I'm not a big fan of taxing the wealthy, but mostly just because I have a huge conflict of interest, being one of the wealthy and all. However, progressive thinkers and politicians have been throwing around the idea of a “wealth tax” lately, which is actually a stupid idea.
So, is a wealth tax fair? It's not that the idea of taxing the most well-to-do of us is necessarily a bad idea, it's that taxing their wealth is a bad way to tax them. It would simply be incredibly difficult to do well in any sort of a fair way. Even Janet Yellen has said it would “have very difficult implementation problems”. That's the understatement of the year.
Would a Wealth Tax Work?
Imagine having to assess the value of everything you own every year. Your clothing, your cars, your art, your house, your toys, your privately held businesses, your real estate investments, your practice, etc. The cost and compliance hassle would be through the roof. In order to reduce that hassle, some assets would necessarily have to not count toward your wealth.
So guess what the wealthy would do—what rich people do to avoid taxes now. They would move money from stuff that counts, to stuff that doesn't count. Your house doesn't count? Great, now I live in a mansion. Only houses over 10,000 square feet count? Great, I'm going to build the nicest 9,900 square foot house you've ever seen. Only publicly traded investments count? Great, I'm going to invest in private businesses. Art doesn't count? Great, I'm going to invest in art. Or move money overseas. Is the IRS really going to send someone to remote Uruguay to assess the value of my property there?
One proposal I heard was to let the owner declare the value of the asset and if the IRS doesn't agree with your value, the IRS can buy it! Holy smokes that would be a crazy gamble to make every time you file your taxes, especially since there might be a year or more between the time you declare the value and when the IRS gets around to looking at it.
This doesn't even address the liquidity issues. Imagine you own $80 million worth of farms but only have $6 million in liquid investments. If your wealth tax is $2 million a year, you're forced to sell your liquid investments and pay capital gains taxes on them. Within 3 years, you're out of liquid investments and now you have to start selling off acreage just to pay the taxes. Maybe that farmland doesn't produce much income, perhaps only $3 million a year. So you're paying a million in income taxes and another couple of million in wealth taxes every year out of that. It just doesn't work for long.
Is a Wealth Tax Constitutional?
In addition, many people think a wealth tax is not constitutional because it is a direct tax. Per Pollock v. Farmers Loan and Trust Company, an 1895 Supreme Court case, a wealth tax would be a direct tax, which must be apportioned among the states or it would not be constitutionally valid. That is, if California is 10% of the population, only 10% of the tax can be paid by Californians. Given the wealth differences between California and Oklahoma, there's no way to do this without a constitutional amendment (like the one they needed to implement the income tax). As you'll recall, a constitutional amendment requires 75% of states to sign off on it. That doesn't seem very likely in today's political environment and certainly won't happen any time soon.
Assessing this stuff every year? Not a good idea.
6 Ways to Tax the Rich That are Better Than a Wealth Tax
So if you can't get more money from the wealthy by taxing their wealth, how can you get more money from the wealthy? Remember, I'm not necessarily a fan of any of these. I'm just saying that unlike a wealth tax, these could actually pass and would actually work at least a little. With each proposal, I'm going to explain what to do with your finances if it actually passes.
# 1 Raising Income Taxes on the Rich
Yes, many of the very wealthy don't have a lot of taxable income. Yes, this would also capture a lot of high-income, low-net-worth people like doctors. (Did I mention I'm not a fan of this plan?) But the wealthy, on average, tend to have much more income than those who are not wealthy. Raising ordinary income tax rates will certainly result in the rich paying more taxes.
What to Do If the Top Income Brackets Are Increased
Lots of options here. First, you can work less. That might keep any of your income from being taxed at those high rates. If the law passes, it usually isn't retroactive either. So you might want to do Roth conversions while rates are still low. Of course, the year it passes you would want to accelerate income and delay deductions to the next year. You would also look more preferentially at tax-protected methods of investing ranging from retirement accounts to insurance-based products like annuities or life insurance. Muni bonds also become even more attractive.
