Author name: Chris Barrett

Through the use of technology and strategic thinking, Chris brings executive-level financial support into your business.

Sell-side quality of earnings

Sell-Side Quality of Earnings Report and 6 Reasons to Get One

When selling a small business, two crucial factors significantly impact the purchase price:

Earnings:
The amount of earnings your company generates is a key determinant, typically measured as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). A sell-side quality of earnings analysis presents an opportunity to enhance both the quantity and quality of these earnings.

EBITDA can be increased by identifying adjustments to your financials that a new buyer should not anticipate incurring. This includes one-time expenses or events, personal expenses that the owner ran through the business, or the normalization of recent changes to business operations.

When the buyer is performing due diligence they are going to be looking for adjustments that will favor them. However, they are not going to point out to you adjustments that will be in your favor it’s up to you to do that.

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Search Funds

A Guide to Search Funds In ETA

If you’re an aspiring entrepreneur but don’t think a startup is right for you, a search fund could be your answer.

Entrepreneurship through acquisition (ETA) is a compelling pathway to realize your business ownership goals and own an established business. Search funds provide the financial vehicle to make that dream a reality.

In this article, we’ll provide an overview of search funds, contrast different models, how to start one, and shed light on the appeal, challenges, and trends surrounding them.

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How to Share your QuickBooks File with a Buyer

Introduction Once you’ve gone under LOI with a potential buyer for your business the buyer will begin to conduct their due diligence. Sharing access to your QuickBooks file can make this process much faster and easier for bother parties. In this article we’ll be showing you just how to do that.  QuickBooks Desktop When sharing a QuickBooks Desktop file for an acquisition we recommend do so via a QuickBooks Accountant Copy. The benefit of sharing the file this way is that you can freeze the books at a specific timeframe, such as the end of the month, quarter, or year. This allows you to continue to operate in the file while you run your business while the buyer can still get in and perform their due diligence without interrupting you.  To send an accountant transfer file follow these few easy steps: Open your QuickBooks Desktop file Go to the File menu and hover over Send Company File Select Portable Company File and then hit Next.  Enter the end of the last complete month. Then select Next. Create a file password for the file. Make sure to share this password with the Buyer as they will need it in order to open it. When you’re ready, select Send QuickBooks Online If you utilize QuickBooks Online sharing access to your account is even easier. To do so follow these simple steps. Sign into your account as the primary admin. Select the gear icon for Settings and then select Manage Users. Select the Accountants tab. Finally, enter the email of the buyer’s financial due diligence provider and select Invite. See How Midwest CPA can Help You While we’ve got you here, why not take a look at our other services. View Services View More Resources Disclaimer The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.

