Chris Asks:
I’m curious how special bonus depreciation impacts cash flow analysis and DTI (Debt-to-Income Ratio)?
I believe it ended on January 1st but it seems like I may be seeing it on 21 and 22 returns. I noticed on certain business returns, whereas section 179 would show up on the k1 the special bonus actually created a net loss on box 1 of the k1 and the depreciation only shows up on page 1 of the 1120s. Should this be added back? Whereas 179 shows up on box 14 I believe. Are both the k1 and 1120 used?
David’s Answer:
Some think “add back depreciation” is straightforward, and quite often it is. However, your question does bring up some nuances.
Why we add back depreciation:
First, let’s keep it simple. We add back depreciation because it does not represent cash being spent. It’s simply an accounting write-off which means it is noncash. Noncash is one of the six types of adjustments we train our lenders/credit analysts to add back when analyzing a tax return for debt repayment and owner compensation.
Secondly, if the depreciation allocation reduces our bottom line, we add it back regardless of its type (regular or normal, section 179 or bonus).
Where do you start?
What is your bottom line? If you start with “taxable income” (called ordinary income on a 1065 and 1120S), add back the front page depreciation. Ignore depreciation on Schedule K or the Schedule M-1. If you start with “net income per books” on the Schedule M-1, Line 1, as some lenders or analysts do, then you need to add back all book depreciation. Check out the blogpost, Lender Depreciation Add-Back? It depends on where you find it for help with that approach.
What about bonus depreciation?
What difference does the changes in “bonus depreciation” rules make with determining cash flow? If a borrower who has benefited from bonus depreciation for the last three years, no longer will benefit from that deduction, and their business practices do not change; they will likely pay more federal income taxes. Paying more taxes impacts cash flow. So, if your process subtracts federal income taxes, consider if that number needs to be adjusted for projecting future cash flow.
What if equipment was not financed?
Do you still add back depreciation? Here is a blogpost that answers that question: Does adding back Section 179 ‘depreciation’ overstate global cash flow?
More on tax return analysis:
In addition to the blog posts mentioned above, depreciation is one of the 35 modules in our Lenders Online Training course on tax return and financial statement analysis where lenders, analysts and underwriters learn to say ‘yes’ to good loans.
Go to LendersOnlineTraining.com to learn more.
