Monday, June 4, 2018
NOBODY EVER SAID TAXES WERE FAIR – GOING IN THE OTHER DIRECTION – PART I
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.