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DSCR Calculator

DSCR Calculator And Guide For Acquisition Entrepreneurs

Back to Learning Center Introduction One of the primary financing options for Entrepreneurship through Acquisition (ETA) is a Small Business Administration (SBA) loan, which is tailored to meet the specific debt needs of small businesses. As your business acquisition specialist, we at Midwest CPA have simplified what the Debt-Service Coverage Ratio (DSCR) is and how it is used when applying for your SBA loan. We have included a DSCR Calculator to help you quickly calculator the DSCR for your specific deal. View DSCR Calculator What Is Debt-Service Coverage Ratio (DSCR)? A Debt-Service Coverage Ratio (DSCR) checks a business’s ability to meet its debt obligations utilizing its net operating income. A DSCR calculator functions as a litmus test for a business’s financial health and its ability to service loans effectively.  DSCR Calculator With Chart DSCR Calculator With Chart Enter your financial information to calculate your Debt-Service Coverage Ratio (DSCR) and see how it compares to standard benchmarks. Net Operating Income ($): Loan Principal ($): Interest Rate (%): Loan Length (years): Debt Service Coverage Ratio (DSCR) A DSCR greater than 1.25 is usually required by the SBA. How The DSCR Calculator Works DSCR is calculated as follows: DSCR = Net Operating Income (NOI) ÷ Total Debt Service (TDS). Net Operating Income represents the income generated by the business after deducting all operating expenses, while Total Debt Service encompasses the sum of all debt-related payments, including principal and interest for the same period.  For example, if a business has an NOI of $100,000 and a TDS of $80,000, the DSCR calculation would be: DSCR = $100,000 ÷ $80,000, resulting in a DSCR of 1.25x. This value indicates that the business generates 1.25 times the income needed to cover its debt obligations. What Is An SBA 7(a) Loan? An SBA 7(a) loan is a financial instrument designed to help small businesses in their journey for growth and expansion. These loans are tailored to assist in various aspects of small business development. The key advantages of an SBA 7(a) loan to Acquisition Entrepreneurs are lower down payments, extended repayment terms, and competitive interest rates. These features offer investors affordable alternatives to conventional financing for accessing capital. DSCR Requirements For SBA Loans In the context of SBA 7(a) financing, a lender will typically require a preferred DSCR of 1.25x or higher. This means that businesses are ideally expected to generate their Net Operating Income (NOI) at least 1.25 times greater than the figure of their Total Debt Service to meet their debt obligations. That being said a DSCR above 1.5 is preferred. Being aware of the DSCR calculation can help you quickly analyze if a deal will meet SBA requirements.   DSCR vs. Other Financial Metrics DSCR Calculation measures the ability of a business to meet debt obligations from net operating income, and differs from other financial metrics: DSCR vs. Debt-to-Income (DTI) –  DTI  provides more information about personal income, making DSCR focused on a company’s financial stability.  DSCR vs. Gross profit margin (GPM) – GPM evaluates a business’s profitability by gauging income relative to cost of goods sold, whilst DSCR focuses on the business’s cash abilities to meet ongoing debt obligations,  DSCR vs. Seller’s Discretionary Earnings (SDE) – SDE helps determine a business’s true cash flow potential, whilst DSCR looks at a business’s true ability to meet debts with the current cash flow amounts. Check out our blog on seller’s discretionary earnings. DSCR vs. Gearing Ratio – Gearing ratios assess a business’s level of debt in relation to equity, whereas DSCR takes a close examination of a business’s overall income inclusive of equity, in order to service debt repayments. Understanding how the DSCR calculator works can help you differentiate it from other metrics. How Midwest CPA Can Help You The DSCR Calculator serves as a gauge of your business’s financial resilience in meeting debt obligations. At Midwest CPA we offer our clients tailored DSCR calculations, as well as provide guidance into SBA loans for ETA initiatives. Book a free consultation with Chris at Midwest CPA today for further advice. Have a professional do it for you While we’ve got you here, why not take a look at our other services. View Services View More Resources FAQs Can I use the DSCR calculator for any business type? Yes, the DSCR can be used for any business type as it is a universal measure of a company’s ability to pay its debts with its operating income. What are the benefits of using the DSCR calculator? Some key benefits of using a DSCR calculator include: Quick assessment of a business’s financial health. Determination of loan eligibility and borrowing capacity. Aid in financial planning and debt management. Insight into the sustainability of current debt levels. Facilitation of discussions with lenders and investors. What Is A “Good” DSCR? A “good” DSCR typically resides within the range of 1.25x or higher. Lenders view this as a strong indicator of a business’s ability to meet debt obligations comfortably. What if my DSCR is low? DSCR holds utmost importance for lenders as it serves as a litmus test for a business’s capacity to meet its debt obligations. A favorable DSCR instills confidence in lenders regarding loan repayment. Understanding how the DSCR calculator works and its results can also assist you in the loan application process. Why is DSCR important for SBA loan approval? In real estate, a lender will typically require a DSCR of at least 1. While an SBA lender will typically require a DSCR of at least 1.25. These ratios will vary from bank to bank. How can my business improve its DSCR? Improving DSCR necessitates ameliorating your business’s financial performance. Strategies may encompass augmenting revenue, reducing expenditures, or refinancing existing debt to boost the ratio. Disclaimer The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.

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what is a quality of earnings report

What Is A Quality Of Earnings Report?

