A primer on depreciation of real estate
The last thing I want to write about on October 15th is income taxes. I will spend all day preparing tax returns for clients and then teach a class on tax preparation tonight. So I will begin by paraphrasing William Shakespeare:
"Friends, Americans, Countrymen; lend me your ears. I come to bury Kushner, not to praise him."
Actually I come to explore the New York Times article that speculates Jared Kushner paid little to no income tax between 2009 and 2016. Many are outraged by this. But this is nothing new.
President Ronald Reagan made that speech in 1985. 33 years later those loopholes were widened by the Tax Cuts and Jobs Act. It is one of those loopholes involved here with what Jared Kushner and many others involved in real estate take advantage of, to avoid paying tax. The question is, do they actually avoid it altogether? This is an excerpt from the NYT article:
"His low tax bills are the result of a common tax-minimizing maneuver that, year after year, generated millions of dollars in losses for Mr. Kushner, according to the documents. But the losses were only on paper — Mr. Kushner and his company did not appear to actually lose any money. The losses were driven by depreciation, a tax benefit that lets real estate investors deduct a portion of the cost of their buildings from their taxable income every year."
Depreciation is simply recovering the cost of business property, over a period of time rather than deducting the full expense in the year of purchase. The Income Tax Code does not allow the deduction of the full cost of real estate in the year of purchase. Residential real estate property purchases are depreciated over a period of 27.5 years. Commercial real estate property purchases are depreciated over a period of 39.5 years.
Let's examine a simple scenario involving how this works. I have a friend, who is NOT my tax client. My friend owns two homes, one in which they reside and another that they rent out. There is no depreciation on their personal residence. There is depreciation each year on their rental property. A typical year for the rental property would look like this:
Rental Income - XX dollars
That income is reduced by these expenses when paid by the property owner and not the tenant:
Mortgage interest payments
Property taxes paid
Homeowner insurance
Repairs
Utilities
Other expenses (management fees, gardener, pest control)
Depreciation
As a result, my friend's property generates a loss each year, for tax purposes. But not in terms of cash flow. That's because as a very wise person once told me, "you do not have to write a check to depreciation."
The NYT article takes pains to point out that Mr. Kushner bought real estate with borrowed funds, meaning he's deducting the cost of buying that building even though he didn't pay cash. Neither did my friend. Most people do not pay cash for real estate. The thing is, the deduction of that cost is permitted because there is a legal requirement to repay those loans. It is the same logic that allows you to claim an education credit for the payment of tuition paid for with student loans.
There is something else going on with depreciation. Here is a hypothetical example. A rental property is purchased for $550,000 (total investment including commissions and improvements made during the time it was owned by the taxpayer). After ten full years of ownership, during which the annual depreciation deduction allowed and claimed was $20,000, it is sold for $800,000 (sale price including the costs of the sale).
The gain on the sale is calculated as follows:
Original Basis - $550,000
Depreciation allowed or allowable - $200,000
Adjusted Basis - $350,000
Sale Price of $800,000 - adjusted basis of $350,000 = a gain of $450,000 on the sale.
Now they actually bought a building for $550,000 and sold it for $800,000, a gain of $250,000. So why the disparity? Because the gain on the sale RECAPTURES the depreciation that was claimed. In the end, once the property is sold, the actual gain is realized.
Depreciation of real estate allows a deduction that must be recaptured when the property is sold. It isn't actually avoiding tax, it is deferring it until the property is sold.
* * *
The article points out very clearly that none of this is illegal. I don't like Mr. Kushner and how he has acted as an advisor to Mr. Trump. But I won't fault him or anyone else for paying only the amount of tax they owe under the laws as currently written.
The problem isn't with those who follow the laws, the problem is with those who write the laws.
"Friends, Americans, Countrymen; lend me your ears. I come to bury Kushner, not to praise him."
Actually I come to explore the New York Times article that speculates Jared Kushner paid little to no income tax between 2009 and 2016. Many are outraged by this. But this is nothing new.
President Ronald Reagan made that speech in 1985. 33 years later those loopholes were widened by the Tax Cuts and Jobs Act. It is one of those loopholes involved here with what Jared Kushner and many others involved in real estate take advantage of, to avoid paying tax. The question is, do they actually avoid it altogether? This is an excerpt from the NYT article:
"His low tax bills are the result of a common tax-minimizing maneuver that, year after year, generated millions of dollars in losses for Mr. Kushner, according to the documents. But the losses were only on paper — Mr. Kushner and his company did not appear to actually lose any money. The losses were driven by depreciation, a tax benefit that lets real estate investors deduct a portion of the cost of their buildings from their taxable income every year."
Depreciation is simply recovering the cost of business property, over a period of time rather than deducting the full expense in the year of purchase. The Income Tax Code does not allow the deduction of the full cost of real estate in the year of purchase. Residential real estate property purchases are depreciated over a period of 27.5 years. Commercial real estate property purchases are depreciated over a period of 39.5 years.
Let's examine a simple scenario involving how this works. I have a friend, who is NOT my tax client. My friend owns two homes, one in which they reside and another that they rent out. There is no depreciation on their personal residence. There is depreciation each year on their rental property. A typical year for the rental property would look like this:
Rental Income - XX dollars
That income is reduced by these expenses when paid by the property owner and not the tenant:
Mortgage interest payments
Property taxes paid
Homeowner insurance
Repairs
Utilities
Other expenses (management fees, gardener, pest control)
Depreciation
As a result, my friend's property generates a loss each year, for tax purposes. But not in terms of cash flow. That's because as a very wise person once told me, "you do not have to write a check to depreciation."
The NYT article takes pains to point out that Mr. Kushner bought real estate with borrowed funds, meaning he's deducting the cost of buying that building even though he didn't pay cash. Neither did my friend. Most people do not pay cash for real estate. The thing is, the deduction of that cost is permitted because there is a legal requirement to repay those loans. It is the same logic that allows you to claim an education credit for the payment of tuition paid for with student loans.
There is something else going on with depreciation. Here is a hypothetical example. A rental property is purchased for $550,000 (total investment including commissions and improvements made during the time it was owned by the taxpayer). After ten full years of ownership, during which the annual depreciation deduction allowed and claimed was $20,000, it is sold for $800,000 (sale price including the costs of the sale).
The gain on the sale is calculated as follows:
Original Basis - $550,000
Depreciation allowed or allowable - $200,000
Adjusted Basis - $350,000
Sale Price of $800,000 - adjusted basis of $350,000 = a gain of $450,000 on the sale.
Now they actually bought a building for $550,000 and sold it for $800,000, a gain of $250,000. So why the disparity? Because the gain on the sale RECAPTURES the depreciation that was claimed. In the end, once the property is sold, the actual gain is realized.
Depreciation of real estate allows a deduction that must be recaptured when the property is sold. It isn't actually avoiding tax, it is deferring it until the property is sold.
* * *
The article points out very clearly that none of this is illegal. I don't like Mr. Kushner and how he has acted as an advisor to Mr. Trump. But I won't fault him or anyone else for paying only the amount of tax they owe under the laws as currently written.
The problem isn't with those who follow the laws, the problem is with those who write the laws.
posted by me at 6:22 AM
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