Recently, the first two pages of President Trump’s 2005 tax returns were leaked to the American people. In response to one of the many questions about the tax returns, Mr. Trump’s spokesperson explained a deduction of roughly $100 million by saying that he had a “large-scale depreciation for construction” in 2005.
What does that mean? I don’t know the exact details of Mr. Trump’s financial situation, but let’s consider how tax rules are applied to real estate developers as opposed to average Americans. We will use the Trump International Hotel and Tower which was under construction in Chicago at that time as an illustrative example - but please note, this may not be the building on which he claimed depreciation.
Investing money in a project to get a return in the future is a good thing. America’s market has boomed from this idea. We even have preferential tax rules for long term capital gains in order to encourage this type of investment.
If you have some savings, and invest your savings in something (like stocks or a mutual fund) you have no tax consequences when you make your investment. When you sell it years later, you pay taxes at the preferential rates on whatever amount of profits you made.
So how is it different for real estate moguls?
Back in season one of The Apprentice (this tax return is from over a decade ago), the winner, Bill Rancic, won and got the assignment to oversee The Trump International Hotel and Tower which Mr. Trump’s organization was building in downtown Chicago.
Constructing that large building required investing hundreds of millions of dollars in the project, which would not have any return for several years. The Trump organization borrowed most - maybe all - of the money. Major lenders included $640 million from Deutsche Bank and $130 million from affiliates of Ken Griffin (the billionaire hedge fund manager).
We would expect that Mr. Trump’s organization would buy the building (the previous headquarters of the Chicago Sun-Times) spend some hundreds of millions of dollars building condominium apartments there (and paying interest on all of the money they borrow) and eventually pay some capital gains taxes when they sell the expensive condominium apartments years later.
That is not quite the way it works in big-time real estate.
First, unlike you when you invest your savings in mutual funds, a smart real estate developer gets to call a large part of his investment an “expense” and therefore have negative income (which he can apply against other income from other projects). Even though Mr. Trump, with the help of Mr. Rancic and others, greatly increased the value of that piece of Chicago, he is allowed to maintain the legal fiction that the value actually goes down over time, and he is losing money. That is called “depreciation”.
- If you buy a building and fix it up, you get to deduct all of those costs over a period of years.
- A real estate developer (if he develops a building and rents it out) can be making a lot of money, but have a loss for tax purposes. He will tell you that he will eventually pay the taxes, but eventually may never happen in many cases (such as still owning the building when he dies).
The more terrifying possibility is that the real estate developer could wait to just change the tax rules once he is in a position to do so. I am eagerly waiting to see this year’s tax reform legislation to see just how wealthy real estate developers, amongst other wealthy individuals, are treated.