When I let go of what I am, I become what I might be. –Lao Tzu
Forbes /AUG 14, 2016 @ 07:03 AM Tim Worstall CONTRIBUTOR I have opinions about economics, finance and public policy.
The New York Times NYT +1.33% is speculating that perhaps the reason that Donald Trump hasn’t released his tax returns is because he’s not actually been paying any Federal taxation. David Cay Johnston has been making similar points before now. Others here will tell you more about the tax laws and whether this is possible or even true. But there’s an economic point which is being glossed over in the analysis. An assumption being made which is an incorrect one. That point being that if the NYT’s contention were true then no one would ever do commercial real estate development. Yet we can obviously see that people do commercial real estate development. Thus the contention cannot be true.
Specifically this concerns the allowances for depreciation oncommercial property:
At least interest is a cash payment. Depreciation is a noncash charge, and is largely an accounting conceit that benefits real estate investors. The theory is that real estate loses value over time and is eventually worthless. As everyone surely knows, most real estate has historically appreciated in value.
No, that’s not correct.
How much Mr. Trump’s property investments might throw off in depreciation depends on what he paid for them, how much he’s spent on capital improvements and how the assets are categorized (some assets qualify for accelerated depreciation). But the 39-year depreciation schedule for commercial property, and purchases and capital investments of $2 billion (a modest estimate, given that Mr. Trump values his assets at $10 billion), would generate depreciation deductions of $50 million a year.
It’s necessary to decompose “real estate” into its three component parts. The first is the land itself. An acre in Manhattan is worth more than an acre in the Mid West. The land underneath the Dakota Building might be worth more than much to all of the land in the two Dakotas (hyperbole alert!). The second is the planning permission, or zoning, of what you are allowed to do with that land. An acre of Central Park has a lower value than an acre right beside Central Park. Because you’re not allowed to do anything with the Park while the land beside it can have a gazillion apartments piled one atop the other. Finally, there’s the value of the actual building which sits atop the land.
Land, with a rising population and wealth, generally does appreciate in value. Planning permission or zoning can rise in value for the same reason – or because it is artificially restricted. There’s no particular shortage of land in California but there is of permissions to build. Which is why California “houses” are markedly more expensive than the same actual building in Dallas, which doesn’t so restrict.
But buildings do fall in value. One description here:
For example the building elements with the shortest life span are the interior finishes which last only the span of the lease, typically 5-10 years. The roof and the mechanical systems are next which typically last about 20 years. The windows, wall cladding, paving surfaces and electrical systems will typically last about 30 years. The building structure and the floor slabs will last as long as the are protected from the weather. The foundations, for all intents and purposes will last forever.
Things need to be replaced over time, depreciation is the accounting charge for things that will need to be replaced over time. Or we can take this information:
Commercial buildings remain in use for many decades. Although about 12% of commercial buildings (comprising 14% of commercial floorspace) were built since 2003, the commercial building stock is still fairly old, with about half of all buildings constructed before 1980; the median age of buildings in 2012 was 32 years
Or this different estimate:
Nationally, SMR found, the average age of U.S. commercial buildings is 41.7
Manhattan has been developed pretty fully for the past 100 years. There’s very little “virgin” land that has been built upon in that time. Just about all commercial real estate development there has been redevelopment therefore. That is, buildings were put up and then, at some point later they were torn down again and something else built upon the site.
Another way to say the same thing is that buildings do depreciate. Thus it’s entirely appropriate to have a depreciation allowance for buildings. Indeed, it’s difficult to see how you could have a properly functioning economy without making that allowance. There’s a capital cost to putting up the building – at the end of some period of time the building will be a pile of rubble again. The taxation of the business of making those buildings must therefore take account of that. For we tax a business on its profits. And profits are what is left after all of the costs.
We can calculate these costs in one of two ways. You get to write off the entire amount against your taxes in the year you spent the money. You buy a computer which will last four years but that’s a business expense that comes off your income in year one. This is something that Trump has actually suggested should become the law. Or we can say that your investment will be usable for four years and so you can write off 25% of the cost each year. Which is what we do do. Depreciation for buildings is the same. As you can see, the average lifespan of a commercial property is some 40 years or so. The depreciation write off is spread over 40 years.
That’s a very close match between tax law and economic reality. Rather more than we usually see in the tax system in fact.
Whether Trump’s tax bill has in fact been zero no doubt we’ll find out. And whether it’s something voters want to get upset about is entirely up to the voters – I’m neither an American citizen nor an American resident. But this specific tax “break”, depreciation on commercial real estate, is entirely justified by the basic economics of the business itself.
If buildings did not depreciate there would be no commercial property redevelopment business. We can see that there is a commercial property redevelopment business – thus commercial buildings do depreciate and a depreciation allowance is the correct thing to have.
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