Thursday, June 23, 2011


I first discussed this in 2007, and have been touting it ever since as a tax reform proposal.

The new Tax Code, as I would write it, will do away with the deduction for depreciation of real estate, including capital improvements to real estate.

According to the
IRS, depreciation is “an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property”. The IRS discusses depreciation in detail in Publication 946 - How To Depreciate Property.

Let’s look at depreciation from the point of view of the Income Statement. Basically, if you purchase an asset (i.e. equipment, a vehicle, or real estate) that will last more than one year you spread the cost of the asset over its “useful life”. You purchase a new computer. You certainly do not purchase a new computer each year – you expect that it will continue to provide service for several years. So you divide the cost of the computer over a period of years to reflect this fact, and to properly report the “economic reality” of the purchase.

If you deducted the full cost of the computer in the year of purchase this would distort the true cost of doing business. Since you generally purchase a new computer every five years, claiming a deduction of 1/5 of the cost each year “more better” represents your cost of operations.

Thus depreciation is used to “recover the cost or other basis of certain property”.

Another way to look at depreciation is from the Balance Sheet perspective. When you purchase an asset that asset has value to you. You trade the asset of cash for a computer. If you sold your business the value of the computer would be included in the value of the business. As an asset ages its value drops. A two-year old computer does not have the same value in the market as a comparable brand new computer. Depreciation is used to reflect the drop in value of the asset.

Thus depreciation is used to reflect the “wear and tear, deterioration, or obsolescence of the property.”

If we look at economic reality, a building has a life of much more than the 27.5 or 39 years over which depreciation is currently allowed. The building I lived in before moving to my current apartment was 100 year old and is still going strong. And, for the most part, the value of real estate does not drop in value over the years. If properly maintained its value will generally increase. My parents purchased their first home for $13,000 and sold it many, many years later for $75,000 (and they were robbed).

Granted real estate values can go down, as we have seen a lot of in the last few years, due to market conditions. But this is the exception and not the rule.

For all intents and purposes, and for the most part, real estate does not “depreciate”. You do not replace a building every few years because it no longer provides the same service or function. And the value of real estate as a component of the value of a business does not drop as it ages. So why should we allow a tax deduction for the depreciation of real estate?

The new Tax Code would not permit a deduction for the depreciation of real property or capital improvements thereto on any income tax return – not on Schedule C, Schedule E, Schedule F, Form 1041, Form 1065, Form 1120, or Form 1120-S.

By doing away with the depreciation of real property a taxpayer would no longer have to “recapture” depreciation when the property is sold, which would greatly simplify the process.

Along the same lines, so as not to distort the economic reality of the situation, I would also do away with Section 179 expensing of personal depreciable property on any income tax return.


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