More on the Trump Tax return discussion
Three pieces of paper have ignited a firestorm. They are three pages of the state income tax returns of Donald Trump from 1995. A piece in the Seattle Times says, "The leak of some of Donald Trump’s tax returns highlights enormous
disparities in the tax code between high-income businesses and
individuals and everyone else that may have allowed the Republican
presidential nominee to avoid paying federal income taxes for nearly 20
years."
No. These disparities are available to anyone who operates a business, or owns real estate that they use for a business purpose (residential rental or non-residential commercial).
It also says, "But real estate companies can also count interest payments and depreciation of their holdings as shortfalls even if they have not actually lost cash on a property, a provision that tax experts argue lets them use paper losses to avoid paying their fair share of federal taxes."
Using the word "shortfalls" is misleading. Depreciation and interest are allowable expenses of any business, real estate or otherwise. A person who owns a small duplex and rents out the half they are not living in is entitled to exactly the same deductions for depreciation, property taxes and mortgage interest as Donald Trump is allowed for any of his commercial properties. The difference is scale, not wealth.
As I pointed out yesterday, there is a special break available to anyone who qualifies as a real estate professional. But that isn't the same as the tax code provisions that allow deductions for business interest (not just on mortgages either) and depreciation of business property.
What is depreciation? It's a method of recovering the cost of a piece of business equipment over a period of time, rather than deducting the expense in the year of purchase. If I bought a house for the purpose of renting it out to tenants, allowing me to deduct the full cost of the house in the year of purchase would result in a big loss. The system of depreciation exists to allow the expense of business property to be deducted over a period known as its useful life. Useful life ostensibly means the period it will take for the business property to wear out and require replacement; though that is not always the actual case.
The useful life of nonresidential real estate is defined by the Internal Revenue Code as a period of 39 years. While buildings do suffer from wear and tear, they don't normally need to be torn down and rebuilt after 39 years. Residential real estate's useful life is even shorter, 27.5 years. But the tax codes takes into account the fact that not all business property wears out. This is through a process known as recapture of depreciation.
Let's go back to our example of the duplex owner. He or she lives in one half and rents out the other half to a tenant. That allows them to deduct 50% of expenses attributable to the entire duplex (mortgage interest, property taxes, depreciation and other expenses). Let's assume the duplex owner paid $200,000 for the property. $200,000 divided by the 27.5 year useful life of the duplex calls for an annual depreciation deduction of $7,273 which would then be multiplied by the 50% allocation resulting in an annual deduction for depreciation of $3,637.
With me so far? Now the duplex owner rented out the other half for ten years, deducting $36,370 for depreciation over the course of the rental usage of the property. Now let's suppose that the owner is going to sell the property and the sale price turns out to be the same as the purchase price. So there should be no gain on the sale and therefore no tax.
This is where depreciation recapture comes into play. The depreciation of $36,370 that was allowed over the ten year rental period must be recaptured and there is a tax owed on this amount. But wait, since there was no capital gain on the sale of the property, the tax on the depreciation recapture could be at a rate of 25%.
I know this is complex stuff. But it is not what the media is portraying it as, a great big loophole only available to the wealthy.
No. These disparities are available to anyone who operates a business, or owns real estate that they use for a business purpose (residential rental or non-residential commercial).
It also says, "But real estate companies can also count interest payments and depreciation of their holdings as shortfalls even if they have not actually lost cash on a property, a provision that tax experts argue lets them use paper losses to avoid paying their fair share of federal taxes."
Using the word "shortfalls" is misleading. Depreciation and interest are allowable expenses of any business, real estate or otherwise. A person who owns a small duplex and rents out the half they are not living in is entitled to exactly the same deductions for depreciation, property taxes and mortgage interest as Donald Trump is allowed for any of his commercial properties. The difference is scale, not wealth.
As I pointed out yesterday, there is a special break available to anyone who qualifies as a real estate professional. But that isn't the same as the tax code provisions that allow deductions for business interest (not just on mortgages either) and depreciation of business property.
What is depreciation? It's a method of recovering the cost of a piece of business equipment over a period of time, rather than deducting the expense in the year of purchase. If I bought a house for the purpose of renting it out to tenants, allowing me to deduct the full cost of the house in the year of purchase would result in a big loss. The system of depreciation exists to allow the expense of business property to be deducted over a period known as its useful life. Useful life ostensibly means the period it will take for the business property to wear out and require replacement; though that is not always the actual case.
The useful life of nonresidential real estate is defined by the Internal Revenue Code as a period of 39 years. While buildings do suffer from wear and tear, they don't normally need to be torn down and rebuilt after 39 years. Residential real estate's useful life is even shorter, 27.5 years. But the tax codes takes into account the fact that not all business property wears out. This is through a process known as recapture of depreciation.
Let's go back to our example of the duplex owner. He or she lives in one half and rents out the other half to a tenant. That allows them to deduct 50% of expenses attributable to the entire duplex (mortgage interest, property taxes, depreciation and other expenses). Let's assume the duplex owner paid $200,000 for the property. $200,000 divided by the 27.5 year useful life of the duplex calls for an annual depreciation deduction of $7,273 which would then be multiplied by the 50% allocation resulting in an annual deduction for depreciation of $3,637.
With me so far? Now the duplex owner rented out the other half for ten years, deducting $36,370 for depreciation over the course of the rental usage of the property. Now let's suppose that the owner is going to sell the property and the sale price turns out to be the same as the purchase price. So there should be no gain on the sale and therefore no tax.
This is where depreciation recapture comes into play. The depreciation of $36,370 that was allowed over the ten year rental period must be recaptured and there is a tax owed on this amount. But wait, since there was no capital gain on the sale of the property, the tax on the depreciation recapture could be at a rate of 25%.
I know this is complex stuff. But it is not what the media is portraying it as, a great big loophole only available to the wealthy.
posted by me at 8:22 AM
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