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Wednesday, August 13, 2014
Wandering Tax Pro Will Not Be Loved in Real Estate Community
Originally Published on forbes.com on September 22nd,2011
For people who follow tax blogs Robert Flach – The Wandering Tax Pro needs no introduction. Bob runs a tax practice in Jersey City where he does returns by hand, scorning the expensive and unreliable software the rest of us use. He works 168 hours a week for a couple of months in the winter (slight exageration there) so that he can spend the rest of the year blogging and going to musicals. I haven’t figured out what he dislikes the most - reality TV, the “idiots in Congress” who make a “mucking fess” out of the tax law or the GD extensions that force him to do some work between May and January. Here he is using his open invitation to guest post on this site to present an idea that I have reasons not to like.
WHAT IS THIS THING CALLED DEPRECIATION
There is no need to create a “millionaire tax” or to increase taxes on any level of income. The same result can be accomplished by doing away with tax loopholes and “expenditures”.
I have been suggesting that we do away with the deduction for depreciation of real estate since 2007. This would apply to individuals who file Schedules C, E or F and to estates and trust and all business entities.
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 (so maybe we should look at Section 179 as well). 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. Under this consideration accelerated depreciation methods are appropriate, as the value of a used asset does not drop proportionately over its life. Thus depreciation is used to reflect the “wear and tear, deterioration, or obsolescence of the property.”
What about real estate? If we look at economic reality, a building has a life of much more than the 27.5 or 39 years currently used for depreciation. The building I lived in before moving to my current apartment was 100 year 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).
So for all intents and purposes, again for the most part (the situation of a few years back was an exception), 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.
Depreciating real estate does not truly reflect economic reality. 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.
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 – while taxpayers could deduct expensive repairs, such as replacing a roof. No longer allowing the depreciation of real estate would do away with the complicated process of “depreciation recapture” – very difficult to explain to angry 1040 filers when they sell rental property or a personal residence that had a home office.
In all of the discussions on tax reform I have never seen this proposal put forth by any of the parties involved. What do you think?
A true depreciation system, which is what we, in principle, had prior to the Economic Recovery Tax Act of 1981 would not allow depreciation to bring property below its “salvage value”. ERTA switched us to a cost recovery system, which is more friendly to investment in tangible property. ERTA turbo charged real estate as a tax shelter. The Tax Reform Act of 1986 brought that to a crashing halt with the enactment of the passive activity loss rules (Section 469) which was a blow to real estate values. Presumably the present value of cost recovery deductions net of future recapture is embedded in the fair market value of buildings. Whatever the merits of the Pro’s suggestion as tax policy, real estate does not need to have another blow dealt to it at this point in time.