# 2 Lower the Estate Tax Exemption
This won't do much to the wealthy while they're alive, but it will certainly keep the next generation from being anywhere near as wealthy. Under 2021 law, $11.7 million ($23.4M married) can be excluded from federal estate tax. After that, it pretty rapidly climbs to a 40% estate tax. There are lots of little tricks you can do to try to minimize this, but when you're really wealthy, your estate is still going to pay a lot of money. This is one of the better ideas (and only requires you to value assets once a lifetime rather than every year), but still requires a lot of time to have much effect on wealth disparity. You could supercharge it, too, by not only lowering the exemption but by raising the rates. Want to really encourage spending and charitable giving and reduce generational wealth? Increase that estate tax rate to 100%!
What to Do If the Estate Tax Exemption Is Lowered
The estate planning attorneys would love for this to happen. All of a sudden they would have three times as many clients. Here's where irrevocable trusts, family limited partnerships, charitable trusts, and complicated gifting strategies come into play. Again, Roth conversions make a lot of sense. You might also want to step up your charitable giving, both during your life and at death. You may find it much more attractive to leave 100% of your money (at least the amount above the exemption) to your favorite charity than 60% to your heirs and 40% to the taxman.
# 3 Raise the Social Security Wage Limit
In 2021, you only pay Social Security tax on the first $142,700 in earned income. By eliminating that ceiling, you would essentially be raising taxes on high earners by 12.4% (okay, maybe slightly less since half of that is deductible). The downside to this plan is the same as raising the top income brackets—you're really nailing the high-income, low-net-worth folks like doctors.
What to Do If the Wage Limit of Social Security Is Raised
If ever there were an incentive to apply the methods of FIRE (Financial Independence, Retire Early), this might be it. Social Security applies only to earned income, so the faster you are living on something that isn't earned the better. S Corps would also become significantly more attractive (since part of the income is an “unearned” distribution) and most doctors would restructure their businesses to be S Corps.
# 4 Close Loopholes: Carried Interest, Bonus Depreciation, 1031 Exchanges, and Step-up in Basis
One man's loophole is another man's deduction, but there is at least one tax break that is pretty much only taken by the wealthy–carried interest. It has shown up on the radar of politicians of both political parties, although it still exists as a way for financially sophisticated folks like hedge fund managers to be paid for their labors with capital gains instead of earned income.
There are other tax breaks that primarily benefit the wealthy, like bonus depreciation on real estate investments, 1031 exchanges, and the step-up in basis at death that could be closed. The step-up in basis, in particular, is good tax policy in my opinion. Imagine having to try to figure out grandpa's basis on his house or stock portfolio from 65 years ago while mourning his death. What a nightmare that would be for the heirs.
What to Do If Loopholes Are Closed
Not much you can do if carried interest goes away and it matters to you, but if 1031 exchanges and depreciation are outlawed, you might just sit on your property instead of exchanging it. If the step-up in basis goes away, you would also be more likely to sell low basis investments if the taxes are going to be paid anyway, especially if you have an estate tax problem. Better to pass on fully taxed assets with that limited exemption.
# 5 Eliminate Capital Gains Brackets
A more aggressive proposal would be to eliminate capital gains brackets and qualified dividend brackets altogether. This would keep the wealthy living off their investments from enjoying lower overall tax rates than their secretaries. However, there are two valid reasons for lower investment taxes. The first, which applies both to capital gains and qualified dividends, is to encourage long-term investment. People respond to incentives. When you tax something, they do less of it. When you subsidize something, they do more of it. Tax investments, and people will invest less.
The second reason only applies to long-term capital gains taxes. The issue is that a large portion of long-term capital gains is just inflation. It's not a real increase in value. Why should you have to pay taxes on inflation? If you buy a property in 2010 for $100,000 and sell it in 2020 for $110,000, you didn't actually make money, but you still have to pay taxes on that $10,000. So the lower long-term capital gains brackets somewhat acknowledge the fact that it isn't fair to tax inflation. While I'm obviously not a fan of this proposal either, it is probably the easiest and most rapid to implement.
What to Do If Capital Gains Brackets Are Eliminated
If ever there were a case for tax-gain harvesting, this would be it. Update the basis on all your investments before the law goes into effect. You will also want to take more advantage of tax-protected accounts like 401(k)s, Roth IRAs, HSAs, 529s, ABLE accounts, and defined benefit plans. Cash value life insurance and annuities start looking a lot more attractive too.
