I’d like to start by preemptively answering a couple of what I expect are the most common questions a reader may have at this point:
- Q: Why haven’t you written for over a year? A: I’m lazy.
- Q: So, why are you writing again now? A: As a grouchy old person, my deep inner need to complain finally boiled over and reached a point where it trumped my laziness.
- Q: Why are you writing even more about taxes? Your whining about the MID clocked in at nearly 10,000 words! We’ve had enough! A: I like complaining about policies that give special tax treatment to people who haven’t done anything special. Don’t worry; I’ll eventually complain about things other than taxes, too.
With those preliminaries out of the way, let’s get started.
I’ve previously discussed, at excruciating length, why the mortgage interest deduction is a silly idea. I decided to focus on that particular property ownership subsidy because, as far as I know, it’s the largest such subsidy both in absolute dollar terms as well as the number of people who benefit from it. In that sense, if I could snap my fingers and magically change one real estate tax policy, that’s the one I’d pick. That said, it’s far from the only way that property owners get special tax treatment. As yet, I haven’t even mentioned several others: Property tax deductions, special exclusions from capital gains taxes on the sale of primary residences, and the mysterious “depreciation” claimed by landlords. I’m sure my readers will be quite relieved to hear that I don’t have as much to say about any of these deductions, because my reasons for opposing all of them are largely the same as they are for the MID. But I still think it’s worthwhile to point out a few highlights about these smaller subsidies, particularly depreciation, which is not as well known outside of real estate investment circles. First, I’ll do my best to provide the quickest, least quantitative review of depreciation that I can before getting into how it applies to your landlord’s taxes.
Imagine that you run a lemonade stand. You spend $25 on lemons and sugar, and have total lemonade sales of $100 for the year. Your profit is $100 – $25 = $75, which is the amount that your business pays taxes on. Simple enough, I hope. Now let’s make it a tiny bit more complicated and suppose that you also buy a fancy lemon squeezer for $50. At first glance, this may seem just like any other expense, so now your taxable income should be $100 – $25 – $50, but there’s an important distinction in the IRS’s eyes: the lemons and sugar you bought were used up making the lemonade, and they’re gone forever. The $25 you spent on them counts as a business expense this year. On the other hand, you still own the lemon squeezer, so in a sense, you haven’t really “spent” $50.
Enter depreciation. This is the way the IRS draws a sort of compromise — equipment is a legitimate business expense which should ultimately be subtracted from your income so you don’t pay taxes on it, but since it lasts a long time, you can’t take the entire initial cost off your taxable income right away. There are a number of ways it could work out in practice, but a simple example in this case would be that you take $5 off your income for each of the next 10 years. In principle, this represents the decrease in value that is likely to occur each year for most types of equipment, due to both regular wear and tear and eventual obsolescence. After year one, the lemon squeezer that you spent $50 on is now slightly worn out and is only worth $45 used, so your business really only “spent” the $5 reduction in value.
I don’t particularly object to the notion of depreciation. It’s a rough approximation to the reduction in value that durable goods undergo over time, but the idea makes sense enough to me. The question is whether these same ideas make sense when applied to real estate. (OK, I’ll spoil the ending: they don’t.)
Quick side note: I’m going to try writing entries that are broken into more digestible chunks, rather than the term-paper length ones I wrote earlier, so I’ll stop this one here and continue next time when we’ll explore the nonsensical idea of “depreciation” of real estate.