Debt is not always a bad 4 letter word! by Jeffrey Brooks, CPA (c)2012 Jeffrey Brooks

Debt can be good! I have many clients who see “red” when they think about being stressed by having to pay back debt each month. A client who I will call Joe (Joe is not the real client’s first name), had some stressful financial setbacks and now has the money to pay off his personal debts of $300,000. When I spoke with Joe in October, we were beginning to prepare his annual tax plan.
Joe said “I have $350,000 in my bank accounts and I want to get these debts paid off!” “I will rest more easy not having to think about paying these payments each month.
Where did the money come from to pay all his debt? He wasn’t sure but together we discovered that:
1. $40,000 came from an old investment that he sold a month ago. Joe has no capital losses carried over from the previous year. The old investment had a cost basis of $10,000. $30,000 of the gain is taxable. At least it is a long term capital gain!
2. $150,000 came from current year’s business revenues,
3. $160,000 came from a sale of a business.
Fortunately Joe visited me in October and not the following April!
1. Joe will have $30K gain on the old investment in #1 above or about $6K in tax. This isn’t bad! Joe’s cash just goes down by $6K.
2. In #2, Joe has a lot of cash from current revenues. The fact I did not tell you in the previous section that his business has $200,000 of taxable income so Joe has $50,000 more in taxable income than Cash. I call this the “tax gap”. IF Joe pays off debt and no longer has the $150,000 in cash to pay off business accounts payable and prepay business expenses, fund a retirement plan and pay payroll and bonuses, Joe’s business taxable income is going to be $200,000 instead of $50,000 ($200,000 taxable income less $150,000 from cash used to pay fully deductible expenses). Joe’s cash will go down $80K because Joe is in the 40% tax bracket! (40% of $200,000 taxable income).
3. In #3, Joe’s former business had furniture, fixtures and equipment that had been fully depreciated. The book value was ZERO! The buyer of Joe’s former business gets Joe to agree that the entire $160,000 purchase price is for furniture, fixtures and equipment. Joe’s cash will go down by $64K because Joe is in the 40% tax bracket! ($160,000 x 40%).
4. Joe tells me that besides his personal debt of $300K that he plans on paying off in the next week, the former business has equipment leases of $100K that now must be paid off. NONE of these pay offs of debt are tax deductible although they reduce cash available to reduce business taxable income! Why is debt not tax deductible? Because the assets purchased with business debt have generated depreciation tax deductions!

Joe’s $350,000 has dwindled to LESS THAN ZERO:

Starting cash $350K, Cash Flow Out of $550K, Ending Cash $-200K!

Therefore, Joe should not pay off all of his $300K in debt right now!

Debt is not always a bad 4 letter word!

Jeff Brooks, CPA is President of JBrooks Wealth Advisors, PC, a CPA firm.

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About Jeffrey Brooks

Jeffrey Brooks, CPA, CFP, MBA since 1976 has specialized in helping clients save significant taxes, help businesses increase their cash flow, revenues and profits while increasing their control and satisfaction. Jeff and his accounting firm sincerely cares about the happiness of his clients.

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