I have a unique tax simplification proposal. I haven’t heard it discussed or proposed anywhere else. I submit it is something to think about. What if we did away with the deduction for depreciation of 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”.
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 27.5 or 39 years. 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.
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 do we allow a tax deduction for the depreciation of real estate?
Doing away with this deduction would provide “Uncle Sam”, and corresponding state uncles or aunts, with additional tax money up front, instead of having to wait years or decades to finally collect it. And bottom line - doing away with the depreciation deduction would more correctly tax the actual economic activity.
Recent court cases and IRS regulations have more clearly defined the difference between a capital improvement that is depreciated and a repair that is currently deducted, moving away from the dollar amount as the criteria and towards the nature of the expense as the determining factor. Under my suggestion there would also be no depreciation of true capital improvements – they would simply be added to cost basis.