WHY TRUMP PAID NO INCOME TAX IN 2020

 

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

TRUMP'S TAX RETURNS AND DEPRECIATION - THE RETURN OF MY CONTROVERSIAL TAX REFORM PROPOSAL

The New York Times has revealed that Trump used excessive business losses to avoid, and evade, federal and state income taxes.

A portion of the losses come from fraudulently claiming personal expenses as business deductions.  Trump has clearly cheated on his tax returns and should be indicted for tax fraud.  But a large percentage of Trump’s losses comes from depreciation of real estate - a perfectly legal but not, in my personal opinion, “legitimate” business tax deduction.

While it is truly a controversial opinion, as I have said often in the past, here and elsewhere, I sincerely believe that we should do away with the business tax deduction for the depreciation of real property - fixed property, principally land and buildings.  The depreciation of real property is a “phantom” expense and distorts the economic reality of the investment activity.  It allows an investor with an actual economic profit to claim a deductible tax loss and avoid, or in my opinion evade, income taxes - at least temporarily (depreciation must be "recaptured", sometimes at a lower tax rate, when the property is sold).

Let me repeat my argument.

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 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. But you do not purchase a new office building every 27.5 or 39 years because the old building is obsolete or no longer functions.   

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.  

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, the value of real estate does not “depreciate”.     

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.  

Depreciation of real property is a “tax expenditure” – “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.’’  This deduction represents federal, and state, revenue losses in the millions, if not billions, each year.

So, what do you think?

TTFN

THE ESSENTIAL 1040

As mentioned in this week’s BUZZ installment, I attended the National Association of Tax Professionals’ annual year-end tax update “The Essential 1040” on Monday at Bally’s on the Boardwalk in Atlantic City.  I attend this one-day seminar every year, and have done so for over 30 years, and also occasionally attend the second day, “Beyond the 1040” (although not this year) depending on the topics being discussed.

Bally’s is a good location.  I have no complaints about the classroom facility or my room, which, as a member of the Total Rewards program, was extremely reasonable – certainly cheaper than that at any other location this class is offered.  This year the seminar included, as it does every year, a relatively skimpy, and definitely not diabetic-friendly, continental breakfast buffet, and an afternoon dessert break.  And, for the first time in 30+ years, the cost of the event included a box lunch (also not diabetic-friendly), paid for by a sponsor who gave a presentation for those who wanted to listen.

As a “stand-alone” offering the seminar was, as usual, excellent, and covered just about everything tax preparers need to know to prepare 2018 Form 1040s.  But, as I said to my business banker on the phone on Monday morning, I was listening to what I had already been told 3 times this year.  Because the only real new development for 2018 was the GOP Tax Act, and I had already attended 2 full-day sessions exclusively on the Act and one 2 hour review of it as part of the NATP Forum, almost everything covered at this seminar was truly redundant for me.  I did, however, learn a couple of new things, which I discuss later in this post.

One saving grace – because there was so much to cover with the new Act this year’s seminar did not include the usual 2 hours of redundant and unnecessary (for me) ethics preaching.  So, one paid for eight 50-minute hours of real education and one actually got eight 50-minute hours of real education.

I had signed up for classes that I knew would cover the GOP Tax Act scheduled later in the year, like this one, because I had hoped that the IRS would be releasing new regulations, interpretations, clarifications and information about the tax law changes.  Unfortunately, very little new details have been released.

Three things continue to be reinforced by GOP Tax Act seminars and discussions –

(1) There is still a lot we don’t know yet about how many of the provisions of the Act will be interpreted and implemented.

(2) Because the Act was basically written overnight, the wording of the law is often defective, confusing and unclear.  “Technical corrections” legislation is clearly needed.

(3) It is very obvious that those who actually write tax law and the idiots in Congress who vote on it have absolutely no concept of the practical implementation of the tax legislation they write and pass, or of the actual preparation of tax returns.

Of this I am certain - by the time we tax professionals fully learn and understand the ins and outs of the new law, the IRS has released all the appropriate regulations, and the Tax Court has clarified the issues of confusion, the Act will expire and we will be back to the Tax Code as it was for 2017.

