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

NOT A LEGITIMATE ARGUMENT - IMHO

The concern that changes in the tax law will at least initially adversely affect certain specific markets and industries, like the real estate market, are, in my opinion, excessive and, to be honest, not a concern that should be taken into consideration by lawmakers.

First of all - People buy, or SHOULD buy, real estate because (1) it is a good investment, and (2) they can afford the purchase.  Tax benefits, while certainly a consideration, should never be the sole, or primary, motivation for any investment decision.  Any corresponding tax benefits are certainly welcomed, but merely “gravy”.

Real estate is a good investment because it “appreciates” perhaps more consistently then stocks or mutual funds, and because it can provide a good “dividend” in terms of net rental income.  However, it does require much more personal involvement on the part of the investor.

While I do agree a person should hold on to an investment before selling until the long-term capital gain requirements are met to realize substantial savings on the gain from a sale, this should NOT be done if it is anticipated that waiting to meet the holding requirement could materially reduce the net gain realized due to a drop in the investment’s price.

As I have been saying for years - The first criteria for evaluating any transaction, strategy, or technique you are considering should always be financial.  Taxes are second.  Never let the tax tail wag the economic dog. 

And second – the one and only purpose of the Internal Revenue Code is to raise the money necessary to fund the government.  Period. 

It is my firm belief, shared by many, that the Tax Code must NOT be used for social engineering, to redistribute income or wealth, to deliver social welfare and other government benefits, to encourage or discourage certain economic decisions (other than savings, investment, and growth), or to provide exclusive benefits for specific industries, business activities, or classes of taxpayers. 

One of the basic principles of sound tax policy, identified by the Tax Foundation, is –

“Neutrality: Taxes should not encourage or discourage certain economic decisions. The purpose of taxes is to raise needed revenue, not to favor or punish specific industries, activities, and products.”  

I have made a similar argument in response to the claim that the GOP tax law changes will substantially reduce charitable contributions (see “THE REPUBLICAN TAX PROPOSALS – EVEN MORE COMMENTS”).

Your thoughts?

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

 

 

 

 

 

 

TAX EFFICIENT INVESTING

You have several options available for investing your current, retirement, college, and health savings.  It is important to understand the tax aspects of each option, and the tax treatment of the various types of investment accounts – currently taxable, tax-deferred, and tax-exempt - to maximize your “after-tax” earnings from your investments.

DOMESTIC STOCKS

Investment in shares of stock, both domestic and foreign, can generate qualified dividends while held and, if held for more than a year, long-term capital gains when sold.  Qualified dividends and long-term capital gains are taxed at a special lower rate, from 0% (no federal income tax) to 20%, depending on your level of overall net taxable income.  Short-term capital gains (from the sale of stock held for one year or less) are taxed at ordinary income rates, from 10% to 39.6%.

Qualified dividends and long-term capital gains are also taxed at the special lower rate under the dreaded Alternative Minimum Tax (AMT).  However this type of income increases your Alternative Minimum Taxable Income (AMTI) and may cause you to become a victim of AMT and/or reduce your AMT exemption.

And, depending on your level of Adjusted Gross Income (AGI), all dividends and capital gains may be subject to the 3.8% Net Investment Income Tax.

Distributions from tax-deferred accounts, retirement accounts like a traditional IRA or 401(k) and the various self-employed retirement accounts, are taxed at ordinary income rates regardless of the source of the income within the account - so qualified dividends and long-term capital gains earned within a tax-deferred retirement account are taxed at ordinary income rates when the money is withdrawn from the account.

While taxable distributions from a tax-deferred account will increase AMTI, these distributions are not subject to the Net Investment Income Tax.

Stock investments that will generate qualified dividends and long-term capital gains are taxed less if held in currently taxable accounts.

If you, or your broker, are more of a day trader, and invest in some stocks for quick turn-over short-term gains, these stocks could ultimately generate more net after-tax income if held in tax-deferred accounts. 

Regardless of where held the gains will be taxed at ordinary income rates, but holding these investments in retirement accounts will defer the taxation of gains to the future, in future dollars, when distributions are made after retirement (and when your marginal tax rate, or all tax rates, could be less than they are now).  And holding them in deferred accounts will allow for greater eventual growth as a result of the tax deferral.

