A Lesson in Depreciation

You may be tempted to skip this part and leave it to the tax expert. Don't. You simply must know something about depreciation. We will try to keep it simple.

Suppose you use a car in your business. You buy a new car for $3,000. After five years, it is worthless. You have to shell out another $3,000 to buy a new car (if you are lucky and the price has not gone up). Where is the money to come from to buy that replacement car if you have to pay high taxes on every dollar that you take in during these five years? Uncle Sam has a heart. He knows about your troubles. He knows that your car depreciates to the point where it has no more value. In our example, he permits you to set aside every year one fifth of the car's cost or $600 on which you do not have to pay taxes. So, at the end of five years, you will have put aside the $3,000 to buy your new car.

To give another illustration, after a number of years, you may have to replace a machine which, although still in good working condition, is obsolete. Here too, you are permitted every year to set aside a certain sum tax free to replace that obsolete equipment. The money which you may set aside or pocket each year without having to pay income taxes is called a depreciation allowance or depre­ciation reserve. This is to compensate you for the loss in value of the equipment which you use in your business, and to permit you to accumulate the funds to buy new equipment.

Depreciation Applied to Real Estate

The traveling salesman uses the car in his business. The manufacturer uses machines. In a syndicate—your equipment—your means of making money is the build­ing which is owned by the syndicate. The building, like any other piece of equipment, is subject to wear and tear and to obsolescence. The tenants, users, and the elements all cause the wear and tear. But do not underestimate ob­solescence. Walk-up apartment houses will not find ten­ants when there are enough apartment houses with ele­vators. Air conditioned apartments will draw tenants from older houses. Office buildings have similar prob­lems. Just walk along Park Avenue in New York City or Main Street of your home town and look at all the new buildings. The owners did not tear down the old struc­tures because they were in the mood to build. They had to put up more modern buildings to meet competition.

The useful life of a building and the deduction per­mitted for depreciation depends on the type, age and the condition of the structure. But a part of the distribution of the syndicate will represent depreciation reserve, or funds which the syndicate may set aside for depreciation, and you will not have to pay income taxes on that part. Be sure to check the brochure to find out what portion of the distribution is subject to income tax and what portion exempt.

New York State law requires that your brochure state how much of the contemplated distributions are income and how much return of capital. Many other states have similar legislation or are in the process of enacting simi­lar laws.

At some time in the future the depreciation allowance will come to an end. All distributions which you receive thereafter are fully subject to income taxes. The reasons are simple. If the syndicate bought a building for $500,000 and over the years it received $500,000 for de­preciation, there is no need to worry anymore about wear and tear and obsolescence. The syndicate got its money back.

Next: Declining Balance Method of Depreciation — Increasing Tax Bite