The Parable Of Two Buildings

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Gross Revenue Building A:  
25,000 sq. ft. x $18/sq./ft. x 90% = $ 405,000
Expenses Building A:  
Operating Expenses $ 140,000
Annual Debt Service $ 220,000
Net Income $ 45,000
Income Tax Due (40%) $ 18,000
   
Gross Revenue Building B:  
25,000 sq. ft. x $18/sq./ft. x 80% = $ 360,000
Expenses Building B:  
Operating Expenses $ 160,000
Annual Debt Service $ 220,000
Net Income <$ 20,000>
Income Tax Due (40%) No Tax Due

Building A and Building B are identical in development, design, construction and size. Each building was completed at the same time and located on opposite sides of the same downtown intersection.

Upon completion, the developer sold the buildings to two different buyers and provided the long-term financing. The market allows the new owners to rent office space in their buildings at $18 per square foot per year. The only difference is in the management of the two buildings and each building’s occupancy rate. Below is a breakdown of the financial performance of each building:

Let us assume that neither building depreciated in value over the course of the first year. Building A’s vacancy rate is only 10 percent and is profitable; Building B’s vacancy rate is 20 percent and is not profitable. Owner B pays no income tax on the building he manages as he has no gain or profit. Yet owner A pays $18,000 income tax on his profits.

In our example, each building was well maintained and there was no deferred maintenance. Each building remained “whole” and only the severed income generated by the building was taxed. The tax was not levied on the source of the income (the building itself) but only on the income it produced. The tax is an indirect tax because it does not diminish the value of the source of the income. In this example, the value of the building has nothing to do with the amount of tax due.

A direct tax is a tax on ownership of the property taxed and is normally measured by the value of the property owned. For example, suppose there was a 15 percent tax on the gross revenue of each building without any allowance for deductions. Owner A would owe $60,750 and owner B would owe $54,000. In this scenario, both owners would have a difficult time covering their operating expenses and would not be able to keep up with routine building maintenance. Since the taxes would be paid ahead of “deferred maintenance,” the value of the buildings—the source of the income—would be diminished by the tax. With a backlog of deferred maintenance, the value of each building would be less at the end of the year. This tax would be a gross receipts tax and would be a tax on the source, or a direct tax. Similarly, a tax on the gross wages of a laborer himself is a direct tax, whereas the tax on the net profit from hiring the laborer is an indirect tax.


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