I am not telling you not to invest tax-deferred funds in stocks that generate qualified dividends and long-term capital gains.  You obviously want to earn as much as possible within a tax-deferred account.  Even though you may lose the benefit of the lower tax rate, you may make up for this by the increased tax-deferred accumulation of income that will ultimately be taxed in the future in future dollars.

What I am saying is that when considering how to invest funds in currently taxable accounts it is more “tax efficient” to choose investments that will generate income taxed at the lower capital gain rates.

INTERNATIONAL STOCK

While the same considerations I discussed under domestic stocks apply to international, or foreign, stock (the stock of a company organized and located outside of the United States), the dividends from international stock will often have foreign tax withheld. 

Foreign tax withheld from dividends generated by currently taxed investments can be taken as a credit - often a 100% dollar for dollar credit against current income tax liability.  Unused credits can be carried forward to be used in future years.

While foreign tax withheld from dividends generated by investments held in a tax-deferred retirement account will reduce the income that is eventually taxed, you do not get the benefit of the tax credit.

You should hold investments in international stock in currently taxable accounts.

TAXABLE BONDS

Bonds pay interest.  Interest is always taxable at ordinary income rates.

Interest on bonds and other direct obligations of the US Government (such as savings bonds and Treasury bonds and notes), while fully taxed at ordinary rates on the 1040, are exempt from state income tax.  

Taxable bonds are a good investment for tax-deferred retirement accounts.

TAX-EXEMPT BONDS

The interest from municipal bonds (issued by the 50 states and the District of Columbia, and the bonds of US possessions like Guam, Puerto Rico and the Virgin Islands) are exempt from the “regular” federal income tax, and the state income tax of a “resident” state (interest from bonds issued by the state of NJ or a NJ municipality, and US possessions, are exempt from NJ state income tax).  Interest from certain “private activity” municipal bonds are taxable under the dreaded AMT.

You should never purchase tax-exempt bonds in a tax-deferred account.

Distributions from a tax-deferred retirement account are subject to federal income tax at ordinary income rates regardless of the source of the income within the account - so interest on tax-exempt municipal bonds earned within a tax-deferred retirement account are taxed at ordinary income rates when the money is withdrawn from the account.

REAL ESTATE INVESTMENT TRUSTS

INVESTOPEDIA tells us that a Real Estate Investment Trust, or REIT, is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.

Generally the dividend payments issued by a REIT are taxed at ordinary income rates.

REITs should be held in tax deferred accounts.

LIMITED PARTNERSHIPS

My personal, albeit selfish, advice is never invest in limited partnerships in a currently taxable account.

Long-time readers of TWTP know that I hate K-1s from limited partnership investments.  Properly reporting all the items from the K-1, including those buried in attached statements, on the taxpayer’s Form 1040, and keeping track of suspensions, carry forwards and tax basis, causes considerable pain in various parts of the anatomy of a tax preparer.  And the additional tax preparation costs that result can be more than, or at least take a large bite out of, any eventual tax and financial benefits from the investment.  I truly believe that a carefully researched mutual fund will provide the same potential tax and financial benefit as any limited partnership investment (and welcome the comments of brokers on this statement).

If your broker insists that you must purchase units in a limited partnership, and no mutual fund will provide the same tax and financial benefits, then purchase the partnership in your IRA, traditional or ROTH, or another tax-deferred or tax-exempt account, so you tax professional does not have to deal with it on the 1040.

MUTUAL FUNDS

Mutual funds invest in all types of investments – domestic and international stocks, taxable and tax-exempt bonds, real estate, and limited partnerships.

Some funds invest in a mix of all investments and some funds limit investments to specific categories – small cap stock funds, growth stock funds, dividend paying stock funds, non or low dividend paying stock funds, international stock funds, corporate bond funds, either domestic or international, government bond funds, municipal bond funds, etc. etc. etc.

The taxability of dividends issued by mutual funds is determined by the rules for taxing the individual investments in the fund. Choosing what types of funds you purchase in currently taxed and tax-deferred accounts should be governed by the types of investments held in the fund.

Mutual funds can issue qualified dividends, non-qualified dividends, tax-exempt dividends, return of capital, and capital gain distributions.  Non-qualified dividends are taxed at ordinary income rates.  Return of capital distributions are not currently taxed as income – they reduce your cost basis in the fund.  Capital gain distributions are taxed at the lower capital gain tax rates.

There are “tax-efficient” mutual funds.  These funds can keep it's turnover low, especially if the fund invests in stock, and avoid or limit income-generating assets, such as dividend-paying stocks.  These funds should be held long-term in currently taxable accounts.