And the more I review the new “postcard” Form 1040 and its 6 supplemental schedules the more I come to believe that this is probably the stupidest thing ever in my 45+ years in the tax preparation business.

So, here is what I learned at the seminar -

* It appears that the Form 1098-T will no longer be as useful as “tits on a bull”. 

The PATH Act of 2015 correctly required educational institutions to report the total amount of payments received for qualifying tuition and fees from a student during the year.  Previously, in most cases, only the amount billed was reported.  The institutions cried that they needed more time to rewrite their software to be able to generate this information (if you ask me a total load of malarkey) and the IRS granted them delays in complying with this new requirement.

Some good news.  It looks like all educational institutions must comply with this requirement for all 2018 Form 1098-T forms.  The draft of the 2018 form shows Item #2, the section previously used to report amounts billed, blocked out with no description and the instructions say this line is “reserved for future use”.

* Sub-chapter S corporation shareholders who have

·         reported a loss from Form K-1, or

·         received a distribution of profits (other than a salary or expense reimbursement), or

·         disposed of shares of stock in the corporation, or

·         received a loan repayment from the corporation

must now attach a computation of their S-corporation stock and loan basis to their Form 1040.  The draft copy of the 2018 Schedule E includes a new column on Page 2 for entries on Line 28 which states “Check if basis computation is required”.  This is not the result of the GOP Tax Act or any tax legislation, but a new requirement established by the IRS.   

* Computers and peripheral equipment are no longer considered to be “listed property”.

Listed property was first created in the Tax Reform Act of 1984.  This act restricted the depreciation deduction for business use of items “lending themselves easily to personal use” and established requirements, such as keeping a log, for substantiating personal and business use.  Computers and peripheral equipment – except for such equipment used 100% for business at a “regular business establishment”, which could include a qualified home office – had been on the “list” of “listed” property.  I explained listed property in a 2008 post here at TWTP – click here.

The GOP Tax Act removed this equipment from the “list”.  Now computers and peripherals can be depreciated or expenses like any other business property and are no longer subject to the additional substantiation requirements.

* The ridiculous excessive “due diligence” requirements for tax preparers, causing us to become social workers, will now apply to returns for taxpayers claiming the new Other Dependent Credit (ODC), as well as the Earned Income Credit, the American Opportunity Credit, the Child Tax Credit, and, also new for 2018, Head of Household status.  The draft copy of the 2018 Form 8867 includes the ODC in one of the columns.

This nonsense is getting out of hand.  Originally the excessive due diligence was only to be required for returns claiming refundable tax credits like the Earned Income Credit or the Additional Child Tax Credit.  As I have said in other venues, soon tax preparers will be required to make random bed checks of taxpayer homes during the year to check on where a claimed dependent is sleeping.

* Veterans who received disability severance payments, that were originally reported as taxable income, from January 18, 1991 through 2016 can file amended returns (IRS Form 1040-X) for all applicable years (not limited to “open” tax years) to claim a refund for the tax paid on this income.  This is a result of the “Combat-Injured Veterans Tax Fairness Act of 2016”.

There is an IRS established “safe harbor” amount or refund claim based on the year of payment –

1991 – 2005 = $1,750

2006 – 2010 = $2,400

2011 – 2016 = $3,200

Qualified veterans do not have to complete the entire Form 1040-X to calculate the refund due.  They can elect to submit a shell Form 1040-X with the personal information (name, SS#, address, year) and enter the applicable safe harbor amount on Lines 15 and 22.  As with anything else related to taxes, claiming the safe harbor refund or calculating the actual refund based on the original return depends on the specific facts and circumstances.  If you quality consult your, or a, tax preparer. 

NATP continues to erroneously, in my opinion based on my research and what I have been told by experts, teach that casual gamblers can now also deduct on Schedule A travel expenses to casinos, racetracks, etc. if losses do not equal or exceed gains.    

