Why the IRS Thinks California Chrome is Different

June 12, 2014

The race horse, California Chrome, recently in the news for his attempt at the Triple Crown, may be different than other horses according to the IRS, and it all has to do with the complicated depreciation system in the U.S.

The tax code has different guidelines on how all horses are to be treated depending on the age, dates of service, and type of horse. Horses are capital assets and tax law requires that all capital assets must be depreciated for tax purposes.

When a firm purchases a new piece of equipment or building (or horse), the investment is not immediately taken out of revenue, but instead deducted in stages, over time. The deduction of the cost of capital over time is called depreciation. The time over which an asset is depreciated is determined by the IRS and Congress.

So how does the tax code see horses like California Chrome?

There are five different asset classes just for horses. According to the IRS, a young race horse and an old horse are different assets, but both had “useful lives” of three years until December 2013 when the tax extenders package expired. At that time, a young race horses’ useful life was extended by four years. Other horses that are neither young race horses, nor normal old horses have useful lives of seven years.

One can observe other seemingly arbitrary asset lives throughout the IRS’s guidelines. What do nuclear fuel assemblies, telephone equipment, and an office chair have in common? The IRS has determined they all have useful lives of five years.

This is a major problem with using depreciation in the tax code. The government is placed in the awkward position of defining asset lives for almost any capital asset you can imagine, despite the fact that an assets’ useful life depends on maintenance, frequency of use, and any number of other factors. The results of trying to simulate this through depreciation policy makes for a regime that is seemingly arbitrary.

Not only do depreciation schedules make little sense in terms of useful lives, they make even less economic sense. Any time a firm is required to depreciate an asset, the assets’ after tax return is diminished because the write off loses value over time. Furthermore, during the depreciation period, the firm is essentially providing an interest free loan to the government by paying the taxes on income before the assets’ cost is full deducted from their balance sheet.

In an ideal world, capital assets could be written off immediately--“expensed.”

If instituted for all assets, full expensing would increase wages, boost the capital stock, and grow the economy. That’s a triple crown that we would all like to win.

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