# 6 Add a Value Added Tax
Think of a Value Added Tax (VAT) as a nationwide sales tax. If taxing income causes people to work and earn less, then taxing purchases causes people to spend less and save more. So there have been many proposals over the years (often called the “Fair Tax”) to replace the income tax with a VAT. Since the wealthy tend to spend more than those with less money, they would pay more VAT tax. The rates on “luxuries” could even be set higher than on more mundane purchases like groceries, although that starts getting pretty complicated quickly. This would be a radical, difficult to implement change and nobody really knows how you go from here to there. But adding it on as a new tax would be significantly easier.
What to Do If There Is a Value Added Tax
Spend less. The less you spend, the less you pay in taxes. What do you do with all that extra money? Well, you could give it to charity or use it to pay any additional estate taxes due.
While a wealth tax is a dumb idea, there are some legitimate options to raise taxes on the wealthy. Unfortunately, most of them also affect the high-earning professionals that make up the audience of this blog. Be prepared to make some adjustments in your tax strategy should any of these proposals actually become law. However, since most proposals never go anywhere, I recommend you wait until they actually do before making any significant changes to your financial or estate plan, especially permanent or expensive ones.
What do you think? What is the most likely way to raise taxes on the wealthy? Which of the above proposals would most disrupt your financial plan? Comment below!
Years ago, I’d agree with your last sentence. Tax changes were proposed in committee, discussed, modified, written about in articles, and you you had time to think about the changes and plan for them.
Then bang! 2017 Christmas break and what seemed like overnight, a Republican Congress, on their way out the door, passed the new tax law that affected many wealthy high income earners. While many of the changes, such as lower income and long term capital gains tax rates helped immediately, some really threw off our long term tax planning. The loss of the stretch IRA was significant for me.
After trying to plan over the last 30 years, I’ve come to realize specific long term planning and constant changing tax laws creates a component of futility and a large component of expense. I have several expensive legal plans such as living trusts, that seemed brilliant at the time but now maybe have some utility and not necessarily a bad idea but not the long term solution I thought they’d be. I find I can really only plan 2-5 years out and otherwise try to remain flexible. I keep as many options open as possible.
There seems to be two uncertainties that I can’t really plan for. The first being, I don’t know when and how fast Congress will change the current or future law. The second, I don’t know when I’m going to die.
The Stretch IRA was changed to ten years, not lost. More info here:
https://www.whitecoatinvestor.com/new-stretch-ira/
I watched the TCJA evolve for months, probably close to a year, before it was passed. I’m surprised that it snuck up on you.
But I agree that tax planning beyond 5 years is not particularly effective in many ways. You do the best you can, then you change your plan when the rules change.
And don’t spend too much on any plans for saving estate taxes which might be obsolete by the time they’re wanted. I’m hedging- 50-50 Roth/trad retirement accounts.
Eliminate the inheritance tax and replace it with no basis increase. Eliminates lots of waste, the only negative is the tax basis might not be easy to know for some assets!
That’s a big negative. Plus, it means estates are being taxed in large part on inflation! I think it’s bad policy to eliminate the step up in basis.
Good point but for businesses no tax until sold so perhaps no tax ever. No sales to pay the tax and basis for significant things could be estimated. Many personal items would either be sold at a loss or not reported.
I seriously disagree re: step up in basis. Do you think capital gains taxes should be completely eliminated? If so, what is your idea to prevent high income investors from getting away with paying near zero taxes? Many have this figured out – I don’t want to make it even easier! If you do think that capital gains taxes are reasonable, then why do they suddenly become wrong when an investor dies? If grandpa should pay cap gains taxes on a sale the day before he dies, his heirs should pay the same taxes the day after he dies. Estate planning would simply involve communicating the original basis to heirs, just as grandpa had better know the basis of his investments during his lifetime.
I’m not following you. High INCOME investors don’t get away with paying zero taxes. Some people are concerned that people with large amounts of WEALTH get away with paying zero taxes, but that’s very different. Getting rid of the step-up in basis goes after their heirs.
