Tax Timing admin
In many situations, the IRS does not allow reinvestment of funds generated by a project without an interim tax penalty. This can be important when you compare one long-term investment to multiple short-term investments that are otherwise identical. For example, consider a farmer in the 40% tax bracket who purchases grain that costs $300, and that triples its value every year.
• If the IRS considers this farm to be one long-term two-year project, the farmer can use the first harvest to reseed, so $300 seed turns into $900 in one year and then into a $2,700 harvest in two years. Uncle Sam considers the profit to be $2,400 and so collects taxes of $960. The farmer is left with post-tax profits of $1,440.
• If the IRS considers this production to be two consecutive one-year projects, then the farmer ends up with $900 at the end of the first year. Uncle Sam collects 40% ·$600 = $240, leaving the farmer with $660. Replanted, the $660 grows to $1,980, of which the IRS collects another 40% ·$1, 980 = $792. The farmer is left with post-tax profits of 60% ·$1, 980 = $1, 188.
The discrepancy between $1,440 and $1,188 is due to the fact that the long-term project can avoid the interim taxation. Similar issues arise whenever an expense can be reclassified from “reinvested profits” (taxed, if not with some credit at reinvestment time) into “necessary maintenance.”
Although you should always get taxes right—and really know the details of the tax situation that applies to you—be aware that you must particularly pay attention to getting taxes right if you are planning to undertake real estate transactions. These have special tax exemptions and tax depreciation writeoffs that are essential to getting the project valuation right.