Why Bonus Depreciation May Affect Your Future Loans
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What is Bonus Depreciation?
Bonus depreciation is a tax incentive for businesses purchasing or financing depreciable assets. We went over bonus depreciation in a previous article, but the short of it is that it’s a way to deduct the full purchase price of qualifying equipment from your business’ taxable income the year you put that equipment in service. Even if you’re only making monthly payments on the equipment instead of purchasing it outright.
What’s interesting about bonus depreciation is that it can be used to reduce a business’ net operating income (NOI) to zero or lower which results in a net operating loss (NOL). Doing this can be useful for immediate tax benefits, but isn’t always the best option for every business as it can create barriers for obtaining future loans by lowering your DSCR.
Disclaimer: The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or business. It is only intended to provide education.
What is DSCR?
Your debt service coverage ratio (DSCR) is what lenders use to determine how much new debt your business can take on based on its current income and debt. Generally, lenders consider any DSCR below 1 to be a red flag.
Lenders look at two major factors to determine a company’s DSCR: its debt service, and NOI. Debt service is the cost of paying off a business’ principal and interest payments over a period of time – usually a year.
A business’ NOI is calculated by subtracting its operating expenses – expenses used to keep a business operational – from its revenue.
How to Calculate DSCR
Unless you keep exceptional financial records, you probably won’t be able to calculate your DSCR with 100% accuracy. However, you can run this basic calculation to get a general idea of where you may stand:
DSCR= Net Operating Income ÷ Total Debt Service
Total Debt Service= (Interest×(1−Tax Rate))+Principal
How Bonus Depreciation May Lower Your DSCR
Because DSCR is calculated using NOI, businesses that use bonus depreciation to reduce their taxable income are also lowering their DSCR. This is further complicated when you factor in the fact that businesses must opt all equipment purchased or financed the year they choose to use bonus depreciation, making it difficult to fine tune their deductions.
So, while businesses using bonus depreciation can earn some nice tax deductions, they should also be conscious of how it could affect their DSCR.
Why This Matters and What You Can Do About It
DSCR isn’t the only factor that lenders account for when examining a loan application, but it’s still a big one. Lenders want to ensure that your business has the capacity to pay them back and a low DSCR doesn’t exactly build their confidence. Luckily, there’s a way to have your cake and eat it too.
For starters, bonus depreciation isn’t the only way to deduct equipment costs from your taxable income. Section 179 of the IRS tax code is another form of accelerated depreciation for businesses that purchase or finance equipment. Unlike bonus depreciation, however, Section 179 allows businesses to be much more precise with their deductions.
With Section 179, businesses can individually select which equipment they’d like to deduct, as opposed to the blanket deduct-all rule associated with taking bonus depreciation. Section 179 still has drawbacks – namely its spending and income limitations – that may make it less appealing for some businesses.
Planning your tax deductions and purchases to fit your business goals is usually the optimal choice, but that decision isn’t always clear. While a low DSCR one year may severely hinder one business’ growth plans, it could also make no difference to another.
If you’re struggling to make a decision, consider consulting a professional. At Atlantic, we offer free consultative services designed to help businesses plan out future equipment purchases and loans in a way that fits their current and future business goals.