The IRS draft instructions for the 2018 Schedule A does not mention this alleged change – it specifically identifies deductible gambling losses as non-winning tickets under the discussion of “Other itemized deductions” and makes no mention of any change in the “What’s New” section.  I have seen nothing “official” from the IRS that says what NATP is teaching.  

I have no more federal tax CPE scheduled between now and the beginning of the 2019 tax filing season.  So, I will have to rely on finalized IRS forms, instructions and publications, and future online and print articles, for further guidance on the implementation of the tax law changes.  As I learn new “stuff” I will tell you about it here at TWTP.

TTFN

NOBODY EVER SAID TAXES WERE FAIR – GOING IN THE OTHER DIRECTION – PART II

OK, here is another deduction in the US Tax Code that unfairly benefits specific taxpayers by disproportionately distorting economic reality.  This is also taken from “The Tax Code Must Be Destroyed”.

The standard mileage allowance for business use of the taxpayer’s personal auto currently includes a component for depreciation of the vehicle.  Depreciation is not a factor in the standard mileage allowance for medical, moving, or charitable travel.  If you elect to deduct the business percentage of actual auto expenses you can include depreciation in the calculation of the deduction.  

For the most part taxpayers who use their car for business would own a car whether or not one was needed for business. The business use, however extensive, is basically secondary to personal use.

I have always owned a car.  Although a large percentage of my driving is for business, I own the car primarily for personal reasons, and would own a car whether it was needed for business or not.   

Currently the standard mileage rate for business is calculated using an annual study of the fixed and variable costs of operating an automobile - including depreciation, insurance, repairs and maintenance, tires, and gas and oil. The rate for medical and moving purposes is based only on the base variable costs, like gas and oil.

Because the main reason for purchasing a car is personal and not business, depreciating the cost of purchasing the car, based on business use, is not really a true business expense.  Only the business use percentage of actual operating expenses should be allowed as a deduction – because the more miles you drive the more you spend for gas, oil, repairs and maintenance, tires, and insurance.

The 2017 business standard mileage rate of 53.5 cents per mile, for example, included 25 cents allocated to depreciation.  Under my change if you use your car for business, either as an employee or a self-employed individual, the standard mileage allowance for business miles would not include a component for depreciation.  So, using the 2016 rate as an example, business standard mileage allowance would be 30 cents per mile and not 54 cents.

Taxpayers electing to deduct the business percentage of actual expenses should not be able to include depreciation in the calculation.  Those who lease a car and use it for business should have the option of using the standard mileage allowance or actual expenses, but the actual expenses should not include the monthly lease payment.

In the case of motor vehicles used 100% in a business – trucks, vans, limos, cars that are leased out to others (including one’s corporation) or used exclusively by couriers or for deliveries – a deduction should be allowed for 100% of the actual costs of maintaining and operating the vehicle, including depreciation. The standard mileage allowance should not be allowed here

This inequity has been to a degree addressed by the elimination of the itemized deduction for all employee business expenses for 2018 through 2025 via the GOP Tax Act.  However, it still exists for business entities, including sole proprietorships reporting income and expenses on Schedule C.

Your thoughts?

Do you have any deductions or credits to add to this list?

TTFN

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.

TTFN

TALKING TAX REFORM - MORE ON THE DEPRECIATION DEDUCTION

If you want to talk about tax loopholes that disproportionately benefit the “wealthy” let’s take a look at the deduction for depreciation of real property.  See my post "A Controversial Tax Reform Idea".

 

Those in the higher brackets – 28% to 39.6% - get, at some point (the deduction may not be currently allowed but “suspended” to be deducted in the year of sale), an ordinary income deduction for a truly phantom expense – depreciation of real estate.  This deduction is merely a “loan” that must be paid back – referred to as “recapture” - when the property is sold.  But it is paid back at a maximum rate of 25%.  So, the net benefit is 3% to 14.5% on a non-existent expense.

 

As a general rule - to which, as with any rule, there are certainly exceptions – real estate does not “depreciate”.  It “appreciates”.  My father sold the home he purchased for $13,000 in the 1950s for $75,000 in the 2000s – and the sale price was too low.

