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?

 

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”.  

 

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.”

 

There are 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.

 

To simplify 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:

 

General 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 period.

 

Alternative Depreciation System (ADS) – you can elect to deduct the cost of the asset over a longer life using the Straight Line method.  

 

MACRS 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.

 

For tax 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.

 

Tax rules 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.

 

Real estate 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” convention.

 

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).

 

When a 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 government.

 

For all 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?

 

Doing away 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.

 

And bottom 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?  

 

TTFN