Introduction The term “QoE” pops up often in business acquisition, but what is a quality of earnings report? When acquiring a business discerning the genuine financial health of a potential acquisition is a key part of good due diligence. This is the role of a Quality of Earnings report. The Quality Of Earnings Report A Quality of Earnings report is not merely a reflection of a company’s profitability. It’s a meticulous analysis that goes beyond superficial numbers, revealing the sustainability, consistency, and reliability of a business’s earnings. For a shrewd entrepreneur, the QoE is a guard against potential pitfalls and a guidepost to promising acquisitions. Why You Need A Quality Of Earnings Report Most companies selling for less than $5M do not have properly maintained financial statements. That being said, even properly maintained financial statements don’t tell the whole story of a company. A Quality of Earnings report focuses on whether or not historical revenue and profit will continue into the future. That is what you really care about, because that future cash flow is what you will depend on to pay down your debt, feed your family, and grow the business. Now, let’s look in more detail at what makes up a QoE report. What Is The Scope Of A Quality Of Earnings Report? A Quality of Earnings report is a consulting engagement and does not have any explicit standards from the American Institute of Certified Public Accountants (AICPA) on the exact processes or deliverables that should be included. That being said, here are a few of the issues that analysis performed in a Quality of Earnings may uncover. Improper Accounting If a company is not adhering to Generally Accepted Accounting Principles (GAAP) they may not be properly representing their financial results. Customer Concentration Revenue is of a higher quality when it comes from a variety of different sources. If all of the revenues for your target are concentrated in one or two customers there could be substantial risk to you as a buyer should one of those customers leave after you purchase the company. Supplier Concentration If a company relies on a single supplier for key resources needed to perform operations then they are at risk of that supplier raising prices, or having supply chain issues. Improper EBITDA Adjustments Just because the seller and their broker say something is an add-back doesn’t make it an add-back. Trust but verify. Related Party Transactions If any employees, customers, or vendors are related to the seller in any way it is possible that the relationship or dealings between the business and those key stakeholders may be different with you as the new owner. Revenue Or Expense Anomalies Some of the expenses or revenues in the historical period may not have occurred in the “normal” course of business. For this reason they should be adjusted out. Sustainability Of Future Earnings The past is not guaranteed to repeat itself. You want to understand how likely earnings are to continue into the future with you as the new owner. Divergence From Industry Benchmarks If the company you are buying has significant differences from industry benchmarks you’ll want to understand what is driving the difference. Recent Developments If something has changed in the business recently such as hiring a new employee, new pricing from a key supplier, or the addition of a new product line you’ll want to know about it. By uncovering these items, you’ll have a comprehensive view of the quality of the earnings you are buying. Profits Vs Quality Of Earnings The broker wants you to think the profits shown on the confidential information memorandum (CIM) tell you everything you need to know, but it will rarely tell the whole story. A Quality of Earnings report will. It dives into revenue consistency, expenditure trends, and filters out anomalies that could skew perceptions. Starting With EBITDA You’ll often hear the term EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) when talking about Quality of Earnings. It’s a foundational metric in the process and removes the distractions of taxes and other expenses. However, a Quality of Earnings report will go beyond just showing a clear view of EBITDA over the historical period. It will include adjustments for non recurring items, differences in accounting methods, and proforma changes that are expected to occur with a new owner. At Midwest CPA, our financial due diligence services analyze EBITDA, and other key financial data that will give you a normalized view of the financials so you know what you are buying. What Are “Normalized” Financials? When buying a business you want to know what financials will look like under normal circumstances with you as the new owner. For example, if the current owner of the business you are buying is getting a 40% discount on the rent for their office because their brother owns the building you would want to “normalize” this rent payment by looking at the financials as if the business had been paying fair market value. In short, “normalized” financials take a company’s earnings and strip away all the unusual stuff. Those things can make the company look more profitable than it usually is. By “normalizing” the financials, you get a clearer picture of how the company would be performing with you as the owner. How To Read A Quality Of Earnings Report A Quality of Earnings report may be structured in a variety of different ways. That being said, the below example shows a common layout that we use at Midwest CPA. Management Adjustments Oftentimes you will find on the CIM that management has already come up with their own adjustments to EBITDA. Management Adjustment Reversals During financial due diligence each of these adjustments will be reviewed and either validated or dismissed. Reclassification Adjustments These adjustments are for items that should not be included in EBITDA in the first place. For example, interest may have been included in total revenue and will need to be adjusted out. Normalization Adjustments These adjustments take

