by Roger Russell
Recent federal legislation liberalizing depreciation and business expensing rules may create a tax trap for hundreds of thousands of unwary taxpayers.
Business owners who reside in states that have adopted some form of the federal rules, but whose business or rental property is in a state that hasn’t, are at risk, according to Jeffrey Pretsfelder, CPA, a state tax specialist with tax research publisher RIA, a Thomson business. The potential risk also applies to the reverse situation -those who live in a state that hasn’t adopted some form of the federal rules but whose business or rental property is in a state that has.
More than 25 states have not adopted the federal rules.
“When an individual has a business or rental property in a state other than his resident state, he is subject to tax on the income from the business or rental property in both the nonresident state and the resident state,” Pretsfelder explained.
“Some business owners who take advantage of the bonus depreciation rules will cost themselves more in state taxes than they save in federal taxes,” he added. “He gets a credit on his resident state return, so that he doesn’t end up paying two state taxes on the same income. The trap results from the fact that that credit equals the lower of the tax paid to the other state or the tax that the resident state imposes on the same income.”
Pretsfelder said that, under the bonus depreciation and expensing rules, “You get a high depreciation deduction in the year you buy the property and lower or no deductions in future years. If either of the two states allows bonus depreciation and expensing and the other state doesn’t, you will be punished because the lower of the two amounts will end up being lower than it would have been had both states followed the same rules. In other words, your credit will be lowered because of the mismatch between the two states’ rules.”
Practitioners with clients who operate a business or rental property in one state and live in another state should run the numbers both ways and see which comes out better, said Pretsfelder. “It’s not impossible even in this low interest rate environment for it still to be better to take the accelerated depreciation,” he said. “In general, if you use something like 3 percent for the time value of money, it’s almost always going to be against you to take the bonus depreciation.”
George Farrah, director of state services for BNA Tax Management, agreed. “Bonus depreciation is a good example of why tax planning must include both federal and state tax considerations,” he said. “The growing lack of conformity among the states and the federal government creates a complex matrix that results in varying outcomes for taxpayers.”
Pretsfelder provided an example (see box) of how this would play out for a taxpayer who has a business in a no-bonus-depreciation state, but who lives in a state that does.
State tax matrix example
A taxpayer is a resident of New Mexico and owns a business in Arizona. New Mexico allows federal bonus depreciation; Arizona does not.
Each year, the taxpayer earns $100,000 from his Arizona business before considering bonus depreciation. In 2003, the taxpayer could take $100,000 of bonus depreciation expense for New Mexico purposes, on a three-year asset. If he did that, for 2004 and 2005, he would have $50,000 more depreciation expense for Arizona purposes than he has for New Mexico purposes.
His other alternative is to forgo bonus depreciation and take the same depreciation on his New Mexico return that he takes on his Arizona return. Assuming he is in the 7 percent New Mexico bracket and the 5 percent Arizona bracket, the box shows the taxes he will pay under the second alternative.
As the bold figures in the Total column of Lines F and O show, not electing to take the federal bonus depreciation deduction will save the taxpayer $5,000 in state taxes. In a low interest rate environment such as today’s, that will more than make up for the fact that making the election gets the taxpayer earlier (but not greater) deductions for depreciation.
Because roughly half the states currently follow the federal pattern and half don’t, there could be hundreds of thousands of taxpayers affected by the disparity, according to Pretsfelder. “Certainly, a given practitioner is likely to have one or more people in these circumstances, and should be aware of it,” he said.
States that have not adopted the rules include such major ones as California, Massachusetts, Illinois, New Jersey and New York. “The list could change, since there’s legislation being proposed in some states that are on the nonconforming list,” said Pretsfelder.
State systems are “all over the map” because they make changes in relation to federal law in several ways, Pretsfelder noted. “Some state systems automatically adopt federal tax law. Every time the federal law changes the state law changes at exactly the same moment, unless they do something to create a legislative exception.”
“Other states say, ‘We conform as of March 31, 2002,’ but until they do it they’re not in conformity, and still others, like New Jersey and Pennsylvania, don’t conform to federal law at all,” he said. “They have their own rules, which happen to be pretty similar in certain cases to the federal position but they don’t lock into the federal law in any general sense.”
An additional consideration, he noted, is the complication of treating assets differently. “It’s more complicated to take something on your federal return and have to treat it differently on one of your state returns. You have to keep track of each asset separately.”
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