Heavy Price Tag, Heavy Considerations

A company is considering investing in new equipment that will cost $965,000. This is a significant expense, and the company will need to carefully evaluate whether this investment is wise. The equipment is expected to have a long service life, and the company will need to consider factors such as depreciation, net cash flow, and interest rates to make an informed decision.

Annual depreciation allowances

The annual depreciation allowance is a tax benefit for real estate investors, allowing them to write off a "paper loss" each year of ownership without spending money out of pocket. The IRS allows depreciation of real property used for rental purposes, which can reduce annual taxable income and lower tax liability.

Depreciation is calculated by determining the depreciable basis of the property, which is the original value minus the value of the land. The land value is not included in the calculation as it is not considered to depreciate over time. The depreciable basis is then divided by the useful life of the property to determine the annual depreciation allowance.

For example, if a duplex is purchased for $500,000, and the land is valued at $100,000, the depreciable basis would be $400,000. As the majority of the income is derived from dwelling units, this is classified as a residential property with a useful life of 27.5 years. Therefore, the annual depreciation allowance would be $14,545 ($400,000 / 27.5 years).

It is important to note that depreciation is spread out over the useful life of the asset, which is 39 years for commercial properties and 27.5 years for residential properties. Additionally, depreciation deductions taken during the holding period of the asset will have to be paid back when the property is sold, unless certain strategies such as a 1031 exchange are employed.

End-of-year book values

Book value is the value of a company's assets after netting out its liabilities. It is the sum of all the line item amounts in the shareholders' equity section on a company's balance sheet. It may also be referred to as net worth.

The book value of a business is the total amount a company would generate if it was liquidated without selling any assets at a loss. It is calculated as:

> Book value of a company = assets - total liabilities

Book value is often different from a company's market value. Market value is often higher than book value because the market price incorporates investors' thoughts and calculations about intangible assets such as intellectual property, human capital, and future growth prospects.

Book value is also used to calculate the book value per share (BVPS), which is the per-share book value. It is calculated as:

> BVPS = Total Shareholder Equity - Preferred Stock / Total Common Shares Outstanding

The price-to-book (P/B) ratio is another useful metric that is calculated as:

> P/B Ratio = Market Share Price / Book Value Per Share

A P/B ratio of 1.0 indicates that the market price of a share of stock is exactly equal to its book value.

Book value is a useful tool for investors to help value a company and its shares.

Bonus depreciation

To qualify for bonus depreciation, certain criteria must be met. Qualifying assets can include:

• Modified Accelerated Cost Recovery System (MACRS) property with a recovery period of 20 years or less, such as computer equipment and office furniture.
• Depreciable computer software.
• Water utility property.
• Qualified leasehold improvement property, like any improvement to the interior portion of a non-residential building.
• Costs of certain film, television, and live theatrical productions.
• Vacation property if a taxpayer uses the vacation property as a short-term rental, such as an Airbnb.
• Residential rental property if the taxpayer conducts a cost-segregation study.
• Vehicles with a useful life of 20 years or less.
• Used equipment if it was not used by the taxpayer at any time prior to acquisition.

Net operating working capital

The formula for calculating NOWC is:

NOWC = Current Opening Assets - Current Opening Liabilities

Alternatively, it can be calculated as:

NOWC = (Cash + Inventories + Accounts Receivable) - (Accounts Payable + Accrued Expenses)

A positive NOWC indicates that a company's assets exceed its liabilities, suggesting financial health and the potential for growth and investment. Conversely, if a company's liabilities exceed its assets, it may be a sign of financial trouble.

It is important to note that NOWC does not consider natural or human capital, allowing companies to assess their performance based solely on financial metrics. This enables investors to make direct comparisons between companies' cash flow and balance sheets.

By understanding NOWC, businesses can make informed decisions, adapt to changes, and ensure they have sufficient funds to accommodate new opportunities or unforeseen events.

Tax rate

The tax rate for equipment investment depends on several factors, including the jurisdiction, type of equipment, and method of depreciation. In the United States, capital gains from the sale of equipment are taxed differently based on the duration of ownership.

Short-term capital gains, resulting from the sale of equipment owned for one year or less, are taxed as ordinary income. In 2023, the short-term capital gains tax rate can be as high as 37%, depending on the tax bracket.

On the other hand, long-term capital gains, derived from equipment held for more than a year, are taxed at lower rates of 0%, 15%, or 20%. These rates are based on graduated income thresholds, and most taxpayers who report long-term capital gains fall into the 15% or lower bracket.

Additionally, the Australian Taxation Office (ATO) categorizes property depreciation into Division 43 (Capital Works Allowance) and Division 40 (Plant and Equipment). Division 43 pertains to the building structure and permanent fixtures, depreciating at 2.5% per year over 40 years for properties constructed after July 1985. Division 40 covers removable or mechanical assets within the property, such as appliances and furniture, with varying depreciation rates set by the ATO based on the asset's effective life.

Frequently asked questions