Up-to-the-minute advice, information, resources, and, on occasion, commentary on federal and New Jersey state income taxes, and the various New Jersey property tax rebate programs, and insights and observations on tax policy and professional tax practice, by 40-year veteran tax professional Robert D Flach.
Thursday, October 13, 2016
LET'S TALK ABOUT DEPRECIATION
In light of
the discussion of Despicable Donald’s humongous tax loss, which may or may not
be to a large part the result of depreciation - Trump has admitted he loves
depreciation, although obviously not as much as he loves himself - I thought I
would reintroduce a controversial tax reform proposal I first put forward in 2007.
What if we
did away with the depreciation deduction for real estate – on the Form 1040 and
on all the various entity tax returns?
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”.
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.
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.
depreciation is used to “recover the cost
or other basis of certain property”.
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.
depreciation is used to reflect the “wear
and tear, deterioration, or obsolescence of the property.”
several ways to depreciate an asset. The simplest method is “Straight Line”.
You deduct the cost of the asset evenly over its life. If you purchase a
computer for $1000 and you expect it to last for five years you would deduct
$200 per year. There are also “accelerated” methods which recognize that the
value of an asset will be reduced disproportionately, with the reduction in
value being greater in the earlier years. As you well know, when you buy a new
car it drops in value the minute you drive it off the lot.
matters, the government provides guidelines for the “useful” life of different
types of assets. The current depreciation system is called the “Modified
Accelerated Cost Recovery System” (MACRS), which came about with the Tax Reform
Act of 1986. MACRS is divided into two separate depreciation systems:
Depreciation System (GDS) – this is “regular” MACRS and is used most often. It
provides the shortest “recovery periods”. You can use the accelerated “150%
Declining Balance” method or the Straight Line method over the GDS recovery
Depreciation System (ADS) – you can elect to deduct the cost of the asset over
a longer life using the Straight Line method.
allows the cost of the asset, other than real estate or improvements thereto,
to be deducted over 3, 5, 7 and 10 years. The most common recovery periods are
5-year, for cars, computers, copiers, typewriters and software, and 7-year, for
furniture and fixtures.
deduction purposes depreciation begins when the asset is “placed in service”
and not necessarily when it was purchased. If I purchase and pay for a computer
online in December of 2016, but the computer is not delivered to my office until
the first week of January 2017, then depreciation begins in January and I can
begin to deduct depreciation on the computer in tax year 2017.
call for a “half-year convention”, which treats all assets whose cost recovery
begins during the year as being placed in service on the midpoint of the year.
It basically allows for 6 months of depreciation. Under certain circumstances
assets can be depreciated using a “mid-quarter” convention, provided a greater
first year depreciation for assets purchased early in the year.
is treated differently in the Tax Code. First of all the cost of land is never
depreciated. So one must remove the value of the land from the purchase price
of the property. The adjusted purchase price of Residential Real Estate,
including residential rental property, is recovered over a “useful life” of
27.5 years. Non-residential Real Estate, i.e. commercial property, has a useful
life of 39 years. The depreciation of real estate uses a “mid-month”
If we look
at economic reality, a building has a life of much more than 27.5 or 39 years.
A building I lived in over a decade ago was 100 years old and 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).
property is sold you must “recapture” any depreciation that was “allowed or
allowable”, so the depreciation deduction is in reality just a loan from the
intents and purposes, again 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 do we allow
a tax deduction for the depreciation of real estate?
with the depreciation deduction would provide the federal and state governments
with additional tax money upfront, instead of having to wait years or decades
till the property is sold to finally collect it.Without this deduction Despicable Donald
would have actually had to pay income tax.
line - doing away with the depreciation deduction would more correctly tax the actual economic activity.
So, what do
you think - should we do away with the depreciation deduction for real estate?