I don’t believe that in this post I even made an argument for the step-up in basis. I was pretty neutral and just told you what to do about it. I actually do think getting rid of it is bad policy though for two reason:
# 1 Few people are going to know the basis and so they’ll end up having to assume $0 basis which is unfair
# 2 One problem with capital gains taxes is that you end up paying them on inflation, which isn’t really an increase in value. The longer the asset has been held, the more of the “gain” is just inflation. At death, it is far more likely that a huge part of the increase is just inflation after such a long holding period. Imagine a family farm that has been owned for 60 years and hasn’t really increased in value on an after-inflation basis. A capital gains tax on it might take away 1/4 of the value of the farm. Now it has to be sold and can’t stay in the family. Or 1/4 of it has to be sold off to pay the taxes. And 1/4 again the next generation etc.
# 3 You want Grandpa to communicate his cost basis to his heirs on his deathbed? Have you interacted with very many people in their last couple of years of life? 🙂 Most executors are faced with a huge mess due to lack of planning. The loss of the step-up in basis affects everyone, not just the wealthy. Grandpa’s $80,000 house and grandpa’s $5,000 car that obviously depreciated but no one knows what he paid for it (so now the basis is $0 and that $5,000 is fully taxable) etc,
Would getting rid of the step-up in basis at death help redistribute wealth from the wealthy to the less wealthy via a relatively inefficient government? Absolutely. Would there be some unforeseen consequences including those above? For sure.
Good point on inflation but under a Supreme Court decision from long ago you should be able to estimate the basis. Nothing is perfect but eliminating the inheritance tax would be a positive in many ways.
You kind of got me on a technicality there with your comment “high INCOME investors don’t get away with paying zero taxes”. In the IRS definition, “net investment income” includes realized capital gains. Realized gains are taxed (albeit at a low rate compared to wages). UNREALIZED gains are, of course, not income and are thus not taxed. Herein lies the trick. High WEALTH individuals will borrow against the value of their portfolio, thus avoiding 100% of taxes if they so wish. Then, upon death, their appreciated assets pay off their portfolio loans AFTER the basis is “stepped up”. Any remaining assets are then handed down to heirs. In this manner, a wealthy individual can live off their accumulated wealth, pay zero taxes, and pass along remaining assets tax-free to their heirs, who use these assets in the same manner as collateral for portfolio loans. Wash, rinse, repeat. Multi-generational wealth with zero tax liability.
That’s a nice ax you’re grinding there. This sounds like a fairness thus morality argument that you’re making here. Take a second and realize you’re on a website run by an unapologetic capitalist, read by high-income earners and whose who hope to be, and that you’re equating wealth with some form of either obligation you’ve decided they owe to others or some form of intrinsic malfeasance.
They’re playing the same game you are. I doubt you tip Uncle Sam every April 15th, so why get so angry at people who are just playing the game better? If you make six figures annually, lots of people in this country and across the world look at you and say “Rich! Tax this person more!” If you disagree that you’re rich, you just don’t have their perspective. You’re certainly entitled to your opinion; it just seems out of place and unjustified.
I’m rich. I believe in most tenants of capitalism. I also have a particular sense of “fairness”. You might see it as an “ax to grind”. My frustration is not at people who play the game. I disagree with the rules of the game. As long as the “build, borrow, die” plan is legal, I may dabble in it. I probably have enough assets to last to my death & then some. I’ll be cautious until I know both how my health & expenditures are going, and how my children are doing as they enter their peak earning years. As I said, my objection is to the rules of the game. Whether the wealthy person is me or Warren Buffet, I don’t think that it’s fair that I will be taxed on the sale of assets today, but if I die tomorrow, all of those assets can be sold tax-free. Taxes are necessary for the functioning of our government. We may disagree with the details of that government’s operations, but at some level, it needs revenue. That revenue should be obtained fairly, and I believe a step-up in basis is unfair.
If enough people believe as you do, the law will change. But I think it’ll be bad policy if it does. That’s okay, there are a lot of other bad policies too.
You can borrow against your assets tax-free (but not interest-free)too if you like. Why shouldn’t wealthy people be able to do so?
And as I mentioned above, I think the step up in basis is good policy.
The estate tax limits how much can be passed on. When combined with the fact that there are multiple members of the following generations, generational wealth doesn’t tend to last long.
