What Causes a Deferred Tax Liability?

It's a given that individuals and companies must pay federal taxes on income earned in a given year. But sometimes those taxes are recognized, and paid, at a future point rather than the year in which a sale occurs or income is earned. This concept is known as deferred tax liability, or DTL.

Through DTL, income taxes are "deferred" to a future period of time and paid at that time. The more complex DTL definition focuses on taxes normally paid through regular financial accounting but deferred to a future date. This deferral comes courtesy of provisions in the Internal Revenue Code (IRC). 

In non-tax language, deferred tax liability means delaying payment of taxes to a future date by using "legal" tax reculations.

Here are some DTL triggers:

Depreciation

Depreciation represents an accounting method that allocates the cost of a physical or tangible asset over its useful lifetime. It can also represent an estimated reduction in the value of a fixed asset, over time. When it comes to financial reporting, tax laws allow for a modified accelerated cost recovery system (MARCS) or straight-line depreciation.

When it comes to real estate ownership, investors can claim an annual depreciation allowance. The IRS allows ordinary income deductions from that real estate to account for wear and tear.

But these taxes don't go away. The IRS eventually wants what's owed. When it comes to real estate, depreciation recapture means the IRS can collect income tax on a gain generated from the sale of a physical asset.

Installment Sales

An installment sale takes place when an asset's seller agrees to receive one or more payments in a tax year after the one in which a sale occurred. According to the IRS, the buyer can repay the seller in the form of a deed of trust, note, mortgage, or land contract.

Through an installment sale, the seller reports the sale in the taxable years when payments are received, rather than in the year in which the actual disposition took place. Rather than paying taxes on a single gain, they pay taxes on proceed when received.

Defined Contribution Plans

Certain types of defined contribution plans can also trigger DTL. Examples of defined contribution plans include traditional 401(k) plans, Simplified Employee Plans (SEPs), and 403(b) plans.

An individual deducts a portion of their pre-tax earnings into these plans. But again, those owed taxes don't disappear. When the individual starts extracting funds from the plan (typically at age 59 1/2), they pay taxes on the withdrawn amount.

A deferred tax liability doesn't mean that owed taxes aren't paid. A DTL delays tax payments to a future date. DTL can work as a strategy to "spread out" what's owed to the IRS. But as with any tax issue, it's a good idea to talk to a qualified tax professional.