A CONTROVERSIAL TAX REFORM IDEA

 

For years now I have been suggesting a unique, and I expect controversial, tax reform proposal that I have never seen discussed by anyone else anywhere else.

 

I would do away with the deduction for depreciation of real estate, including capital improvements to real estate, on individual and business income tax returns. The Tax Code should not permit a deduction for the depreciation of real property or capital improvements thereto on Schedule C, Schedule E, or Schedule F of Form 1040, Form 1041, Form 1065, Form 1120, or Form 1120-S.

 

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.”

 

If we look at economic reality, 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.

 

For all intents and purposes, in most cases 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?

 

An added benefit - by doing away with the depreciation of real property taxpayers would no longer have to deal with the “recapture” depreciation when the property is sold, which would greatly simplify the process.

 

So what do you think?

 

BTW – the above is taken from my e-book “A Tax Professional for Tax Reform”.  Click here to download a copy.

 

TAFN