I accept your point on inflation. This could be addressed with a formula, or by further reducing capital gains taxes on assets held 5, 10, 20, 30 years & so on. Our tax forms can work with relatively complicated calculations to accommodate this. A fairly simple method would be to assume 2.5% annual inflation and accordingly reduce “gains” for long held assets. That way, grandpa’s farm which was purchased 60 years ago might have a relatively tiny actual gain after inflation, while Musk’s shares in Tesla have a huge gain. My point is not to “punish” investors in any way, but to acknowledge that the wealthy earn “income” in diverse ways, many of which are not traditional “labor”. More to the point, I don’t want traditional W-2 workers to be at a disadvantage to those who live on dividends, capital gains, carried interest (or portfolio loans, when you get to that level). I believe in progressive taxation levels. I don’t think 40% taxation for high earners is confiscatory. If the inflation factor could be taken into account, I think capital gains could otherwise be taxed as normal income. If assets were no longer “stepped up” in basis on death (and again, if inflation is taken into account), I could agree to elimination of estate taxes. If a wealthy individual plays the “build, borrow, die” plan, the sale of assets upon death to pay off their portfolio loans would be properly taxed, just as if the individual sold assets to pay off these loans the day before they died. Many people believe that the act of dying should not be taxed. I think dying should not absolve one’s obligations to pay taxes that would have been due had the exact same transaction taken place the previous day, though.
What do you think about the MMT idea that you only need to increase taxes if there is inflation? Since they (the government) opened up the purse strings perhaps because MMT, perhaps they wait until we see sustained inflation before increasing taxes. Er, ok that’s unlikely. I guess we have to see which tax they can get through now so that they can tighten it later. That’s the game. Get it passed now, then let inflation cause it to tax more and more people as the years go by…
In a lot of ways inflation is a tax.
Really interesting stuff to think about. I ultimately agree with your point that we sort of have to just see what happens and then make the right adjustments as necessary. To act proactively in this case can result in implementing a lot of strategies that in fact may hinder our wealth building and be a case of the tail wagging the dog.
I’m with the hedge your bets crew, no certainty of when we die or what the tax code will be at that moment and for us and our heirs in the longer term future, aside from how much I might leave them. So I might reach RMD age with 50% Roth 50% not retirement accounts, annual gifts to all my heirs maxed out. And informed kids who might choose to refuse part of an inheritance if it boosts their income such that they/ my grandkids lose their health insurance or lose money on the gain by no longer getting college financial aid etc. One friend of mine wants to ensure her irresponsible and in one case incompetent kids don’t go to jail after neglecting to pay the taxes due on their inheritance.
I’m with the hedge your bets crew, no certainty of when we die or what the tax code will be at that moment and for us and our heirs in the longer term future, aside from how much I might leave them. So I might reach RMD age with 50% Roth 50% not retirement accounts, annual gifts to all my heirs maxed out. And informed kids who might choose to refuse part of an inheritance if it boosts their income such that they/ my grandkids lose their health insurance or lose money on the gain by no longer getting college financial aid etc. One friend of mine wants to ensure her irresponsible and in one case incompetent kids don’t go to jail after neglecting to pay the taxes due on their inheritance.
Also let me point out that when I worked in the UK I paid income tax- similar amount as in the US- AND a VAT. It was apparently higher than the 9% sales tax not VAT I have to pay now in Alabama but it was nice not having to do the math when paying and less penny change.
Of all the ways to increase taxes, I feel the most reasonable one would be by instituting a federal sales tax of some type.
Democrats hate it because that means taxing everyone and not just targeting the rich. I’d argue that wealthy people tend to spend more than non-wealthy people and everyone needs to have skin in the game when it comes to funding the government.
Republicans hate it because they don’t want to raise taxes for any reason yet love to spend on borrowed money. I’d argue that at some point, you have start collecting for the massive amounts of debt that we as a nation have racked up.
Disincentivizing spending may lead more people to save for the future, a problem we have in this country. And for those who still want to spend more, they would fund the government.
Regards,
Psy-FI MD
Does the US Government have an income problem or a spending problem?
