Friday, November 16, 2007

HERE IS SOMETHING TO THINK ABOUT

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 depreciation deduction for 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”. The IRS discusses depreciation in detail in Publication 946 - How To Depreciate 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. In some instances, such as for “listed property” which is used less than 50% of the time for business, ADS must be used.

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 2007, but the computer is not delivered to my office until the first week of January 2008, then depreciation begins in January and I can begin to deduct depreciation on the computer in tax year 2008.

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), including the portion of a residence that is used as a home office, 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. 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).

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?

Where depreciation of real estate comes into play most often in the world of 1040s, at least in my 35 years of experience, is with the rental of a 2-family building. One floor of the building is used as the personal residence of the owner and the other is rented out. Depreciation is claimed as a deduction against rental income on Schedule E and, in most cases, either creates or increases a tax loss. It is possible for the rental activity to provide positive cash flow, but because of the depreciation deduction result in a deductible loss. The depreciation deduction can increase the return’s refund by up to $1,000 or more!

The problem arises when the taxpayer(s) sell the property.

With a two-family house as described above, if the required conditions are met one half of the gain on the sale, up to $250,000 or $500,000 depending on filing status, is eligible for exclusion under Section 121. The other half is taxable as a capital gain. Any depreciation “allowed or allowable” (see my post on “Ask The Tax Pro – Allowed or Allowable”) over the years must be “recaptured”, or added back, to the taxable gain from the rental half of the property.

If the total net gain on the sale of the property is $100,000, generally (but not necessarily if, for example, capital improvements were made directly to the rental half) $50,000 will be allocated to the personal residence and $50,000 to the rental activity. If the taxpayer claimed $25,000 in depreciation on Schedule E over the years, or was entitled to claim $25,000 in depreciation (the “allowable” portion of “allowed or allowable”), the taxable capital gain is $75,000.

While long-term capital gain is taxed at 5% or 15%, gain resulting from depreciation recapture can be taxed at up to a maximum of 25%. In the above example, if the taxpayer was in the 25% bracket before adding the capital gain, $50,000 is fully taxed at 15%, for $7,500 in tax, and the $25,000 depreciation recapture would be taxed at 25%, for $6,250 in tax, resulting in total federal tax of $13,750 (effective 18 1/3% tax) – plus the appropriate state income tax on $75,000.

The above is the tax reality. But here is what the taxpayer will probably be thinking:

· “I sold my personal residence and my gain was only $100,000 – so I do not have to pay any federal or state income taxes!” – or

· “Since it was a two family house I only have to pay tax on half the profit - $50,000!” – or, worst of all

· “Hey, I just bought a new house that cost more than what I sold the old one for, so there is no tax!”

What is “more bad” is if the sale, after claiming all closing costs from the purchase and sale and capital improvements made over the years but before factoring in the depreciation recapture, results in a net loss! If we assume $25,000 in depreciation recapture against a $5,000 loss (50%) that is $20,000 taxed at up to 25%, or $5,000 in federal tax, plus state tax on the $20,000. You have to answer your client when he screams, “but I lost money – why am I paying tax?”

It is possible that recaptured depreciation can add $12,000+ to the overall federal and state tax bill – which more often than not comes as a complete shock to the taxpayer. And of course I was not told about the sale, which happened in May, until I get the client’s “stuff” in March of the following year. And again of course, the taxpayer did not increase withholding or make any estimated tax payments to cover the gain.

You try to explain to the client that he/she/they was/were saving $500-$1,000 each year by deducting the depreciation in the past, and now they are just paying “Sam” back – but clients cannot always understand or accept this. That $500-$1,000 per year was spent a long time ago!

In the “good old days”, when ordinary income rates were higher and there was a 50% or 60% capital gain exclusion (I am dating myself again) instead of reduced capital gain rates, it was easier to show a client that he actually made money in the long run by claiming depreciation – but not so today when the possible 25% rate on depreciation recapture could be the same as the rate for ordinary income.

And you won’t avoid the problem simply by not deducting depreciation when it is “allowable” – back to the “allowed or allowable” rule.

So we can see that in the long run depreciating real estate on the 1040 only results in increased “agita” for both taxpayer and tax professional.

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. This is a topic for another posting. Under my suggestion there would also be no depreciation of true capital improvements – they would simply be added to cost basis.

No longer “allowing” the depreciation of real estate would not only affect the tax on the sale of rental property, but also remove the need for a taxpayer to recapture depreciation claimed on a home office when the residence is sold.

As THE WANDERING TAX PRO deals with individual income tax issues I will not go into this suggestion from a corporate tax point of view, at least at this time. Perhaps I will discuss it in a future posting.

So, what do you think - should we do away with the depreciation deduction for real estate, at least on the 1040? I am especially interested in hearing the opinions of my fellow tax bloggers.

This post has been especially long, and I apologize if it was because of my being long-winded.

TTFN

2 comments:

SS CPA said...

I definitely see your point. It would simplify the reporting process as well. Your objective is somewhat accomplished by the passive activity rules which limit passive losses to $25,000 per year on active participants with less than $100K of modified AGI (and phasing out above $100K to 150K), but it is generally the lower income folks who have trouble understanding this rule and the consequences upon disposition of the rental. At least these limitations on losses prevent the problem from being exacerbated.

Another argument for your position is that upon recapture at disposition, the gain from the sale (i.e. the combined recapture gain and remaining capital gain) will in many cases throw the taxpayer into a higher tax bracket making the 25% highest bracket more certain, where as in earlier years of depreciation, the taxpayer may have only been in the 10% or 15% bracket and only benefited with this lower percentage deduction. Do you agree with my understanding here?

On the other hand, the real estate industry thrives on getting as much of a write-off as you can right now and worry about the future later. I doubt you could get political support for that.

I wish they could give the taxpayer the option to take depreciation or not. I guess this is somewhat done with the option of choosing the ADS over the GDS.

Not to get into something that you intended to avoid, but if you have one set of rules for individuals and another for corporations, this will throw a level of complexity into taxpayer planning. Most small businesses and/or individuals tend to want to put real estate in an LLC, which would be taxed as a partnership or disregarded entity, basically being reported on the individual return as we are dealing with here. If you take away depreciation from one and leave it with corporations, then taxpapers may elect to transfer the rentals to C's or S's to get around this.

If you disagree with my logic on this please let me know. I'm just putting some thoughts down as I see them.

Robert D Flach said...

SS CPA-

Thanks for your input.

(1) I have found that most taxpayers with two family homes are not regularly affected by the passive rules that limit the rental loss deduction. I have only seen this happen in a year when income is especially high due to a unique one-time situation. In most cases the net loss deduction is no where near the $25,000 figure.

(2) I agree with you that the new capital gain rules and increased depreciation recapture rate can possibly cause the taxpayer to pay more tax on the recapture than was actually saved over the years by claiming the deduction. Plus, while theoretically taxed separately, the recapture gain could make the taxpayer a victim of the dreaded AMT by increasing AGI and AMTI.

(3) I do agree that it would be truly an uphill battle to get this passed.

(4) I would expect that if given an option most taxpayers would think short term and want to “take the money and run”, opting for the current increased refund rather than thinking about the future. However, this concept would be good in certain situations.

(5) I do agree that the rules for depreciating real estate should be consistent for both individual and business (corporate) taxpayers.

TWTP