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How to buy a business

9 Steps On How To Buy A Business

Back to Learning Center Introduction So, you’re in the market and wondering how to buy a business? Great choice! Acquiring an existing business can offer you immediate cash flow, a proven track record, and a faster path to profitability. As a specialist acquisition CPA firm, we’ve seen the benefits for our clients. In this post, we will walk you through the process of how to buy a business, from finding a business to financing, due diligence and more. Franchising vs. Buying a business When you’re considering entering the world of business ownership, you’ll likely encounter two main paths: buying an existing business or investing in a franchise. While both options come with their own sets of advantages and challenges, understanding the key differences can help you make an informed decision that aligns with your goals, lifestyle, and skill set. Franchising Pros: Structured Support: Franchises often provide extensive training programs, marketing support, and operational guidance. Brand Recognition: You’re buying into an established brand that customers already know and trust. Lower Risk: With a proven business model, franchises often present less risk compared to starting a business from scratch. Cons: Limited Control: Franchisors set the rules, and you’ll need to follow their operational guidelines, which may limit your creative freedom. Ongoing Fees: Franchises often require ongoing royalty fees, which can eat into your profits. Initial Franchise Fees: Besides the cost of buying the franchise, you’ll often have to pay an initial franchise fee, which can be quite hefty. Buying an existing business Pros: Immediate cash flow: When you buy an existing business, you get immediate cash flow.  Complete Control: You have the freedom to run the business as you see fit, allowing you to implement your vision and strategies. No Royalty Fees: Unlike franchises, you keep all the profits, as there are no ongoing fees payable to a franchisor. Established Operations: An existing business likely has employees, suppliers, and systems in place, saving you the time and effort needed to build these from scratch. Cons: High upfront costs: Buying a business requires a significant financial investment upfront. Make sure you’re prepared for this. Hidden issues: Every business has its challenges. Whether it’s employee issues or inaccurate financial statements, you’ll want to know about these before you buy. Time-Consuming: Taking over an existing business can be a long process, requiring extensive due diligence and potentially complicated financing arrangements. Key Considerations Whether you’re considering buying a stand alone business or franchise, it’s beneficial to think about some practical aspects first, such as: Your Skill Set: Assess your own skills and experiences. If you’re new to business ownership, the support from a franchisor might be invaluable. Financial Commitment: Both options require a significant financial investment, but the nature of the costs and on-going financial commitments differs. Risk Tolerance: Are you comfortable taking risks and solving unexpected problems, or do you find security in a proven model? Long-Term Goals: Consider your long-term business goals. Do you aspire to own multiple locations, or are you content with operating a single unit? Reasons Behind The Sale Of The Business Before you make any decisions, it’s crucial to understand why the business you’re interested in is on the market in the first place.  There are many reasons for selling a business. Be wary of owners who are just trying to offload a sinking ship. An owner that does not have a good reason to sell is also more likely to back out of the deal.  To prevent lost time and money you want a seller that is as committed to the sale as you are and has a valid reason for selling. Here are some common high motivation reasons to look out for: Retirement Health problems Divorce Disagreements between partners Death of the owner Questions To Ask The Current Owner A good idea is to spend some time with the current owner and get to know them, how they operate, how they interact with key stakeholders and what they think about the business. You can pick up a few insights into their success by spending time with them in their business. Ask them questions about the history of the business, current operations and future growth potential. Understand key relationships, potential problems and what skills they believe the new owner needs to have. 9 Steps: How To Buy A Business Step 1: Self-Assessment Before you even start looking, you need to ask yourself some questions. What are your skills? What are your goals? Do you have access to financing? What types of businesses could you effectively manage? Doing a self assessment will help you identify the type of business that’s right for you. Step 2: Market Research Once you have an idea of what you’re looking for, start researching the market. You will need to check out the competition in that market, take a closer look at customer behavior and what the industry trends are. Step 3: How To Find A Business To Buy There are various ways to find a business to buy. You can use business brokers, online marketplaces, or tap into your network. Directly from the Owner: One way to find a business to buy is directly from the owner. This often allows for more straightforward negotiations. Business Brokers: Business brokers can help you find businesses that match your criteria and budget. They can also assist in negotiations. Online Platforms: Websites like BizBuySell offer listings of businesses for sale, sorted by industry, location, and price. Networking: Your professional network can be a goldmine for finding businesses for sale. Don’t underestimate the power of word-of-mouth. Step 5: Due Diligence This is where you dig deep. Examine the business’s financial records, contracts, and any other relevant documents. You can use our Due Diligence Checklist For Buying a Business to make sure you don’t miss anything. It is important to get this step right. You don’t want to acquire a business that later turns out to be a dead weight.  Here’s a glimpse of what our Due Diligence Checklist

