I just rough drafted this in response to a question about depreciation recapture. If you know taxes, please ignore that this is pretty inaccurate terminology wise, but captures the gist of what the questioner really wanted to know:
Taxpayer: So I bought this house for $150,000 and I'm renting it out to people. Since I spent $150,000, I get to deduct that, right?
Taxpayer: Why not?
IRS: Because then every business would buy a bunch of really expensive crap on credit, and deduct it from their taxes, and never pay any taxes. I’ll tell you what, you can deduct the mortgage interest, real estate taxes, insurance and pretty much everything else you spend, just not the house.
Taxpayer: Well that’s kinda fair, but I am ultimately going to pay $150,000 back to the bank, so I should be able to deduct it. And what about the people who pay cash? Can they deduct it?
IRS: Nope. Still too big of a deduction, besides, the house is probably going to go up in value.
Taxpayer: Yeah, and then you’ll make me pay taxes on the gain!
IRS: Exactly! How about this, we’ll let you deduct a little of the house, every year, until you’ve deducted it all. We’ll pick a perfectly common sense and easy to calculate number, like…27 and a half!
Taxpayer: 27.5? That’s your perfect, logical and sensible number.
IRS: Yep. You can deduct 1 twenty-seventh and a half of the house’s value every year until you’ve deducted the full value.
Taxpayer, Well, it’s a little stupid, but I guess it’s fair.
IRS: BUT! Since we’re letting you deduct a number that’s not real (since you didn’t actually pay it during the year) you subtract it from what you paid for the house when figuring out the gain when you sell it.
Taxpayer: Now that’s just stupid!
IRS: Not really. If we let you deduct the whole $150,000 right up front, it would only make sense that when you sold the house you have to pay taxes on every penny you make on the sale, so we’re just doing the same thing.
IRS: One Twenty-Seventh and a Half at a time.
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