Depreciation…Blessing or Curse?

This week we are going to begin embarking on a journey that starts with the concept of depreciation and leads us to many forks in today’s tax code.  We’ll talk about exactly what depreciation is further in the post; but, I want to begin with just how many areas of your real estate business are touched by this seemingly basic idea.  Here is just a short list of the other tax areas affected by depreciation:

• Repair vs. Improvement
• Gain on Sale
• Net income or net loss in a given year
• Passive or active participation?
• Alternative Minimum Tax
• Consequences to your heirs

That’s a lot of stuff for such a basic principal!  In fact as we progress through the various facets and have a good grasp on the blessing and curses of depreciation we have the roadmap to lead us into discussion of all of those topics at a later time.

Let’s deal with exactly what the principal of depreciation is first.  In short; depreciation is simply the idea that the usefulness of something used over an extended period of time depletes over time.  Therefore, the tax code allows you to capture this expense in the current year.  Seems pretty logical that the shiny new vehicle your business purchased this year won’t be so shiny in a few years and that in several years you are going to need to purchase another one as the mileage creeps up; right?  Well, what about that warehouse you just purchased?  According to the tax code the assumption is you will also need to rebuild it at some future point in time; logical, maybe or maybe not?

The magic comes when you realize that this expense was not something you wrote a check for that year and therefore no actual cash outlay was involved.  Seems pretty useful right; a profitable business suddenly becomes unprofitable without actually spending any money and at the same time the taxes due on the profit are one less check you are writing too.  Not to worry, Congress has noticed…and noticed again…and noticed yet again.  Therefore, the code is littered with the tables of schemes whereby year after year Congress has made adjustments to determine how long it will take an asset to need replacement, how much of that you can claim in the first year, and even what happens if you don’t participate.

That’s right; not participating is not an option!  Curse?  Could very well be.  Let’s assume that one year as you are preparing your taxes you realize that the depreciation deduction is not going to help you that year…maybe you’ve already hit break-even and showing a further loss won’t benefit you in that year.  You could decide just not to take the depreciation that year; right?  Well, let’s look at an extended example of this.

You purchase that warehouse this year for $39,000 and the useful life is 39-years according to the current tax code.  The simple math means you’ve gained an additional $1,000 of expense each year for the next thirty-nine years that is not cash out of your pocket.  However, you don’t take that expense ever and in year forty you decide to sell the property for the same $39,000.  Bought for $39,000, sold for $39,000; no gain right?  The curse of the tax code says wrong…that property cost you nothing and you just sold it for $39,000 which gives you a taxable gain of $39,000.  Check please says the IRS of your new found gain.  Wait you say…I bought and sold for the same amount and I did not take the expense all those years so it cost me $39,000 not zero and I don’t have a gain I broke even on this deal?  No deal, you were required to take the depreciation and choosing not to actually hurts your cause.

So now that I have your attention on how important it is to get this right and keep up with Congress and their array of tables and we further realize how many additional areas of taxation are affected we will dig into the details over the next several posts of the who, what, and when of depreciation.

Bryan L. Wakefield, MS Acct.

Principal, Corridor Tax & Accounting, LLC

1020 Philip Powers Dr., Laurel, MD 20707

Office: (410) 630-1538  | Fax: (410) 630-1652

BWakefield@CorTaxAct.com | www.CorTaxAct.com

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