About halfway through Sunday night’s presidential debate, the conversation turned to taxes, and specifically to the topic of candidate Donald Trump’s taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. returns. Following revelations that Trump claimed more than $900 million in business losses in 1995, debate moderator Anderson Cooper wanted to know if Trump had used those losses to lower his tax bill.
COOPER: Did you use that $916 million loss to avoid paying federal income taxes?
TRUMP: Of course I did. Of course I did. And so do all of [Hillary Clinton’s] donors, or most of her donors. I know many of her donors. Her donors took massive tax write-offs. A lot of my write-off was depreciation and a lot of other things Hillary Clinton as a senator allowed and she always allowed because the people that give her all this money, they want it…
COOPER: Can you say how many years you have avoided paying personal federal income taxes?
TRUMP: No. but I pay tax and I pay federal tax too. But I have a write-off, a lot of it is depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. , which is a wonderful charge. I love depreciation. You know, she has given it to us.
Some viewers of Sunday night’s debate were probably puzzled by Trump’s reference to “depreciation.” Other viewers, such as small business owners, were probably quite familiar with what Trump was talking about.
Either way, there’s a lot of controversy and confusion about depreciation in the federal tax code – and especially regarding how real estate businesses, such as Trump’s, use depreciation deductions. The goal of this post is to explain how depreciation in the U.S. tax code works and why the current system of tax depreciation is so controversial.
The Basics
Here’s a very simplified version of how business income taxes in the United States work:
- Step one: You add up your revenues (“total income”)
- Step two: You subtract your expenses (“deductions”)
- Step three: You report the difference (“taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. ”)
- Step four: You multiply your taxable income by a tax rate, to calculate your total tax
The topic of depreciation falls under step two, in which businesses deduct their expenses. In general, businesses are allowed to deduct most ordinary business costs: wages and salaries, maintenance, advertising, interest payments, and so on. Furthermore, businesses are allowed to deduct these costs in the same year that they occur: if a company paid an air conditioning bill in 2014, it is allowed to deduct the full cost from income reported on its 2014 tax return.
However, there are certain categories of expenses that businesses are not allowed to deduct immediately. Most importantly, businesses cannot take an immediate deduction for the cost of their capital expenses. The category of capital expenses includes any business purchase that is expected to be useful for a long time: machinery, furniture, computers, buildings, and so on.
Instead, businesses are required to deduct the cost of their capital expenses over long periods of time, according to a set of depreciation schedules. For instance, a timber company that buys a new chainsaw would generally be required to deduct the cost over 5 years, while a railroad company that buys a new bridge would generally deduct the cost over 20 years. Whenever a business buys a new capital asset, it is required to look up the appropriate depreciation schedule, to determine what fraction of the asset’s cost it can deduct each year.
These gradual deductions for the cost of capital expenses are known as “depreciation deductions,” and they have been a feature of the federal income tax since its enactment. However, federal depreciation schedules have changed many times over the last 100 years, generally in the direction of allowing businesses to deduct their capital expenses more quickly.
The Controversy
Why aren’t businesses allowed to deduct their capital expenses immediately, and why are depreciation deductions so controversial? It all has to do with a fundamental dispute over the purpose of business income taxes: whether businesses should be taxed on the change in their net worth, or on their cash flow.[1]
To understand this dispute, let’s imagine a business that spends $1,000 on its air conditioning bill, and $1,000 on a new jackhammer.
Some policymakers and economists believe that the federal government should tax businesses on their change in net worth. Using this framework, we can analyze what deductions the business should be able to take:
- When the business spent $1,000 on its air conditioning bill, its net worth decreased by $1,000. Therefore, it should be allowed to take a deduction of $1,000.
- When the business spent $1,000 on a jackhammer, its net worth did not decrease; it simply transferred its wealth from cash into a physical asset. Therefore, the business should not be allowed to immediately deduct the $1,000 spent on the jackhammer.
- However, it is likely that the jackhammer will decline in value over time (or “depreciate”), due to wear and tear. Therefore, the business should be able to claim a deduction each year for the depreciation in the jackhammer’s value.
Other economists, policymakers, and commentators (myself included) believe that the federal government should tax businesses on their cash flow: how much cash they make and spend each year. We can analyze what deductions the business should be able to take according to this framework as well:
- When the business spent $1,000 on its air conditioning bill, it expended $1,000 in cash. Therefore, it should be allowed to deduct $1,000.
- When the business spent $1,000 on a jackhammer, it expended $1,000 in cash. Therefore, it should be allowed to take a $1,000 deduction immediately.
- If and when the value of the jackhammer declines over time, the business should not be able to claim a deduction for the depreciation, because the business’s cash flow hasn’t changed.
In practice, the federal tax system adopts a hybrid of these two approaches, when determining what deductions a business is allowed to take. Following the first approach, the U.S. tax code does not allow businesses to deduct their capital expenses immediately, but does allow businesses to deduct the costs gradually over time. However, in a concession to the second approach, the U.S. tax code contains several provisions that allow businesses to deduct their capital expenses more quickly, such as bonus depreciation and small business expensing. In practice, federal depreciation schedules are largely unrelated to the actual rates of depreciation of different assets, and are instead the product of extensive negotiation among policymakers who favor one approach or the other.
The question of which of these two approaches is correct has been a subject of contentious debate for decades. Supporters of taxing businesses on their change in net worth argue that their framework makes it easier to tax high-income Americans and discourage tax avoidance. Proponents of taxing business on their cash flow argue that doing so is more economically efficient and would make the tax system simpler.
Real Estate
The case of depreciation deductions for real estate businesses is especially controversial, because unlike many other capital assets, real estate tends to increase in value over time.
For supporters of cash-flow taxation, the fact that real estate increases in value over time is immaterial. Under the cash-flow framework, businesses should be able to immediately deduct the full cost of the buildings they purchase, and should then pay taxes on all of the resulting profits.
But for policymakers who want to tax businesses on their change in net worth, the fact that buildings tend to increase in value is very important. It means that real estate businesses should not be allowed to claim any depreciation deductions for their buildings over time, in addition to not deducting the buildings’ cost when purchased.
In practice, the U.S. tax code adopts a compromise between these two widely divergent views. Businesses are required to deduct the cost of residential buildings over 27.5 years and the commercial buildings over 39 years. These are two of the slowest depreciation schedules under the U.S. tax code, making supporters of cash-flow taxation cringe. On the other hand, the fact that real estate businesses are able to claim depreciation deductions for their buildings at all makes supporters of change-in-net-worth taxation very upset.
Is Depreciation a “Loophole”?
After Trump’s comments in the debate, a wide range of commentators referred to tax depreciation as “a ploy,” “a gift,” and a method of tax avoidance. These comments are probably not very helpful to advancing an informed debate about taxes. Depreciation deductions have been a standard feature of the federal tax system for more than 100 years, and are utilized by millions of small and large businesses every year.
For those who believe that businesses should be taxed on their change in net worth, then it makes sense to claim that current depreciation deductions are too generous, particularly for real estate. In addition, there is a legitimate case to be made that a wide range of tax provisions work together to lower taxes on real estate businesses significantly.
On the other hand, for those who believe that businesses should be taxed on their cash flow, it is reasonable to criticize the current system of depreciation deductions for not being generous enough. There’s a good case that the tax code discourages businesses from undertaking new investments by requiring them to deduct the cost of their capital expenses over long periods of time.
All of this is to say that, like any other area of the federal tax code, depreciation deductions are a product of negotiation and compromise between different ideals. For this reason, it is probably unfair to call depreciation a “loophole.”