12. Why You May Have to Pay More Income Taxes Every Year

If you have read the chapter about the declining bal­ance method of depreciation, you will know that an ever-increasing portion of the distribution may become tax­able because of the choice of the method of depreciation. Now let us examine the combination of the effect of the declining balance method of depreciation and of the change in the character of the mortgage payments as we have discussed them so far.

To keep our example as simple as is possible, let us assume that 30 investors pay $10,000 each and that all that money was used to pay $300,000 cash at the time of the acquisition of the building. The investors receive 10% distribution on their investment, that is $30,000. The syndicate has to pay $60,000 every year on the $600,000 mortgage. The first year, $36,000 represents in­terest at 6%. $24,000 of that payment on the mortgage is a repayment of the mortgage debt. So far as the col­lector is concerned, we have to account for an income of $54,000, the $30,000 paid out to the investors, and the $24,000 used to reduce the mortgage. (Remember, that the interest payment on the mortgage, that is the $36,000 is a deductible business expense and not subject to taxes) .

For the first year, under the declining balance method, 6% of $800,000—the value of the building exclusive of the value of the land—that is $48,000 was claimed for de­preciation. Fifty-four thousand dollars of gross income less the $48,000 for depreciation leaves only $6,000 tax­able income. Since the investors receive a total distribu­tion of $30,000 and only $6,000 is taxable, 80% of the income is not subject to income taxes. They pay income taxes on only 20%.

Years later, the investors still get $30,000 (we hope). But then, out of $60,000 which the syndicate pays on the mortgage, $42,000 is applied to the reduction of the mortgage indebtedness. $18,000 is applied to interest. So we have to account for $72,000 to the collector, $42,000 which is used to reduce the mortgage, $30,000 which we pay to the investors. By that time the depreciation allow­ance which the syndicate may claim under the declining balance method amounts to only 2%, that is $16,000. So we have income of $72,000, less $16,000 depreciation al­lowance. That leaves a taxable income of $56,000. The investors get $30,000 in cash, but have to pay income taxes on $56,000. Each investor receives $1,000 a year, but pays income taxes, as if he had received $1,866. If he is in the 40% bracket, he pays $746 in taxes out of the $1,000 which he receives. This is an illustration, to show you what could happen. We hope that the manager of your syndicate won't let this happen. He probably can do something about it by refinancing the mortgage or by changing to another method of depreciation. But you as an investor must be aware of the risk that you are run­ning.

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