Yes.
obviously WAAAAAAY more of a spending problem
I’m with you on the income tax fixes, but I have to say your wealth tax problems aren’t really show stoppers (setting aside the legal issue, as we have to agree on “what we should do” before we agree on “what we can do”).
People hiding assets in non-taxed classes? Tax those classes. Hiding assets overseas? Require declaration of overseas assets. Too much overhead? Only tax wealth above 20MM–yes, they can pay for someone to do the calculation. Too little liquidity? Cry me a river, megamillionaire, and tell that to the grandma who loses her house because she can’t pay the property taxes.
Even the “declare the value and let the IRS buy it” idea is fine with a quick tweak: Put a premium on the IRS purchase. Say 25% (or 50%, or whatever). And make sure the owner can pay back taxes to avoid an IRS sale. Under this scheme, the IRS is only going to go after hugely understated assets. A wealth tax that’s 80% effective is fine–these edge cases are not sufficient to tank the idea.
Each of the 100,000 Net Worth returns can be Individually audited, under penalty of perjury, by skilled IRS auditors. Not much room for playing around.
So all the gold, art, and other physical assets can be found? And valuing business is very subjective!
Those subject to the tax, people with a net worth of 50 million plus, will be represented by accountants/attorneys who will advise them not to risk a felony conviction for hiding assets (which are likely a very small percent of the total). Valuing a business at that level is sophisticated enough to handle the subjectivity.
Loaded question:
My wife and I are both primary care docs making above the median for our specialties. We sold our “doctor home” and moved to a low cost of living state with loan repayment options. I went to an expensive private college for undergrad and have $200K in undergrad loans and then we each have $500K in government loans for our expensive, private medical school educations. Yes, I said that right, we EACH have $500K. So total we are in debt at a whopping $1,200,000. Do we even try to make $20,000 a month payment to have them paid off in 6 years (a goal we set) or do we heavily invest in our retirement and pay the minimum until the balances are forgiven and we bite the bullet on the tax hit for the forgiven amount? I feel like with that much debt the path isn’t as clear as it could be.
Recommendations/suggestions?
Paying off that debt should definitely be a top priority. How long do you want that albatross hanging around your necks? What does your budget look like if you make maximum retirement contributions, live like a resident, and put everything left over toward the debt? Can you still pay it off in 6 years? If so, that would be my recommendation. Sounds like you’ve taken a good first step by moving to a lower COL area.
Now, if you both have beaucoup retirement options (like, 2 x Solo 401k’s, 2 x backdoor Roth IRAs, family HSA, maybe other options too) that compete with paying off the loan quickly, then it becomes a tougher choice. Retirement accounts will save you lots in the long term, and once your yearly contribution limits expire, you can never get them back. That would be a tougher trade-off, and would depend on things like your tax situation.
You need formal student loan advice/coaching to help you run the numbers. Getting PSLF qualifying jobs is the best option, but you may be a good candidate for IDR forgiveness too if you’re not willing to do that. You can book an appointment here:
https://studentloanadvice.com
Why are you both not doing 10 year PSLF? If you worked for a non-profit hospital during residency and made minimum payments during that time, they will count for 3 of your 10 years. That means just 7 more years of minimum payments with the rest forgiven tax free. Seems like a no brainer decision from my perspective.
I’d favor:
-More tax brackets going to incomes much higher than ~$600k, with a top marginal rate ~50%
-Simplify the tax code: eliminate AMT, 199A, ACA taxes
-Eliminate loopholes like carried interest and the hummer loophole
-Eliminate depreciation for real estate, and 1031 exchanges
-Lower the standard deduction (makes charitable contributions non-deductible for many) and increase home interest deduction back to $1M (doesn’t buy as much house as it used to)
-Set the estate tax exemption back to ~$5/10M (seems about right to me)
-Increase enforcement and penalties for big abusers (I can think of some examples)
-Maybe a federal luxury tax
I really don’t think taxes are the problem. I think spending is a bigger problem. They need to have a line item veto and get rid of all the pork in the budgets. It is too easy to spend other people’s money. When a bill is approved, it should only be approved for the amount of money available. Waste is as much of a problem too.
