Consider the following:
Mary and John are attorneys who both are in the 25% marginal tax bracket. They are equally productive and efficient in their work as attorneys. They both own houses that need a paint job. The cost of hiring a painter to paint their homes is $9000.
- John hires a painter to paint his house. In order to pay the painter, John must work six extra weekends in order to earn another $12,000. After paying $3000 in taxes, John can then pay the painter $9000. For having worked to earn an additional $12,000 and paid $3000 more in income tax, John will have a house with a $9000 paint job – which he will commence “consuming.” John had to pay $3000 in income taxes in order to consume $9000.
- Mary decides to do the job herself on five successive weekends. The fmv of these services is $9000. When she has completed the job, Mary will have a house with a $9000 paint job – which she will commence “consuming.” Mary paid nothing in income taxes in order to consume $9000.
Notice: John was able to earn $2000 per weekend. Mary “earned” $1800 per weekend. Mary is not as productive or as efficient a painter as she is an attorney. (Otherwise she should give up practicing law and take up house painting.) Nevertheless, Mary expended fewer resources in order to acquire a painted house than John did. How?
- The answer lies in the fact that John had to pay income tax on his “consumption,” and Mary did not.
- Services that one performs for oneself give rise to “imputed income.”
- As a matter of administrative practice and convenience, we do not tax imputed income.
- As the facts of this hypothetical illustrate, not taxing imputed income causes inefficiency. Mary would create more value by practicing law on the weekends than by painting.
- Not taxing imputed income also causes distortions because from Mary’s point of view, not taxing her imputed income encourages her to perform more services for herself – so long as the cost of her inefficiency is less than the income taxes that she saves.
- In addition to these inefficiencies and distortions, not taxing imputed income derived from performing services for oneself costs the U.S. Treasury money. Obviously, we should not be concerned about de minimis amounts, e.g., mowing our own lawns. But one major source of lost revenue is the non-taxation of imputed income derived by the stay-at-home parent.
Eileen and Robert are both in the 25% tax bracket. Assume that the annual rental rate for a home is 10% of the home’s fmv. Both Robert and Eileen have accumulated $250,000. The income necessary to accumulate this money has already been subject to income tax. Prevailing interest rates are 8%.
- Robert elects to take the $20,000 return on his investments to pay the rent on a house valued at $150,000. After paying $5000 in income taxes, he will have $15,000 with which to pay rent. His investment will not grow because he uses his entire return on investment to pay income tax plus rent.
- Eileen elects to change the form in which she holds some of her investment and to use $150,000 to purchase a house. She will still have $100,000 invested. Eileen can live in her house rent-free and will earn a 6% (i.e., 8% − (25% of 8%)) after-tax return on her investment, compounded annually. See table 1 in the discussion of Bruun, supra. In less than 16 years, Eileen will have $250,000 PLUS she will own a $150,000 home (assuming that it does not lose value; in fact its value might increase).
Notice: Obviously Eileen came out ahead of Robert. Both Eileen and Robert started with the same wealth and lived in the same type of house. How did Eileen do so much better than Robert?
- Again, Robert had to pay income tax on his consumption while Eileen did not.
- The fair rental value of property that a taxpayer owns is also imputed income, and it is not subject to income tax.
- As the facts of this hypothetical illustrate, not taxing imputed income causes inefficiency because it encourages taxpayers to invest in a certain type of asset in preference to other
investments only because of certain characteristics of the property.
- In the not-so-distant past, the fmv of a house did not usually decline.
- A house is something that a consumer can and wants to consume.
- Not taxing imputed income derived from ownership of property increases a taxpayer’s return on investing in such property. Eileen received $15,000 worth of rent annually on her $150,000 investment – a tax-free return of 10%. A net after-tax return of 10% subject to 25% income tax would require a before-tax return of 13.33%.
- A major source of lost revenue to the Treasury through the non-taxation of the fair rental value of property that taxpayer owns results from Americans’ widespread ownership of homes – and the ownership of homes that are more expensive than what many taxpayers would otherwise purchase.
- Perhaps the risk-adjusted return on Turkish apricot futures is greater than the 10% return Eileen so easily consumed on her investments, but Eileen will not choose to maximize her
investment return in this manner unless the return on such an investment is greater than 13.33%. The Tax Code assures that many taxpayers will prefer to purchase assets such as homes rather
than make investments with higher before-tax returns.
- In the event that not imputing the fair rental value of property to its owner as taxable income is not sufficient incentive to invest in homes –
- § 163(h) permits deduction of mortgage interest on up to $1,000,000 of indebtedness incurred to purchase a home or of interest on up to $100,000 of home equity indebtedness.
- § 121 permits exclusion from gross income of up to $250,000 of gain from the sale or exchange of a taxpayer’s principal residence under prescribed circumstances.
- § 164(a)(1) permits a deduction for state and local, and foreign real property taxes. 1
- Of course, these rules greatly increase demand for houses. Without question, the Tax Code has distorted the market for houses and increased their fmv.
- In the event that not imputing the fair rental value of property to its owner as taxable income is not sufficient incentive to invest in homes –
Now consider whether taxpayer realizes less gross income upon receipt of a benefit for which his employer paid cash when he foregoes the opportunity to earn imputed income.
Problem: Taxpayer Koons entered into a contract of employment with Aerojet General Corporation (Aerojet) to work at its plant near Sacramento, California. Aerojet agreed to pay taxpayer’s travel and moving expenses of Koons to move himself and his family from Big Springs, Texas to Sacramento. This included the cost of hiring a moving company to move his furniture and belongings. Aerojet reimbursed Koons for his payment to the movers, whose charges were no more than their fmv. In 1959, there was no deduction or exclusion for this expenditure (see §§ 217, 132(a)(6), 62(a)(15)) , so Koons had to include Aerojet’s reimbursement in his gross income. Koons paid the income tax on the reimbursement and sued for a refund. At trial, he offered to show that the value to him of hiring a moving company was much less than its cost. He also offered to show that had he known that the cost of moving was taxable income, he would have rented a trailer and done most of the work himself. He had done this on five other occasions. Koons argued that he should include in his gross income only the rental cost of a trailer.
- Should a trial court judge sustain the United States’s objections to his offer of proof as irrelevant?
- Must taxpayer Koons include in his gross income the fmv of the services rendered, or some lesser amount?
- See Koons v. United States, 315 F.2d 542 (1963).
- How well does the argument “I could have done it myself for a lot less money” square with the tax rules governing imputed income? – with SHS?
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