Series H Savings Bond program. They pay interest every six months, a popular feature with retirees, and have the full faith and credit backing of the U.S. government. The Series HH Savings Bond program was deemed to be paper-intensive by the Treasury and is being discontinued to cut costs as the Treasury moves toward a paperless system. Additional information on Series HH and other Savings Bond programs can be located at www.publicdebt.treas.gov/.

Don't Forget the Holding Period Rules for Qualified Dividends

Qualified dividends are now taxed at no more than 15%. However, don't forget that shareholders must satisfy a holding period rule to be eligible for the new low rates. Specifically, the shareholder must hold the stock on which the dividend is paid for more than 60 days during the 121day period that begins 60 days before the ex-dividend date (the day following the last day on which shareholders of record are entitled to receive the upcoming dividend payment). When the holding period rule is not met, dividends are taxed at ordinary income rates.

Note that a stricter holding period rule applies to preferred stock dividends that are attributable to periods aggregating in excess of 366 days. In this circumstance, the shareholder must hold the preferred stock on which the dividend is paid for more than 90 days during the 181-day period that begins 90 days before the ex-dividend date in order to qualify for the reduced rates.

Finally, watch out for "preferred stock dividends" that are not really dividends at all. Some "preferred stock" issues are actually nothing more than publicly traded "wrappers" around batches of corporate bonds. "Dividends" paid on these issues are really interest and are, therefore, taxed at ordinary income rates.·

Interesting Website

The Internet ScamBusters^TM website at www.scambusters.com reports the Federal Trade Commission received more than 500,000 consumer complaints in 2003. Forty-two percent of those complaints were related to identity theft. Internet fraud accounted for 55 percent of the reported complaints, up from 45 percent in 2002. The ScamBusters^TM website includes information on telemarketing scams, ways to reduce spam, real vs. fake viruses, what to do if you've been scammed, and much more.

The Importance of Your Investment Period and Rate of Return

To investors, the term risk usually means losing money. Money is generally lost in one of two ways. The first is the absolute loss of principal (e.g., the market declines and a $100,000 investment is now worth $50,000). The second way is a loss of purchasing power through inflation (e.g., $100,000 today won't buy what it would five years ago, or even last' year) gradually, but significantly eroding the real value of your portfolio over time.

Unfortunately, when the term risk is used, most investors automatically think of a loss of principal and fail to consider the potential long-term eroding effect of inflation. In reality, risk depends on your time horizon, i.e., the length of time you have to achieve your goal. For a short-term time horizon, the annual ups and downs (volatility) of an investment are a bigger risk than inflation. Thus, a common short-term investment strategy is a portfolio oriented towards stable principal value with interest-generating investments. For example, if you needed money within five years, it would be risky to have that money invested in stocks, because their prices tend to fluctuate a lot. They may be down when you need to sell them in order to have the cash needed for your goal.

Conversely, with a long-term time horizon, the average return rate becomes more important to reaching your goals than the volatility you will likely encounter along the way to meeting them. In other words, it is generally more important that the average return on your investments is sufficient to achieve your goals than the fact that the investment's value may experience volatility over the time it is invested. This is due to two reasons. The annual volatility tends to work itself out due to the offsetting of good years against bad over the long time frame. In addition, higher return rates produce disproportionately higher results due to compounding.

Compounding over a long period of time causes an investment with an average annual return rate of 10% to generate much more than twice the amount of an investment with an average annual return of 5%. A single $100,000 investment, for 20 years, earning a compounded (annually) return of 5%, will grow to $265,330 at the end of the period. However, the same $100,000, earning a 10% compounded return, will grow to $672,750 during the same period. This scenario assumes the $100,000 investment is held in a tax-deferred account. The results would be less in each case if a portion of the earnings were withdrawn each year to pay taxes.

Using the same $100,000 investment in the previous paragraph, let's look at the possible decrease in purchasing power due to inflation over that same 20 years using only modest inflation rates. With inflation at 2% or 3% (compounded annually), it would take $148,595 and $180,611, respectively, in 20 years to equal the purchasing power of our $100,000 today. Thus, for a long-term investor, inflation may represent a bigger risk than annual volatility, prompting a long-term investment strategy focusing on asset classes with high average return rates.

Finally, in a long-term scenario, short-term volatility becomes less of a concern, although it certainly should not be ignored. Think of portfolio volatility in the context of dribbling a basketball up a hill. The ball bounces up and down like the stock market, but you eventually reach your goal...the hilltop.

Converting a Residence to Rental Property

For various reasons, you may consider converting your personal residence to rental property. This decision is often made as a result of the inability to sell the property at a gain, the desire to retain the property for future personal use, or the strength of the rental market in your area. However, a decision to convert to rental also should consider economic factors such as your marginal tax rate and the potential loss of your ability to exclude up to $250,000 ($500,000, if married) of gain from the sale of your principal residence for federal income tax purposes.

Other economic factors to consider include the expected growth rate for rental property in your area, length of time the house will be rented before being sold, cash flow from renting, effect of the passive activity rules (which limit and defer tax deductions), and the expected rate of return available on other investments. Generally, the economic advantage from converting a personal residence to a rental rather than selling it is increased as your marginal tax rate increases, the growth rate of the rental property increases, and the rate of return on alternative investments decreases. But, each situation should be thoroughly analyzed given its particular facts and circumstances.

If selling your personal residence would result in a nondeductible loss, you can seriously consider converting the residence to a rental property. While tax savings opportunities are generally limited for residential rental conversions, primarily because of the passive activity loss rules, converting a personal residence into rental property may allow you to eventually recognize a loss on the property's subsequent sale if the property continues to decline in value.

The fact that a residence is rented at the time of the sale does not automatically preclude gain from being excluded under the gain exclusion rules. Instead, the exclusion of gain depends on whether the taxpayer meets the ownership and use requirements and the one-sale-in-two-years test at the time of the sale. In all cases, however, gain exclusion cannot be claimed to the extent of depreciation adjustments attributable to periods after May 6, 1997.

The decision to convert your residence to rental property is complex, and the ramifications of this decision are far-reaching. Please call us to thoroughly explore the numerous tax and economic issues related to such a conversion.