IN THE NEWS: The Estate Tax, Part 3 – BONUS: Why Is It Hard to Measure Income from Assets?

Posted by Mark Hutson on 12/26/17 9:26 AM

Dr. Mark Hutson is a Manager at Summit with extensive experience in building, designing, and running economic forecasting models in private, public, and academic settings. He has consulted for government agencies, law firms, trade groups, think tanks, and academic researchers.

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Our recent two posts about the Estate Tax talked about some problems with calculating income, but focused primarily on capital gains. Today, we’ll run through an example of how other assets are subject to similar problems, such as how rents and usage charges can be complicated to assess.

Take, for example, rents on an apartment. Let’s assume that you lease an apartment and agree to pay $1,000 each month, which in DuPont Circle means that you’ll have about 700 square feet and 11 roommates. Each time you make a payment, the landlord has to pay taxes on that rent, right?

Well, no. The landlord also has to pay to heat the building, fix things around the apartment, pay the city for trash removal and sewage, etc. Let’s say that costs $400 a month in utilities, services, and property taxes. So, even though the landlord is getting $1,000 in revenue, she is only $600 wealthier. So, under Haig-Simons, she’d owe taxes on the $600, not the $1,000. Thus, the owner would pay income taxes on your rent of $7,200 over the year, rather than the $12,000 in total receipts. (See table below for summary.)

Table: Example of Net Rental Income
    Per Month      Per Year    Capital
Improvement
Rent +$1,000 +$12,000  
Upkeep and taxes -$400 -$4,800  
Annual garage improvement -$417 -$5,000  
Capital improvement -$183 $2,200 -$60,500
Revenue +$1,000 +$12,000  
Expenditure -$1,000 -$12,000  
Net taxable income $0 $0  

But wait, they are also improving the building. Due to tenant demand, the building manager is both doing its annual garage refurbishment and building common-use tennis court/hibachi pavilion on the roof. The annual garage refurbishment, when prorated to your apartment, costs $5,000. Since this is an annual expense, this can be deducted as a direct cost against your rent; suddenly the landlord’s income for the year is only $2,200. So that would be the taxable rent after accounting for the ridiculously-expense garage.

Of course, common-use tennis court/hibachi pavilions aren’t free, either. That investment is a prorated $60,500 against your rent. That is soooo much more than your rent, so how does this work? Is the landlord suddenly $58,300 poorer and eligible for a tax rebate? Does the American taxpayer have to offset your tennis and diced chicken habit by giving this landlord money back? The answer is… sort of. Capital improvements, basically investments in a property that accrue (and persist) over multiple years get deducted over multiple years, as well. So, something permanent like a building upgrade gets amortized (split) over 27.5 years. So, that $60,500 turns into an annual value of… $2,200 per year. This means that the landlord’s net income is $0 from your $12,000 in rent!

Of course, the building is also a lot more valuable now, what with the happy tenants and a wait-list a mile long. So, if the landlord ever decides to sell the building, they may trigger some capital gains (see above) from their original purchase price. And this is before we even get into depreciating the original purchase!

So, as you can see, something as simple as renting out a property can get very complicated very quickly.

Topics: tax

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