Wear and Tear and Obsolescence

In previous chapters we examined the tax effects of de¬preciation. The major feature which we examined was, that every year you may keep some of the money which comes in without having to pay income taxes. To under¬stand other aspects of depreciation we will forget about the syndicate for a moment. Think of your building or any property which you use in your own business. To the extent your building or your property wears out and de¬preciates in value because of such wear and tear you suf¬fer a loss. The money set aside makes up for the loss. The building or property owned by the syndicate is subject to the same wear and tear as the building or property owned by you individually and has the same privileges with re¬spect to depreciation reserves. You as an investor obtain your share of such depreciation allowance by distribu¬tions which are free from income taxes.

Depreciation is not only a tax feature. Uncle Sam gives you the tax benefits for good reasons. Equipment does wear out and does become obsolete. Buildings have a long useful life but do not last forever. You want to know how you are affected by all this. There are several an¬swers. It is best to examine some illustrations.

Depreciation of a Lease-Hold

Suppose the syndicate acquires a 50 year lease-hold. This means that the syndicate does not acquire owner¬ship of the land and building but leases it for 50 years with the right to sublet or make its own leases with the tenants during that period. The source of the income and profit of the syndicate will be the difference between the rent which the syndicate will have to pay to the owner and the rent which the syndicate collects from sub¬tenants. It is not difficult to see that after the expiration of 50 years the syndicate will not have any property left from which it could derive any profits. Its own lease will have expired. Consequently at the end of 50 years the syndicate will not be in a position to sub-let to other ten¬ants. Its sole source of profits has ceased to exist. If this hypothetical syndicate claims every year 2% depreciation based on the cost of its lease-hold, it will hit it exactly on the nose. At the end of 50 years it will have claimed 100% depreciation (50 times 2%), and it will have noth¬ing left.

If during these 50 years the syndicate paid you 12% on your investment each year, 2% was really a return of the money which you invested and only 10% was income, less income taxes of course. If the distribution amounted to 10%, the same 2% was a return of capital and only 8% was income, again less your income taxes. The depre¬ciation allowance claimed corresponded exactly to the actual yearly diminution in value. To restate this once more in plain language: part of the money which was distributed to you every year was a repayment of the money which you invested. It was not profit.
When a leasehold is syndicated, you should clearly consider a part of each payment to you as a return of cap¬ital, because the life of the lease is running out, slowly but surely.

Next: Depreciation of a Building