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Numbers Don’t Lie: The Crucial Role of Financial Due Diligence

Introduction Acquiring a business offers the potential for significant gains, benefiting not only you but your family as well. However, there is also a substantial amount of risk that acquisition entrepreneurs are taking on. If you’re buying a business with a personally guaranteed loan, failure could decimate your financial future. That is why performing sufficient due diligence is so important.    One of the most important aspects of the due diligence process is financial due diligence. In this article, I will provide a comprehensive overview of the essential aspects surrounding financial due diligence within the context of a potential small to medium-sized business (SMB) acquisition. What financial due diligence is not. When people first learn about financial due diligence it is very common that they confuse the process for something else.  Here are a few of the common misconceptions people have: Financial due diligence is not an audit An audit is a very specific type of engagement that seeks to give an opinion on whether or not financial statements adhere to accepted accounting principles (usually GAAP in the United States). In contrast, financial due diligence aims to identify and explain trends, while also presenting a normalized view of metrics like earnings before interest, taxes, depreciation, and amortization (EBITDA), seller discretionary earnings (SDE), and net working capital (NWC). So while a financial due diligence provider may utilize the work of audit financials (if available) during their engagement, the two processes are very different. Financial due diligence is not a projection/forecast Financial due diligence is based on historical performance. The analysis of the historical period can be useful when determining the feasibility of a projection or when creating a projection.  That being said, generally an engagement to project future results will be done separately. Financial due diligence is not a valuation or a recommendation to buy or pass on the deal A valuation team may use the work from a financial due diligence provider in order to properly value a business. However, a business valuation generally requires a skillset that is different from the skillset of a financial due diligence provider. Furthermore, the decision to proceed with or decline the deal rests ultimately with you, the buyer. Your financial due diligence provider will present you with relevant facts that can help you to make an informed decision but they generally will not take a hard stance in either direction.   What are the objectives of financial due diligence? When financial due diligence is complete, the end result is typically a report that can be shared with the buyer, their lender and their investors.  When completed effectively, this report should offer insights into three key areas: 1. Understanding of the business model It is important to know how the business you are buying is generating revenue and profit. A good financial due diligence report will clearly show how a company has done that historically. 2. Normalized financials Especially when taking out debt, it is very important to have a normalized picture of the businesses financials.  For most small to mid-sized business acquisitions, the financial metrics that should be of primary concern are: EBITDA, SDE, and NWC. In order to get a proper picture of these 3 metrics a good provider will utilize a combination of the seller’s business tax returns, bank statements, and internal bookkeeping records to verify that the information that has been presented to you by the seller and their broker is factual.  3. The feasibility of your forecast While a financial due diligence engagement does not generate projections itself, it does provide you with a series of facts and figures that can help you assess the reasonableness of the projections you have created. Overview of the financial due diligence process Every financial due diligence engagement follows a different trajectory. However, generally they will move through 3 overarching stages. 1. Financial Due Diligence Preparation: Scope the Project By properly scoping the project you can greatly decrease due diligence costs, save time, and reduce potential dead deal costs.  You do this by carefully outlining the size/complexity of the business, the needs of the lender, your needs as a buyer, and the amount and quality of information that will be available from the seller.  Industry Research Even if you are already an expert in the industry it is always a good thing to do additional research. Even just spending an hour Googling the target company and skimming a few annual reports from the largest companies in the industry. Information Gathering This is where you will curate a list of items to request from the seller. Typically, the historical period that is analyzed will be 2-3 years.  At a minimum you’ll want to ask for tax returns, bank statements, and monthly internal accounting records for the historical period.  Format Information/Initial analysis As you look at companies to purchase in the range of $1-$5MM in enterprise value, what you will find is that the information will be provided in a variety of different formats in most cases.  During this step you’ll want to review every document that has been sent to you and distill all relevant information into a usable format. Oftentimes this comes in the form of an Excel file.  Once the data is in a usable format you can start to analyze it. I recommend starting to analyze the data at the highest level. Then as you notice trends and abnormalities you can drill in and build a list of questions for the seller.  A few examples of analysis that can be performed are: Year over year EBITDA bridge Tax to book bridge  Current year outturn  Seasonality analysis  Revenue concentration  Gross margin trends  Churn Analysis Fixed vs variable cost sensitivity  Employee cost analysis  Operating expense trends 2. Analysis Q&A with Seller After doing the high level of analysis it is natural to have built up a list of questions for the seller. I recommend sending a list of those questions to the seller and setting up a meeting for a few days