TAX-EXEMPT ACCOUNTS: ROTH IRAs AND 401(K)s, EDUCATION ACCOUNTS, HEALTH SAVINGS ACCOUNTS, AND MEDICAL SAVINGS ACCOUNTS

It really does not matter how you invest funds held in accounts whose distributions will never be taxed. 

Qualified distributions from a ROTH IRA or 401(k) account, a Section 529 qualified tuition program, a Coverdell Education IRA, a Health Savings Account, or a Medical Savings Account are totally tax free.  So taxes are not a consideration in determining where to invest the money.  Obviously you want to make sure that all distributions from these types of accounts are qualified distributions.

Before you invest you should consult a tax professional.  Do not rely on a broker for tax advice.

TTFN

THE NEW TAX CODE - INTEREST AND TAXES

Currently a taxpayer can deduct on Schedule A either state and local income taxes, including employee contributions to state unemployment, disability and family leave funds, or state and local sales taxes, real estate taxes on all property held, personal property taxes, foreign taxes, mortgage interest, including points, on acquisition debt and home equity debt on two personal residences, mortgage insurance premiums, and investment interest.

There has been talk of doing away with the deductions for real estate taxes, state income taxes, and mortgage interest. My new Tax Code would allow an itemized deduction for state and local income taxes, real estate taxes paid on the taxpayer’s primary personal residence only, and mortgage interest on acquisition debt only for the primary personal residence only.

So taxpayers who itemize would be able to deduct state and local income taxes paid, including state fund withholdings, and the real estate taxes and acquisition debt interest on the home in which they live.

There would be no current deduction for real estate taxes on any other real estate held by the taxpayer. Real estate taxes on vacation homes would be considered a personal expense and non-deductible. Real estate taxes on rental property would continue to be deductible as currently allowed on Schedule E. Real estate taxes on property held for investment, such as vacant lots or houses purchased to be “flipped”, would be capitalized and added to the cost basis in determining gain or loss. There would be no deduction for personal property taxes. Foreign tax paid would be allowed as a credit only, direct from a Form 1099 or K-1 and without the need for a Form 1116, regardless of the amount of the foreign tax paid.

Only interest on “acquisition debt” – money borrowed to buy, build or substantially improve a taxpayer’s primary personal residence, and secured by the residence - would be deductible. There would be no deduction for mortgage interest on a second personal residence or for interest on home equity debt not used to substantially improve one’s primary personal residence.

Interest on home equity borrowing would be allowed on Schedule C, E or F if the money borrowed was used for business or rental purposes, using the current “follow the money” tracking rules.

This would require special new rules and regulations for banks and mortgage companies for issuing home-secured loans.

A “mortgage” loan would only be permitted for “acquisition debt”. Interest on a “mortgage” for a taxpayer’s primary personal residence would be fully deductible, up to the current acquisition debt limitations. “Home equity debt” would have to be a totally separate loan, and interest on this type of loan would not be deductible. A Form 1098 would only be issued for interest paid on a “mortgage” loan, and the bank or mortgage company would be required to report only interest paid on up to $1 Million of principal, and indicate if the mortgage was secured by a primary personal residence.

One would not be able to refinance a home-secured loan to include both types of debt in one loan. Therefore a homeowner could not refinance a “mortgage” to get additional money in hand unless he/she could prove to the lender that the money is used to “substantially improve” the secured residence. One would have to refinance the “mortgage” for the exact same principal, adding perhaps related closing costs, and take out a separate “home equity” loan to get any money in hand.

By instituting these requirements a taxpayer, or his/her preparer, would truly be able to just take the amount of mortgage interest reported on the Form 1098 for the primary personal residence and transfer it to Schedule A.

Points on acquisition debt for a taxpayer’s primary principal residence would be deductible as mortgage interest – but would have to be “amortized” over the life of the mortgage in all situations. Points paid on the purchase of vacation or investment property would be capitalized and added to cost basis in determining gain or loss when sold.

Why would I allow these deductions in the new simple and fair Tax Code?

The Internal Revenue Code taxes Americans based on income measured in pure dollars. However it is a fact that the “value” of one’s level of income differs, sometimes greatly, based on one’s geographical location. A family living in the northeast (New York, certainly New Jersey, Connecticut) or California that has an income of $150,000 may be just getting by, while a similar family that resides in “middle America” lives like royalty on $150,000. Many components of the Tax Code are indexed for inflation, but nothing is indexed for geography. To be honest I have no idea how one would even begin to index for geography.

