A correspondent upon the Twitter is confused – to be kind about it – over Donald Trump’s tax bill:
So he can’t have assets that are increasing and decreasing in value at the same time. C’mon you’ve gotta be smart enough to know there’s a stank on this. Hes rich and a cheat or not and bad at business. Has to be one or the other
— Jaaaaay (@jaaaaay34) October 4, 2020
The confusion stems, I think, from thinking that depreciation means that the buildings are going down in value. Well, yes and no, yes and no.
To illustrate using my own experience and British tax law. The American system is different in detail – tax system in foreign is different shocker! – but the basic principles are the same.
Between me and the building society I own a flat in Bath. Have done for near 40 years now. It’s rented out. So, there’s an income from the flat. There are also expenses to do with owning the place. It’s of that Bath sandstone so every few decades the facade needs cleaning off and repointing. The roof doesn’t last two centuries – the age of the place – so there’s the bill every few decades for repairing or replacing that. Plumbing also doesn’t last forever.
Renting a place out is a business. There are costs and there is income. Tax is due on net income – profits – not gross income from a business. So, if the plumber has to be called out that’s an expense, which is taken off the income, before tax is due. That’s obvious and fine.
But those decadal bills. We can imagine different ways of dealing with this. Present the bills when the work is done and that’s an expense. It’ll clearly swamp any rent in that one year so you get to carry those losses forward. OK, much the same way normal business taxation works.
Or, we might say that a sensible landlord puts some portion of the rent aside each year to build up a pot to carry out that maintenance when done. We could have the tax system recognise a special account where this is done. OK.
What we actually do is say, well, approximately and roughly you understand, the entire place needs to be rebuilt every 50 years. So, you get an allowance of 2% of the value of the place each year. This can be offset against that rental income before calculating the taxable amount on which tax is then charged. This is called depreciation.
This isn’t quite right, not in the purist economic sense. Because that value you get the 2% against is the value of the building plus the land plus the planning permission to build on that land – the market price. But the building isn’t worth that, not anywhere in the South of England it isn’t. You can check this by looking at your house insurance. That nice little £300k des res – the one you paid £300k for – doesn’t get £300k from the insurance company for you if it burns down. It gets you perhaps £150k, the cost of rebuilding it. The other £150k is the value of the land – mebbe £10k, summat like that – and the value of the permission to build upon that land.
We can check this. Land without planning permission is of much lower value than land with planning permission.
So, we do have an error in this system, the depreciation is upon that land and planning permission as well as the building itself. But, on the other hand, we’ve also got something easy for HMRC to administer and a tax system which accountants can get to grips with. Cool.
So, we’re saying that the building is falling in value over time. Which it is, it needs repair. Thus there’s a loss, or a future cost, which the tax system recognises.
Over the past 40 years has that flat lost value? Like buggery it has. But that’s the capital value of it. I really have had to pay out to maintain it. Those maintenance bills are costs which are, righteously, set against the income. Any tax system is going to have that recognition and some form of those allowances. Sure, maybe not exactly these details but something like it.
So, I’ve been claiming costs and depreciation all these decades. Have I lost money, become poorer? Nope. And that increase in the capital value gets taxed – which it does now in the UK – when I come to sell.
I’ve got losses, depreciation, while becoming richer – capital value.
Scale this up by a few orders of magnitude and we’ve Donald Trump’s tax bill. Those buildings need maintenance and repair. The tax allowance for that is depreciation. That feeds through into the annual tax bill. The capital value – no, I don’t know New York real estate just like you don’t so neither of us knows the capital value of those buildings, nor whether that’s higher than he paid or not – is something different. Trump could be, entirely righteously, claiming annual and ongoing losses while stacking up the capital gains.
Just because that’s how the system works and that’s how any system of the taxation of real estate is going to work. Allowances for maintenance plus some sort of taxation on capital gains – the second only coming into play when a place is sold.
And if you’d like to whine about said system just because Orange Man Bad then perhaps you’d like to understand the system before you do so?