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Should you Make S-Corporation Election?

Why Make S-Corp Election? As a pass-through LLC your total income is going to be subject to self-employment taxes (also known as FICA taxes) equaling 15.3%. With an S-Corporation this is not necessarily the case.  This is because when you make an election to be taxed as an S-Corporation you then will start to pay yourself a salary and report it on Form W-2.  This portion of your income is still subject to self employment taxes.  However, the profit from your business after subtracting out your wages will not be subject to self employment taxes. This has the potential to result in huge savings for you. Checkout how much you can save in the calculator below! S-Corp Tax Savings Calculator Estimated business income: Enter a reasonable salary for yourself: Submit I Have My Results! What’s next? This calculator is not exact. It only acts as a general guide to show the potential savings that making S-Corp election could have for you.  That being said the next step is to educate yourself on all the requirements that your business needs to meet in order to qualify to make the election. Those requirements are: Be a domestic company Have only allowable shareholders. This would include individuals, certain trusts, and estates. Have no more than 100 shareholders Have only one class of stock Not be an ineligible corporation such as an insurance company or a bank. If you meet all of these requirements you should still consider all of the additional administrative costs that come with being an S-Corp. One of the largest additional costs will be your tax filing at the end of the year. If you are currently a single member LLC then you are generally going to be reporting your income on Schedule C of your 1040. As an S-Corp you will file using Form 1120-S. This form is more complex than a Schedule C and your tax pro will charge you more for that complexity.  How do I Make S-Corp Election? Once you’ve met with a qualified tax professional and determined S-Corp election is right for you, you need to file Form 2553 to make the election.  This form is due no later than 2 months and 15 days after the beginning of the tax year the election is to take effect.  Reasonable Salary A common question that will come up from Midwest CPA clients when making S-Corp election is. How do I determine a “reasonable salary”. The general rule is to pay yourself what a competitor might pay you if they were to hire you to do the same work that you do now. To determine what a competitor might pay you, you can analyze job postings, salary guides, and even your previous wage if your business is in an industry you were previously employed in.  Should the IRS analyze your salary they will look at a variety of factors including: Experience Time at work Timing of payments Comparable business salaries Compensation agreements The calculation used to determine salary Responsibilities Accountable Plan Another detail you cannot forget when making S-Corp election is to create an accountable plan. This is an internal policy that follows IRS regulations for reimbursing employees for business expenses.  Without this plan in place you are considered to be on a non-accountable plan. In this case any reimbursements are considered taxable income to be reported on an employees W-2 Form.  This is incredibly important for a small business owner especially if you are regularly reimbursing yourself for expenses such as your home office, cell phone, or car.  If you don’t currently have a plan in place reach out to your CPA and they will likely have a template you can use to get started. While we’ve got you here, why not take a look at our real estate CPA services. View Services View More Resources Disclaimer The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.

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can land be depreciated

Can Land be Depreciated?

