We recently learned, with the public release of his tax returns, that Donald T Rump paid no federal income tax in 2020. Trump claimed a $16 million loss from his real estate businesses. That loss put him almost $5 million in the red for 2020.
New York tax attorney Steven Goldburd said in an email to The Hill, quoted in “Trump’s tax returns show real estate losses, inheritance impact, no 2020 charitable giving” at THE HILL.COM (highlight is mine) –
“These losses can be from actual losses, but more likely from real estate depreciation expenses. These entities may not actually [be] losing money, but in fact have the depreciation that are wiping out the partnership’s income.”
I expect the depreciation deductions for his many properties caused Trump to pay no federal income tax in 2020. I cannot say whether or not Trump’s specific depreciation deductions are correct (the honesty of everything Trump does is always in question), but I can say depreciation of real estate is a legal business deduction used by everyone who invests in real estate – from the individual or family with a two-family home or vacation rental to billionaire real estate moguls.
The deduction for depreciation of real estate is a “phantom expense” that distorts the economic reality of the investment activity. This deduction causes an activity producing a positive cash profit to become a deductible tax loss. For many many years I have been saying we should do away with the tax 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 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?
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.
When a building is sold all depreciation that has been claimed, or should have been claimed (i.e. “allowed or allowable”) over the years must be “recaptured” and added to the actual net taxable gain, or used to reduce the actual net deductible loss, from the sale. The recaptured depreciation portion of a net gain is taxed at a higher tax rate than the normal “capital gain” rate of 0%, 15% or 20% – and can provide a costly shock to the taxpayer selling a two-family home or vacation property.
Obviously, my belief that we should do away with the tax deduction for depreciation of real estate is not a popular one – but I believe it is a fiscally responsible one.
What do you think?
TTFN
No comments:
Post a Comment