Deferred income tax is a liability owed by a company or individual which must be paid at a later time. A prime example of this is 401(k) retirement where an individual may contribute part of their earnings pre-tax directly to their retirement with the understanding they will be obligated to pay the tax when they receive their distributions from their 401(k).
The problem with deferred income tax is the amount of misinformation out there. Deferred income tax applies to numerous tax situations. However, this article will focus on four common deferred income tax scenarios: installment sales, section 1031 exchanges, qualified retirement plans, and depreciation. While installment sales, section 1031 exchanges, and depreciation are technically deferred capital gains tax, they have become incredibly more popular since the pandemic. It’s become a priority for individuals and companies to defer tax liabilities until a time the wallets are little more flush.
Understanding Deferred Income Tax
How does deferred income tax work? What are the benefits? To understand deferred income tax, one must first look at why it began.
The History Behind Deferred Income Tax
Take a step back to 1978. Pensions were expensive to grow and maintain. They could also disappear due to misconduct or dissolution of the company. It seemed like the distant future of retirement was a sucker’s bet. The years preceding 1978 were filled with cash contributions from the employer to the employee instead of contributing to a qualified retirement account. All this would change with the passing of Revenue Act of 1978 which enacted the famed Internal Revenue Code Section 401(k). By 1981, the IRS issued new rules allowing the pre-tax contribution to 401(k) plans.
The Long-Term Success
Initially, the idea didn’t take off but several of the early proponents held on, believing the 401(k) was the future of investing and retirement plans. By the 1990s, the 401(k)s were booming. Of course, the downside to this plan was the volatile markets which arose throughout the early 2000s. Recession after recession. Even so, today, the 401(k) plan remains the most popular due to the ability to grow rapidly from investments.
The goal of deferred income tax is to temporarily alleviate the tax burden from the individual or the company. It works by allowing a transaction in which the company or individual may have had temporary control of the asset or income to be transferred, contributed, or held by a qualified intermediary or qualified retirement account. In other words, the money still exists but is not immediately accessible to the taxpayer (whether a company or individual). When it is time for the money to become accessible to the taxpayer, such as 401(k) RMD (required minimum distributions), it is at that time the deferred income tax becomes due. The tax is not due until the income the tax was due on becomes available.
Why does deferred tax matter? How does it affect everyday taxpayers? Are there any benefits? Any drawbacks? The next eight questions and answers explore the in-and-outs of deferred income tax.
What is deferred tax in simple terms?
Deferred tax is the most simple terms is a liability (tax) which exists from the moment the income is earned but is delayed until the income accessed. In addition to 401(k) plans, the deferred tax is often used in 1031 exchanges. Not familiar with the term? Plenty of people know what they are even if they don’t know their name. Ever hear on the news if a house is sold and the proceeds of the house are rolled into another house before the end of the year, no tax is due? It’s a bit more complex than that but the principle is the same.
If a house used for renting to tenants is sold and the taxpayer wants to invest in another similar rental property (such as apartments), the proceeds of the sale must be held with a qualified intermediary, a third-party which holds the proceeds and pays the seller of the replacement party. A qualified intermediary can be anyone who is not a disqualified person but it’s usually advisable to hire a professional company who has a good reputation and long history of 1031 exchanges.
How are deferred taxes calculated?
Calculating deferred taxes can be overwhelming. It’s usually a good idea to consult with a tax professional to calculate the future liability. But for those who like a ‘hands-on’ approach, here’s a few simple tips to project tax liability.
When it comes to 401(k) plans, deferred taxes come down to tax brackets. 401(k) distributions are treated like income. Therefore, the tax liability must be calculated as such. Receive over $100,000 in 401(k) normal distributions? 24% tax liability. However, most taxpayers hold out 30% if they have any other income sources or investments.
When deferring the proceeds of a sale through a 1031 exchange, it is critical to remember the taxes are not due on the proceeds of the sale but rather the profit. For example, if a rental house was purchased for $120,000 and later sold for $160,000. The initial profit will appear to be $40,000 (but depreciation of the house will have to be calculated which will reduce the taxpayer’s basis in the house).
When depreciating any asset to reduce tax liability, it is critical to remember the deferred tax will catch up when the asset is sold. For example, first year bonus depreciation was 50% until the enactment of Tax Cuts and Jobs Act of 2017 (TCJA) in the end of 2018 which changed the bonus depreciation to 100%. For example, if a taxpayer depreciates out a semi-truck which is used for work until the depreciation reaches zero ($0), when they sale the truck, the deferred tax will be recaptured. If the semi-truck is sold for $40,000 and it is three years old, the taxpayer will owe the deferred tax. In other words, taking the bonus depreciation on earlier tax returns allowed the taxpayer to not pay the tax. But once the asset is sold off, the IRS wants their share of the tax.
Examples of Deferred Income
Throughout the article, various examples of deferred income have been discussed but in this section, the nitty-gritty parts of deferred income tax will be explored in depth. The article has dived into 401(k)s and 1031 exchanges. Now it’s time to dive into installment sales and depreciation.