It costs an awful lot to live in, for example, New York, certainly New Jersey, Connecticut, and California. State and local income and property taxes are the highest in the country. The cost of real estate is also excessively high. As a result one must earn a lot more money to be able to live in these states – and salaries are arbitrarily increased to reflect the increased cost of living. Yet $150,000 in income is taxed by the federal government at the same rate in New York City as it is in Hope, Arkansas.

Taxes and the cost of a home, and therefore also the amount of “acquisition debt” mortgage interest paid on a residence, are higher in the Northeast, and California. Since we pay taxes on “net income” after deductions, allowing an itemized deduction for these items would help to somewhat geographically “equalize” the tax burden.

No deduction would be allowed for mortgage insurance premiums in any circumstances. This deduction should never have been allowed in the first place.

As of this writing I think I would keep the itemized deduction for investment interest as it is under current law, and continue to limit it to net investment income. Home equity interest could be deductible as investment interest under current tracking rules.

TTFN

REAL ESTATE IN AN IRA

I recently received an email from a long-time client, who is retired, asking whether he can buy an investment property with funds from his IRA.

According to the Tax Code the only thing that you cannot invest your IRA money in is “collectibles”. Real estate is not considered a “prohibited investment”.

IRS Publication 590 (Individual Retirement Arrangements) tells us -

“If your traditional IRA invests in collectibles, the amount invested is considered distributed to you in the year invested. You may have to pay the 10% additional tax on early distributions, discussed later.

Collectibles. These include:

• Artworks,
• Rugs,
• Antiques,
• Metals,
• Gems,
• Stamps,
• Coins,
• Alcoholic beverages, and
• Certain other tangible personal property.

Exception. Your IRA can invest in one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins minted by the Treasury Department. It can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion.”

It goes on to discuss what you cannot do with your IRA (aka “prohibited transactions) -

“Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.

Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).

The following are examples of prohibited transactions with a traditional IRA.

• Borrowing money from it.
• Selling property to it.
• Receiving unreasonable compensation for managing it.
• Using it as security for a loan.
• Buying property for personal use (present or future) with IRA funds.”

In doing some brief research before answering the email I came across a good article on the subject by Kaye A. Thomas titled “Real Estate in Your IRA: Self Directed or Self-Destructed?” in The Tax Guide for Investors at FAIRMARK.COM. The following is from that article -

“Prohibited transactions:
A prohibited transaction occurs when you interact with your IRA in certain ways. Here are some of the things you aren't allowed to do:

 You can't sell property to your IRA, or buy property from your IRA.
 You can't loan money to your IRA, or borrow money from your IRA.
 You can't use the account, or any part of it, as security for a loan.
 You can't receive goods or services from your IRA, or provide goods or services to your IRA.

You aren't allowed to do any of these things directly or indirectly. That means you can't avoid this rule by having your IRA deal with a company you own, or with a family member. And these are outright prohibitions: they aren't allowed even if you do everything in a fair and reasonable manner.

Violations:
Looking at the list above, you can see how easy it would be to violate the rules if you hold real estate in your IRA. Even if your IRA purchases the property from an unrelated party, you'll have a prohibited transaction if you provide services to the IRA.

Suppose you have your IRA buy a broken-down property and fix it up so the IRA can sell it at a profit. That seems like a great way to add value, but if you personally do the remodeling work, or do it through a relative or a business you own, the IRS may say you've made a prohibited transaction because you're providing services to the IRA.

Suppose you have your IRA buy a rental property. Who is going to find tenants, collect rent and perform other management services? If you do this, or have a related person or business do it, here again the IRS may say you have a prohibited transaction.”

There are other reasons not to own investment real estate in your IRA. Because an IRA is treated as a tax-exempt trust, as I pointed out in an earlier post here at TWTP, like Vegas, “What Happens in an IRA Stays in the IRA”.

A real estate investment held inside an IRA will not allow you to take advantage of the potential tax benefits of –

(a) depreciation deductions,
(b) special lower capital gain rates on the gain from the sale of the property, and
(c) stepped-up basis to beneficiaries.

My bottom line to the client was – I do not recommend buying investment real estate property in an IRA.

Any comments or questions?

TTFN