 

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.

 

Being a phantom expense, the deduction for depreciation of real estate distorts the true economic reality of the investment activity.  An activity producing a positive cash profit becomes a deductible tax loss. 

 

A good example is the truly huuuuuuge loss reported on the one tax return of arrogant idiot Donald T Rump that we have actually seen, almost a billion dollars, that caused him to avoid income taxes that year and potentially on several carryback or carryforward years, has been explained by many as the result of the deduction for depreciation on real estate.

 

If the cocktail napkin scribblings that is the “framework” for tax reform truly wants to do away with tax loopholes that benefit the wealthy it should include the deduction for depreciation of real property on the list. 

 

What do you think?

 

TTFN

 

 

 

 

 

 

SOME THOUGHTS ON EMPLOYEE BUSINESS EXPENSES

While doing away with all itemized deductions except mortgage interest and charitable contributions, as it is thought the “framework” for tax reform does, would certainly simplify the Tax Code, it would, in some instances, be unfair.

 

Let’s look at the deduction for “employee business expenses”.

 

Many employers have established an “accountable” plan for reimbursing employees for these expenses.  If an employee incurs a legitimate job-related out-of-pocket expense he/she submits proof of payment to the employer and is reimbursed. 

 

However, others, especially outside commission salesmen, are not reimbursed for the expenses incurred to generate sales.  The employer pays the employee a draw and a commission based on sales volume.  The employee is expected to “eat” his out of pocket expenses, which could be extensive in terms of business miles, meals and entertaining, and promotional expenses. 

 

In the case of the reimbursed employee, his net salary is, in effect, all “in-pocket”.  In the case of the unreimbursed employee his net “in pocket” is his net salary less his unreimbursed expenses.  And the salary of the unreimbursed employee is usually higher due to the “unreimbursementness”.  The unreimbursed employee is being more highly taxed than the reimbursed employee.

 

If the commission salesman was self-employed instead of an employee he/she would be able to deduct in full all related expenses, and pay tax, income and payroll, on the true “in pocket”.

 

Currently the unreimbursed employee can claim a tax deduction for his/her expenses on Schedule A, although this is limited by the 2% of AGI exclusion for “miscellaneous” expenses.  FYI, back when I started in “the business” (early 1970s) outside salesmen could deduct unreimbursed expenses as an “Adjustment to Income”.

 

On the other hand, allowing employees a deduction for business automobile expenses that includes depreciation is perhaps excessive and unfair.

 

For the most part taxpayers who use their car for business, other than commuting, would own a car whether or not one was needed for business. The business use, however extensive, is basically secondary to personal use.  I own a car. I have always owned a car.  Although a large percentage of my current driving is business related (because since I work out of a home office I have no “commute”), I own the car primarily for personal and not business reasons, and would own a car whether it was needed for business or not.   

 

Currently the standard mileage rate for business is calculated using an annual study of fixed and variable costs of operating an automobile - including insurance, repairs and maintenance, tires, gas and oil, and depreciation. For example, the 2016 business standard mileage rate of 54 cents per mile included 24 cents allocated to depreciation.  

 

But because the main reason for purchasing a car is personal and not business, depreciating the cost of purchasing the car, based on business use, is not really a true business expense.  Only the business use percentage of actual operating expenses should be allowed as a deduction – because the more miles you drive the more you spend for gas, oil, repairs and maintenance, tires, and probably insurance.

 

So, to be more representative of the actual out of pocket business expense the 2016 standard mileage allowance should have been 30 cents per mile – the 54 cents less the 24 cents for depreciation.  This would apply on both Form 2106 and Schedule C.

 

In the case of motor vehicles used 100% in a business,  a deduction would be allowed for 100% of the actual costs of maintaining and operating the vehicle, including depreciation. In this situation perhaps the standard mileage allowance should not be allowed.

 

More stuff to think about.  So what do you think?

 

TTFN

 

 

 

 

 

 

 

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