“Eliminate depreciation for real estate”
BOOM, Rents now 10% higher everywhere to cover the difference. Depreciation is supposed to be a way to expense things that wear out during the normal course of use. Things that are “fixed” like a leaky roof, new paint, or a sagging door are repaired and immediately deducted *just like all businesses do.* Depreciation is the wearing out of the entire roof which is usually 5 figures a pop, the driveway, the structure itself, the HVAC system, etc etc. If you eliminate the ability to effectively tell the IRS the value of your tangible property has diminished due to regular use, then oil drillers can’t depreciate their rigs, farmers their tractors/barns/fencing, construction companies their cranes, cellular companies their towers, office complexes their buildings, physicians offices their machinery (you think urologists just take the hit on that lithotripsy machine?).
To you, it’s just the condenser unit on an HVAC system. To me, it’s part and parcel of how I make money. When it wears out, I replace that joker, and they ain’t cheap. If I can’t depreciate that, you better believe I’m increasing rent to cover the cost of that condenser unit but also the extra tax I gotta pay on the “profit” I received from the higher gross rent that I increased just to cover the cost of my unit. Rents in a lot of areas are pretty competitive, and even more so since the CDC basically told landlords to kick rocks for the last year. My name is on that note, personally guaranteeing my six figure investment, so knock depreciation all you want as a giveaway to the rich, but when rents everywhere across the country take a huge jump, you’ll realize you should be careful what you wish for.
*Source: salty small landlord having to put a new roof on a house and praying my tenants don’t suddenly just stop paying me even though I’m legally obligated to keep the house in good repair for them.
Excellent point.
No argument from me that expenses that a landlord (which I have been by the way) incurs should be tax-deductible. This includes a new roof, new water heater, new AC, plus smaller repairs. Actually, I think you can make a reasonable case that these things should be fully deductible in the year you incur the cost. It could have consequences that are good (eg. able to time these repairs in higher income years) or bad (eg. one big deduction drops you into a lower tax bracket for the year), but it would simplify the tax code. Deprecating a $1,200 laptop over 5 years seems a bit silly to me. I know the TCJA allows more bonus depreciation, which is a good thing, if it’s not abused.
I was talking about depreciating the dwelling. I never understood the point of this. Interest on a loan and any actual expenses you pay are of course already deductible – why get an extra deduction that has to be paid back later in a lump sum? It’s also somewhat of a gift for higher earners, because the deductions are at your full marginal rate, but recapture is capped at 25%. And it seems like bad tax policy, because it requires people to track their depreciation for up to 27.5 years, and it causes problems for people who calculated it incorrectly, forgot to take it, etc. Just get rid of it and let landlords pay taxes on (income – expenses) each year.
Items you depreciate cannot also be expensed/deducted in the year you buy them. It’s one or the other. And those depreciatable items certainly do wear out. Maybe you can argue the deduction is too generous or the recapture is too generous or something, but it’s not an “extra” deduction. Houses really do wear out.
I don’t think I’m explaining this well. Depreciating a capital expense (like a roof, AC unit, or manufacturing machine at a big corp) *is* a form of deduction, it’s just one that the IRS either allows or requires you to spread out over some number of years. It’s an interesting discussion of which expenses should be allowed/required to be depreciated vs. deducted in a single year, but in either case, you still get the full deduction. It gets subtracted on your tax return either way. As a landlord, every dollar you actually spend on your property would still be deductible (or depreciable) with our without a dwelling depreciation. So, the dwelling depreciation does indeed seem like “extra” to me, because you don’t actually have to spend any money in order to get it. The IRS seems to recognize this because they require you to recapture it when you sell the property, which they don’t for other forms of depreciation.
Here’s another way to look at it. Depreciation tables are supposed to reflect the drop in market value of the business item, like a car. You buy it for $30k, a year later it’s worth $24k, a year after that $20k, etc. So, the depreciation tries to reflect this drop in value on your balance sheet. If you sell it for more than the depreciated value, you pay capital gains tax on the difference. If you sell for less, you can deduct the difference between the sale price and depreciated value. Faster depreciating items tend to get shorter depreciation times. Dwellings do not tend to decrease in value. They tend to increase in value. That’s why dwelling depreciation almost always needs to be recaptured. Sure, if you didn’t maintain the property at all, it could be reasonable to assume it’s a worthless pile of rotting wood after 27.5 years. But most landlords do maintain their properties, and are already allowed to separately deduct the cost to do it. It’s *not* reasonable to assume the value of a property decreases to 0 after 27.5 years.