Introduction A common question we receive from our real estate investor clients at Midwest CPA is “Can land be depreciated?”. The short answer is no, but the topic is more complex than it seems. Once it’s established that land cannot be depreciated, the next question arises: “How much of the property purchase price should be allocated to the land versus the building?” Allocating a higher amount to the building is in the investor’s best interest, as the building is depreciable. The greater the allocation to the building’s basis, the higher the depreciation expense the real estate investor can utilize to reduce taxes. However, selecting any percentage arbitrarily is not allowed by the IRS. This is a common mistake made by generalist CPAs, who often allocate 10-15% to land for every property they prepare a return for. Such a percentage may not hold up under scrutiny during an audit, potentially leading to additional taxes and penalties. Conversely, an excessively high percentage could result in overpaying taxes. This is why it’s essential to work with a specialized real estate CPA. The goal should be to find the most reasonable and accurate method for determining land versus building cost allocation. In this article, we will explore five methods to achieve this goal. 1. Tax Assessor’s Allocation This is the most used method and is generally well accepted by the IRS. Each year, the local tax assessor provides property value assessments used to calculate the property tax bill. For instance, if the land value is assessed at $63,000 and the building value at $387,000, with a total property value of $450,000, the land value percentage would be 14% ($63,000/$450,000). If the property was purchased for $600,000, $84,000 (14% x $600,000) would be allocated to the land value, while the remaining $516,000 would be allocated to the building value for depreciation purposes. 2. Replacement Cost Under this method, the taxpayer estimates a reasonable cost to construct a new structure similar to the one on the property. Often the property insurance policy will outline an expected cost to replace the building, and this can be used to estimate the replacement cost. Subtracting the estimated replacement cost from the purchase price helps determine the value attributable to the land. 3. Full Scope-Land Appraisal This method involves a qualified professional appraiser analyzing the property to determine the land value. The appraiser considers comparison sales, the property’s highest and best use, overall market conditions, and income generated by the property. Following the guidelines of the Uniform Standards of Professional Appraisal Practice (USPAP), this method offers high accuracy and support. However, it can be time-consuming and costly, making it more suitable for expensive real estate. 4. Real Estate Professional Appraisal This appraisal is much more limited in scope than the one above and will not follow USPAP guidelines. Further, this analysis does not require a professional appraiser as it can be performed by a real estate professional instead. Their analysis will likely rely mostly on an analysis of comparative sales. At Midwest CPA we recommend that this method be used only in rare circumstances. 5. Rule of Thumb Finally, there is the rule of thumb method that is used by a lot of generalist tax professionals due to its ease and speed to calculate. A percentage of anywhere from 10-30% will be selected and used across all properties. This method leaves you as a taxpayer with the lowest level of protection in an audit since there is very little support for your position. Conclusion By understanding these methods and their implications, real estate investors can make informed decisions about land versus building cost allocation. This way you can ensure you remain in compliance with the IRS while still working to optimize tax planning strategies. Work With a Real Estate CPA Firm Real Estate taxation is complicated. That is why partnering with a specialized CPA firm can make a significant difference in your financial success. A real estate CPA firm, like Midwest CPA, possesses in-depth knowledge and expertise in the intricacies of real estate taxation, ensuring that you navigate the tax landscape with confidence. While we’ve got you here, why not take a look at our real estate CPA services. View Services View More Resources Disclaimer The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.

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6 tax saving tips for house flippers

