How Rental House Owners Can Benefit from the $25,000 Special Allowance

Understanding tax rules can reveal tremendous tax-saving opportunities—even when general rules disallow certain losses from passive activities. In this post, we explore a special allowance and explain how contractors can benefit from using the cash method of accounting.

Why This Exception Matters

• Tax-Saving Opportunity: This exception to the general rule can offer significant savings.

• Important Consideration: Understanding and utilizing this special allowance could reduce your overall tax burden.

Choosing the Right Accounting Method

As a contractor, it's crucial to follow tax rules and select the proper accounting method to accurately report your income and expenses. One of the most common methods used is the cash method of accounting.

What Is the Cash Method of Accounting?

The cash method is a simple and straightforward approach:

• Income Reporting: Report income when you receive payment.

• Expense Reporting: Report expenses when you pay them.

Is the Cash Method Right for You?

While ideal for many contractors, certain restrictions apply:

• Who Cannot Use the Cash Method:

  • C Corporations or Partnerships with a C corporation partner whose average annual gross receipts exceed $25 million over the past three years.

  • Tax Shelters are also restricted from using this method.

• S Corporations:

  • May use the cash method unless their average annual gross receipts exceed $25 million over the past three years. In such cases, the accrual method must be used for non-exempt long-term contracts.

• Inventory Considerations:

  • If you are required to account for inventory, you must use the accrual method.

How Does the Cash Method Work?

The cash method follows specific Treasury Regulations, ensuring straightforward reporting:

• Timing of Income:

  • For example, if you complete a job in December of Year 1 but pick up the check in January of Year 2, you report the income in Year 1 because you had unrestricted access to it.

• Regulatory Basis:

  • Treasury Regulation § 1.446-1(c)(1)(i) mandates reporting income when received and deducting expenses when paid.

  • Treasury Regulation § 1.461-1(a)(1) allows deduction of expenses in the year of payment.

• Capital Expenditures:

  • If an expenditure creates an asset with a useful life beyond the taxable year, the full amount may not be deductible in that same year.

  • The “one-year rule” from Zaninovich v. Commissioner (616 F.2d 429, 9th Cir. 1980) helps distinguish between currently deductible expenses and capital expenditures. In this case, the court allowed a full deduction for prepaid rent in the year of payment.

Final Thoughts

The cash method of accounting is a straightforward way for most contractors to manage income and expenses. However, given the restrictions and potential nuances:

• Consult a Texas Tax Professional: Ensure this method is suitable for your business needs and complies with all tax regulations.

• Stay Informed: Regularly review tax rules to maximize any tax-saving opportunities available to your business.