Recently
I posted on some of the many inequities in the US Tax Code. In addition to items that unfairly burden
specific taxpayers there are also items in the Code that unfairly benefit
specific taxpayers.
I am
not talking about the multitude of industry-specific “loopholes” in the
Code. In my opinion all of these should
be removed. And I am not talking about
temporary deduction and credit enhancements to benefit victims of natural
disasters. These are needed. What I am talking about are items that disproportionately distort economic reality.
Here
is one example, which I have posted about often in the past – the deduction for
depreciation of real property and capital improvements thereto. This is taken from my free report “The Tax Code Must Be Destroyed”.
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
us look at depreciation from the point of view of the Income Statement of a
business or rental activity. 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, deducting
the cost over a five year period “more better” represents the 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 the asset of 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.”
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 several years ago was 100 years old at the time 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 years later for $75,000 (and they
were robbed). Granted real estate values
can go down due to market conditions. But this is the exception and not the
rule.
So,
for all intents and purposes, 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?
Being
a “phantom expense”, the deduction for depreciation of real estate distorts the
economic reality of the investment activity.
An activity producing a positive cash profit becomes a deductible tax
loss.
Real
estate is an investment, just like stocks, bonds, mutual funds, etc. You invest in rental real estate because you
expect the building to increase in value over time, often more so than stocks
and mutual funds, and because it generates “dividends” in the form of net “in
pocket” rental income. The deduction for
depreciation of real estate is like allowing those who purchase stock to
depreciate the purchase price of the stock as a deduction against the dividends
paid out.
Doing
away with the depreciation of real property means taxpayers no longer have to
deal with depreciation “recapture” when the property is sold, which would
greatly simplify the overall process.
So,
what do you think?
On Wednesday
I will discuss another unfair tax benefit.
TTFN
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