And as I said I think it’s also bad tax policy due to the complexity and long period of time you need to keep records, and the awkwardness of putting a big spike of artificial income in a single year.
Let’s step back a minute.
You own a property. You put a brand new roof on it. Now you can depreciate the roof.
I buy the property from you the next month. That brand new roof roof is still decreasing in value each year, no? But I can’t depreciate it separately, can I, EXCEPT as part of the total depreciation of the dwelling. That doesn’t seem reasonable, does it? So I should also get to depreciate it. If it turns out that it appreciates instead while I own it, then I pay capital gains on it.
Hope that helps.
Again, you can argue depreciation shouldn’t be recaptured at a discounted rate, but not that depreciation of the structure itself is unfair.
In a lot of ways, the dwelling depreciates and the land appreciates. Much of what people interpret as the value of their house going up is really just the value of their land going up plus all the dollars they’re pouring into house maintenance and upgrades. Few would argue my two year old brick is more valuable than that same brick when it was brand new. Same with shingles, windows, paint etc.
“Structures depreciate and land appreciates” is a reasonable rule of thumb, but doesn’t hold all the time. Cost of labor and materials tend to go up with inflation, so a well-built structure may appreciate, especially if demand is increasing too. Most home buyers don’t want to scrape and rebuild a house before they move in.
I get what you are saying. You want to be able to deduct, each year, the “paper loss” of the decrease in value of your roof, garbage, disposal, etc. But these are not physically separable from the entire property, which is probably appreciating faster than you are putting money into it. Are you also willing to pay taxes on the yearly *appreciation* of the land? And other parts of the dwelling that might appreciate (foundation, frame)? No, you wouldn’t want to do that. That’s why I think it’s unfair. Eliminating this deprecation theoretically wouldn’t change the govt’s tax receipts, because it all would come out in the wash as capital gains when the property is sold. It would just simplify things a lot.
When I was a landlord, I just about broke even on rent vs. expenses. (Some “expenses” were things I would have bought anyway, like ~half my computer and phone.) Dwelling depreciation gave me a yearly paper loss. But because my AGI was >$150K I couldn’t deduct these and they carried forward. When I sold the property I had about a $50k carry forward loss, and a $50k depreciation recapture. Because I was in the 24% bracket these canceled out. But if I were in the 37% bracket I would have gotten a 12% arbitrage, which would have basically been a $6,000 gift from Uncle Sam, because the rules as written imply that the entire property is expected to lose value. And it didn’t; it appreciated 60% in 10 years. Roof included.
Good points. WCI seems to want to double dip his depreciation. He wants to deduct the cost of the new roof when it is replaced, and ALSO depreciate the structure. (Am I following that right?) As you said, maintaining a structure prevents it from becoming worthless in 27.5 years. That maintenance is the entirety of the business expense that is needed to PREVENT actual depreciation of the structure, and is a proper business expense. I think that once a property depreciates to zero, the local taxing authorities should hold the option of purchasing it for exactly that value.
I don’t mean to be a jerk. I actually am pretty uninformed about tax details of real estate investing. I’m just rather confused when I see numerous articles describing the “advantage” of being able to depreciate real estate when it is almost continuously appreciating in actual value. Chris’s thoughts on deducting actual maintenance and improvements makes perfect sense to me.
Depreciation is actually a pretty legitimate business expense. If you want to attack a loophole and raise taxes on the rich, I’d go after the tax-free exchange. It’s kind of bizarre that you can do that with insurance products and you can do it with real estate but you can’t do it with a stock, a mutual fund, a franchise, or a small business.
A roof is depreciated over 27.5 years, just like the entire structure. So yes, if you buy a structure you get to depreciate it. If you add a new roof to it, you depreciate the roof separately. You do not get to depreciate the land, which is actually what appreciates for the most part.
I say don’t raise taxes, just print more money to pay for all that government debt 🙂
Is the idea of a flat tax in any way viable? I always liked the idea but its a pipe dream, I’m afraid. Congress would lose power and they never vote for that.