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I don't understand why an investor is forced to depreciate a rental property. In many cases (say for an investor with one rental unit only) the depreciation amount is less than the standard deduction so for someone with not much else to deduct it really does not bring any value. It is actually worst than taking the standard deduction as the investor ends up somehow paying back the tax return at some point.. What is the logic behind it?

example from https://www.investopedia.com/terms/d/depreciationrecapture.asp

For example, consider a rental property that was purchased for $350,000 and has an annual depreciation of $20,000. After 11 years, the owner decides to sell the property for $430,000. The adjusted cost basis then is $350,000 - ($20,000 x 11) = $130,000. The realized gain on the sale will be $430,000 - $130,000 = $300,000. Capital gain on the property can be calculated as $300,000 - ($20,000 x 11) = $80,000, and the depreciation recapture gain is $20,000 x 11 = $220,000.

Let’s assume a 15% capital gains tax and that the owner falls in the 28% income tax bracket for 2017. The total amount of tax that the taxpayer will owe on the sale of this rental property is (0.15 x $80,000) + (0.28 x $220,000) = $12,000 + $61,600 = $73,600. The depreciation recapture amount is, thus, $61,600.

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    Depreciation isn’t an itemized deduction, so it is in addition to either itemized deductions or the standard deduction.
    – prl
    Mar 10, 2019 at 6:10
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    In theory the recapture amount should equal the tax benefit previously received from the depreciation. Of course, due to progressive tax brackets and inflation, it may not be.
    – prl
    Mar 10, 2019 at 6:12

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First off, some corrections:

  1. If the rental depreciation causes a loss, you still can deduct it separately from your income even if you use the standard deduction. If you are unable to deduct the loss because your income is too high or you maxed out the allowed deduction, the losses are carried forward until you have future passive income to offset, or you sell the property.
  2. Looks like the investopedia article has a minor mistake in it. The example tax rate of 28% on depreciation recapture maxes out at 25% even if your personal tax rate is higher than that.

Now with #1 in mind, you don't have to be (as) concerned with being forced to take depreciation and "paying it back" when you sell, since you shouldn't normally lose it unless you forget to depreciate each year. For the most part, it is to your advantage to be able to take the losses on a yearly basis rather than having to wait until you sell the property (so you can re-invest the tax savings if you wish).

That being said, I can think of some possible downsides of being forced to depreciate:

  • If you have rental losses and your regular income is so low that you can't even use all of the loss that year, you will lose some of the deduction. Carrying forward your losses is also not optional; you can only carry forward losses that are eligible (due to income and caps per year).
  • Forcing you to depreciate almost necessitates the average person getting assistance in preparing their taxes.
  • If you are in a lower tax rate while you are depreciating, and then you are in a higher rate when you sell the property, you could pay more total taxes on depreciation recapture than the sum total you depreciated.

As for your actual question of why is depreciation mandatory? It's hard to know what went through the minds of Congress when the law was drafted, but it's probably fair to say that the idea of depreciation was created as a tax benefit that most property owners would prefer to have. Making it mandatory does simplify the paperwork since you can assume everyone must recapture upon sale, and potentially reduces fraud from those that would otherwise try to claim it doesn't apply to them.

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    Nice. As I started to read, I was focused on "why mandatory" and while it wasn't the bulk of the answer, the "why" of much of the tax code is either "because someone wanted to do it, and others agreed" or borders on too political an answer. My own answer would have been that huge property owners also own a number of congressmen. And I'd get called out for posting....
    – JTP - Apologise to Monica ♦
    Mar 10, 2019 at 15:53
  • This makes a lot more sense now indeed. Thanks.
    – NicolasW
    Mar 12, 2019 at 2:29
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Suppose that the rental real estate was bought without a loan. Then the depreciation system prevents the cost of the rental real estate from being taken as an immediate business expense in total.

Then suppose that the rental real estate was bought with a loan. The payment of interest on the loan is a business expense but the payment of principal on the loan is not a business expense. So the real estate depreciation is needed so as to approximately make the principal of the loan a business expense.

The cost of the rental real estate, in the form of yearly depreciation, sets against the income that the property produces and that on the profit/loss accounting.

The profit/loss accounting relates to the cost of doing business. The balance sheet has a different purpose in that it could relate to long-term investment.

Real-estate-investment-trusts, for instance, usually feature funds-from-operations and don't include depreciation in that profit/loss accounting. But the actual bottom-line earnings do include deprecation in the profit/loss accounting. The bottom-line earnings would be what the shareholders of the REIT pay taxes on.

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