Taxing Sales of Depreciable Assets

Abstract

Investors in depreciable assets used in a trade or business claim depreciation deductions following investment, and upon sale or other disposition of their assets are taxed on gain or loss equal to differences between amounts realized and adjusted basis. The taxation of these realized gains and losses is asymmetric: losses are deductible against ordinary income, whereas a portion of the gain on sales of personal property, and virtually all gains on sales of real property, are taxed at more favorable capital gain tax rates. Evidence from U.S. tax returns in 2012 indicates that the aggregate annual magnitude of the tax saving due to the asymmetric taxation of these gains and losses is relatively modest, roughly between $800 million and $1.71 billion. This paper considers the policy basis of this asymmetric tax treatment, noting that depreciation rules together with the elective nature of sale and realization implies that the tax system inefficiently discourages sales of depreciable business assets on which taxpayers have unrealized gains. In order to maintain efficient reallocation of used assets it is necessary to tax realized gains rather lightly. Taxpayers with unrealized losses on depreciable property have the option of retaining or discarding the property, in the first case claiming subsequent depreciation deductions against ordinary income and in the second claiming an immediate ordinary loss. The availability of these options implies that limiting the tax rate applicable to deductions for losses on sales of depreciable assets again would also inefficiently discourage asset sales. Consequently, the elective nature of asset sales implies that an efficient system imposes asymmetric taxes on gains and losses from sales of depreciable assets.