Cactus forgets about use of money

Cactus Kate blogs on the recommendations of the Tax Working Group. With respect, I disagree with her on one aspect. She says:

Much has been made of building depreciation. Those who still think this is a starter should read up on the IRD website about “depreciation recovered” . It is erroneous to say that the current system doesn’t already have a clawback on sale where depreciation has been overclaimed. As it does for other fixed assets depreciated in business as well.

Now it is true that when a building is sold, you have to pay back the cost of the tax on the claimed depreciation. Everyone knows this. But Cactus misses the point – you get to have interest free use of that money in the interim – this is like interest free student loans, but even better.

It is effectively lending landlords taxpayers money for free. Residential buildings do not generally depreciate – they appreciate (along with the ladn they are on).

Let me give an example. Say you purchase a house and the building is deemed to be worth $200,000 of the total price. You can claim 3% depreciation diminishing value. In year one that is $6,000. Now if you pay 38% tax, then you effectively end up with $2,280 extra cash.

Now even if you are the worst investor in the world, let us assume you can at least earn the risk free rate of return of 6.29%. So you earn $143.41 of your $2,280.

Now that doesn’t sound much. However in year two you then have $2,423.41 of money to invest plus you claim $5,820 off your income as depreciation, which at 38% which is a further $2,212 to invest. So then your return courtesy of the taxpayer is $291.54.

If you sell your property after ten years, you will have claimed $52,515 off your income, resulting in reduced taxation of $19,956. But you will by then have $28,774 of extra money (at the conservative risk free rate of return), so after paying back the claimed depreciation you still have $8,818 left over.

If you keep your property for 30 years, then after paying back the depreciation you will have $106,639 surplus from being able to use that money interest free. Now this is in nominal terms, so won’t be as much in real terms. But it is still money for nothing and bad economics – just like interest free student loans are bad.

Depreciation is a necessary tax loss, when the asset really does depreciate, as it allows you to fund the cost of replacement. But when we have decades of evidence that residential buildings appreciate, not depreciate, I’d rather not give out interest free loans to property owners to claim a depreciation that doesn’t exist.