6 Tax Saving Tips For House Flippers

Introduction In the realm of house flipping, every dollar counts when it comes to profitability. However, a prevailing myth has led many to believe that there are limited options for tax savings, particularly since house flippers are classified as dealers by the IRS. Consequently, each house flip is often carried out with minimal tax efficiency, leaving potential savings on the table. In this article, we will debunk this myth and shed light on smart tax moves specifically tailored to house flippers. By implementing these tax strategies, you can unlock valuable savings that contribute to the overall success and profitability of your house flipping business. The Types of Taxes Affecting House Flippers To navigate the tax landscape as a house flipper, it’s crucial to understand the various types of taxes you’ll encounter. Generally, house flippers encounter three primary types of taxes: Short-Term Capital Gains: When you sell a property within a year of acquiring it, the profit from the sale is classified as short-term capital gains. These gains are subject to taxation at your ordinary income tax rate. Long-Term Capital Gains: If you hold a property for more than a year before selling, the profits will be considered long-term capital gains. Long-term capital gains are generally taxed at lower rates than short-term gains, providing potential tax advantages. Self-Employment Taxes: House flippers are self-employed individuals and therefore are responsible for paying self-employment taxes. These taxes encompass both the employer and employee portions of Social Security and Medicare taxes. Understanding these tax categories is essential because each strategy we discuss in this article aims to either reduce or potentially eliminate the impact of these taxes. 1. Making S-Corporation Election When flipping houses as a sole proprietor or an LLC, the entire income you generate is typically subject to self-employment taxes. However, you can optimize your tax structure by making an S-Corporation (S-Corp) election. Here’s how it works: By filing Form 2553 for your LLC you can elect to be taxed as an S-Corp. This election allows you to pay yourself a reasonable salary, which is subject to self-employment taxes, while the remaining profits from your business are not. By taking advantage of this strategy, you can significantly increase your tax efficiency. With self-employment taxes amounting to 15.3%, making an S-Corp election can result in substantial tax savings. 2. Flipping Your Own Home and Utilizing Section 121 Exclusion If you’re open to living in the home you’re flipping, this strategy has the potential to completely eliminate the amount of tax you owe. The Section 121 exclusion allows individuals to exclude up to $250,000 in gains from taxation, while married couples can exclude up to $500,000. To qualify for this exclusion, you must meet the following criteria: Residency Requirement: You need to have lived in the home for at least 2 out of the last 5 years. Timing Limitations: Note that you cannot utilize this exclusion more than once within a 2-year timeframe. By leveraging the Section 121 exclusion, you can potentially eliminate the tax burden associated with the gains from flipping your own home, allowing you to keep more of your profits. 3. Holding Property for a Year: Maximizing Long-Term Capital Gains When you purchase a property and flip it within one year, the gain on that sale is classified as a short-term capital gain. Short-term capital gains are subject to taxation at your ordinary income tax rate, which can be as high as 37% in 2023. Additionally, these gains are also subject to self-employment taxes at a rate of 15.3%. However, by holding the property for at least one year, you can take advantage of long-term capital gains treatment. Here’s how it benefits you: Preferred Tax Rate: The gain on the sale will be considered a long-term capital gain and taxed at the preferred capital gains rate, which currently maxes out at 20% in 2023. This is significantly lower than ordinary income tax rates. Exemption from Self-Employment Taxes: Long-term capital gains are not subject to self-employment taxes.  By strategically holding properties for a year or longer before selling, you can optimize your tax position, benefiting from long-term capital gains tax rates and eliminating the self-employment tax burden. 4. Renting Property Before Selling: Leveraging a 1031 Exchange Renting out a property before selling it can open up opportunities for tax deferral through a 1031 exchange. Here’s how it works: A 1031 exchange allows taxpayers to defer taxes on the gains from the sale of real estate held for investment purposes. However, it’s important to note that the IRS excludes properties held for sale by dealers, and house flippers typically fall into this category. Consequently, they cannot take advantage of a 1031 exchange for their flipping activities. Nevertheless, many house flippers have a long-term investment strategy alongside their flipping ventures. They may come across properties that aren’t suitable for flipping at the moment but could serve as profitable long-term investments. In such cases, you can purchase the property, perform the necessary rehab, and then rent it out to tenants for a few years. By doing so, you create an opportunity to qualify for a 1031 exchange and defer taxes on your gain when you eventually sell the property. To further enhance this strategy, consider exploring the possibility of refinancing the rehabbed property to withdraw your initial investment tax-free. You can then reinvest this money into additional flips, maximizing your returns and expanding your house flipping portfolio. By strategically renting properties before selling them and utilizing the benefits of a 1031 exchange, you can optimize your tax position, defer taxes, and potentially leverage your initial investment for further house flipping opportunities. 5. Quality Bookkeeping to Optimize Tax Deductions There are two main benefits of keeping quality records: Compliance and Deduction Optimization: Keeping accurate records is essential for ensuring compliance with IRS regulations. Additionally, it allows you to identify and claim every possible deduction available to you as a house flipper.  Project Performance and Budget Management: Effective bookkeeping provides you with valuable insights into the financial performance of your house flipping projects. This level of financial visibility empowers you to make informed

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