8. Declining Balance Method of Depreciation — Increasing Tax Bite

Look at these figures which are typical and which are taken from an actual syndicate. They show the estimated percentages and amount of annual distribution on which the investor must pay income taxes during the first five years based on an investment of $5,000.

Total                           Taxable                      Taxable
Cash                           Amount                     Percentage
Distribution
1st year                          $500                       $129.25 25.85%
2nd year                         $500                       $181.75 36.35%
3rd year                          $500                      $233.00 46.60%
4th year                          $500                      $283.00 56.60%
5th year                          $500                      $335.55 67.11%

If you invest in this syndicate, you should ask two questions. First, why must you pay every year income taxes on a larger portion of your distribution? Second, is this going to go on the same way so that in a few years you will have to pay income taxes on everything you receive?

To answer your first question, we must tell you a little more about depreciation. Suppose you have a building that has an estimated useful life of 25 years. The syndicator could set aside every year a 4% deprecitaion reserve amounting to 4% of the value of the building. (No de­preciation reserve is allowed for the land. It does not have to be replaced or become obsolete). The sum set aside would not be subject to income taxes. Our tax laws offer an alternative. The syndicator may use the so-called declining balance method of depreciation. In plain English, during the first year he may set aside a larger de­preciation reserve—6% in the above example—and in later years correspondingly a smaller depreciation re­serve. (Less than 4% in our example).

Chances are that the syndicator uses the declining bal­ance method or another depreciation method which per­mits a faster depreciation during the first years and in turn requires a lower depreciation rate in subsequent years. That is why at the beginning of a syndication, a small portion of your distribution will be subject to in­come taxes and in later years you will have to pay income taxes on an ever-increasing portion of your distribution.

To answer the second question—will there be a time when you will have to pay income taxes on everything you receive?—that time will definitely come. The real question is when will that time come.

You must, therefore, look for two things in the bro­chure. What portion of your distribution is taxable now and in future years. When does your full distribution be­come taxable. This information is vital. After all, if you receive $500 tax free on a $5,000 investment, you have a 10% return. If you pay 40% taxes on your $500, you retain $300 and your return is 6%.

Take one more look at the columns of figures set out at the beginning of this chapter. You will notice that they are projected for only five years, that each year about 10% more of the distribution becomes subject to income taxes. If the computations had been extended for another five years, you would probably notice that beginning with the 9th year, your total distribution would be fully taxable. If in your brochure the estimated taxable and estimated non-taxable portions of your distributions are projected for only a few years, you may safely assume that it won't be long before your entire distributions will be fully subject to income taxes.

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