Installment sales are commonplace among companies. For example, a shareholder of a corporation may sell their shares to their fellow shareholders. Let’s say they agree on a price of $1,000,000 and let’s say the basis (also known as what the shareholder contributed to the company) is $500,000. They have agreed to pay out the $1,000,000 over a five-year period. So essentially, $200,000 per year. If the taxpayer were to report this sale in TY2021 and they were not receive these funds at once, the tax bill would be enormous. However, if they were to break down the price over five years by using Form 6252 Installment Sale Income on their 1040, the tax would be deferred and paid out over the five-year period.
Depreciation. It is tempting to use the bonus depreciation instead of the standard MACRS depreciation. It is a double-edged sword for those who enjoy the reduction in tax liability. Let’s say an excavator is purchased for $110,000 in TY2019. The taxpayer elected to use 100% bonus depreciation and wrote-off the full value of the excavator the first year.
Now through a series of unforeseen events, a key component in the excavator broke and the taxpayer elected to sell the excavator to a repair shop for $50,000 in TY2020. The taxpayer would be liable for paying the deferred tax. If they had elected MACRS depreciation, only a small portion would have written off and when the excavator was sold, they would have had an over $30,000 loss. Either way, using depreciation is a form of deferring tax until a later time. At some point, the taxpayer will pay.
What are current deferred taxes?
Deferred taxes are classified into two categories: current and noncurrent. Current taxes are the amount overpaid in anticipation of tax liability. A common example would be increased federal withholding on a W-2. Noncurrent taxes are taxes paid in the future such as through later years of installment sales or 401(k) distributions.
Why is deferred income tax an asset?
Deferred income tax is a tax due in the future. Having said that, it is an asset. When income tax is deferred, it saves the taxpayer from paying a tax they may not be able to afford at this time in their life. 1031 exchanges are a prime example of this scenario. A rental house may make more money in the long-run than simply selling off the asset during a slow market. So, it may be in the taxpayer’s interest to roll the proceeds of an old rental into a new rental.
A similar scenario happens with depreciation. When depreciation is used to reduce tax liability, the tax is deferred to a later time when the asset is sold. Either way, it should be understood by accountants and taxpayers alike – depreciation does not erase a tax liability. It will defer the income tax to a later time.
Examples of Deferred Tax Liability Sources
An individual has their taxes done in TY2019. They elect to depreciate their new fleet of delivery vehicles for their business. Their accountant uses the 100% bonus depreciation. Unfortunately, the fleet of delivery vehicles have a number of maintenance problems in TY2021 and the individual decides to switch vehicle makes. They sell the vehicles for a considerably low price. When the individual goes to file their next tax return, the accountant explains they must pay tax on the capital gains of the vehicles. While the individual paid a high price for the vehicles and sold them for a low price, in the eyes of tax law, the individual’s basis was already reduced to $0.
An individual works for the same company for over thirty years. They have contributed the maximum amount to their 401(k) every year. When the individual retires at a qualified age, they are required to pay tax on their withdrawals from their 401(k)s. Why? When the individual contributed to 401(k) contributions through their salary, the contributions were contributed pre-tax thus deferring the tax to a later time.
An individual decides to sell their share of a vacation home they co-own with four other individuals. The individual originally invested $300,000 in the home. The co-owners offer to buy the share for $600,000. However, the house is going to need some work so they agree to pay out the $600,000 over a four-year period. This is an installment agreement sale. By doing this, the individual avoids paying the tax on a $300,000 profit all in one year. It is instead spread out over a four-year period.
An individual decides to sell a rental property in favor of purchasing another one in the same neighborhood. To prevent owing tax on the sale, as the individual intends to continue as a landlord, the individual hires a professional 1031 exchange firm to act as their qualified intermediary. While the individual works on closing on the house, the firm holds onto the money until the closing period when they pay the money directly to the seller of the property thus allowing the money never touch the individual’s hands.
The IRS vs. GAAP
It’s understandable that some companies and individuals struggle to calculate depreciation on their tax returns every year. The Generally Accepted Accounting Principles (GAAP) and the IRS determine the depreciation of an asset differently. The IRS uses MACRS (modified accelerated cost recovery system) depreciation method. The MACRS, while an accepted depreciation by the IRS, lacks the ability to depreciate intangible property. GAAP, on the other hand, lends the discretion of depreciation to the accountants. The second difference between the two is the evaluation of depreciation. In other words, if an asset was purchased for $10,000 and it was considered a five-year property by MACRS, its value would be up in approximately five years. Whereas GAAP looks at the economic value of an asset. The economic value may make it a seven-year asset thus resulting in different sets of numbers. This can impact a tax return so it is advisable to discuss the issue with a tax professional.
Deferred income tax is a tax due to be paid in the future. It is an asset until it is later paid and a common useful tactic to allow an individual or company to invest their money and pay tax at the time they access the money, whether it is a few months or few years.
Professional Help with Tax Issues
The experienced financial professionals at The Tax Crisis Institute have been helping Nevada and California residents with federal, state and property tax issues since 1983, and they are committed to making sure that their clients do not pay the government any more than they have to. If you need help with a tax matter, you can fill out our online form or call one of our offices. We have locations in Orange County, Bakersfield, Los Angeles and Las Vegas.