E1AR0002@SMUVM1.BITNET (10/20/86)
TAX LAW
Mortgage Interest, Depreciation and a Book Review
There was a question regarding whether the deductability of mortgage
interest is reasonable.
The answer according to a paperback called "Federal Income Taxation" by Marvin
A. Chielsten is yes.
Let us compare two people where mortgage deduction is unavailable.
Person A has $100,000 in the bank. He uses the interest on this
money to rent a house for personal living. He pays tax on the interest,
it is income.
Person B has $100,000 in the bank. He buys a house with it.
Although both people are in the same financial position, their taxes
would be quite different if mortgage interest is not deductable.
Deductability of mortgage interest makes these two people equal for
tax purposes.
In short a person who buys a permanent structure for personal use with
cash has "imputed income", the income they would have earned on the money
had they invested it or rented out the structure. Allowing a person to
deduct mortgage interest will make equal for tax purposes the person with
"imputed income" with that person paying mortgage interest.
Sadly, it does not do anything about the renter.
By making second loans up to the basis of the house deductable, the
government allows the homeowner who has mortgaged his house to be equivalent
to the person enjoying "imputed" income.
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The book makes reasonable a whole bunch of things and gives an intuitive
grounding for the tax law. Tax law is not as unreasonable as one may make
it out to be and much of it makes good sense.
Take depreciation for instance. Companies that buy capital goods, e. g.
oil refineries, are required to take the expense off a little at a time
rather than by deducting it in one lump sum at the time of purchase.
I used to think this was ridiculous and things would be a lot easier if
all expenses were treated identically.
If companies were allowed to deduct such purchases in full at the time
made, this would be equivalent to them not having to pay tax on the
earnings from such an investment. The book has the calculations to
prove it. Let us assume that A took a million dollars and invested it
in a plant that would return 20% in profits in ten years. If the law
had no depreciation, he could take off a million dollars from his
income for this business expense. Person B took the million dollars
and put it in the bank and earned interest. At the end of ten years,
A would be in the same financial position as B would be if that interest
was tax-free. This is because the present-value of the million dollars
deduction in year zero is so much more than the present-value
cost of a million dollars income spread out over the useful life of the
object.
In fact all the depreciation systems allowed, including straight line
depreciation give companies an advantage over the fair way to do depreciation,
on the basis of "sinking funds" which are used in taxing the income from
annuities. Congress has decided to give a tax break to capital expenditures
vis-a-vis those who simply put money in the bank.
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One of the most important points is that most of the complications of the
tax law is in determining when the taxes paid rather than if. A company
which can defer taxes from a profit can put the money paid in taxes
to work earning interest. Thus there is a substantial benefit in
saying that profit from a given transaction is not earned now but is
earned later for tax purposes.
The other issue is attribution. Let us say A buys a capital item
for $100.00 and gives it to B at a time when it was worth $150.00.
B holds it until it is worth $200.00 and sells it. Obviously there is
a $100.00 worth of capital gains to be taxed. Is it taxed at A or B's
rate?
The book has a very clear discussion of these principles including some
of the history of the development of such law and should be
read by anyone who is interested in tax laws. Both myself
and my roommate enjoyed it very much.
P. S. these are principles that transcend "tax reform" so don't worry
about buying an edition whose date is before 1986.