hey… schweser’s way is strictly for tax purposes.
say for example… you buy a house for $100,000 and you own it for 5 years and each year you straight line depreciate it down to zero.
so at the end of the five years, the book value of the house is $0 but at the same time, markets have been doing well and you sell the house for $150,000. (not exactly what always happens though right :))
well the US gov’t can’t be fooled by this and as a result they are not going to allow you to realize150,000 in capital gains because your book value is zero.
so what they do is they tax the “depreciation recapture” and the capital gain differently.
so lets say for example depreciation recapture is taxed at 40% and cap gains at 20%.
the reason why it isimportant to do it this way, is because in your ERAT, you need to know exatly what your cash flows are. in this case, taxes will be higher because 100K is taxed at 40% and 50K taxed at 20%, so total taxes are 40K + 10K = 50K instead of (150K*20%) = 30K
this obviously impacts your net present value of your investment.
another reason for why gov’ts tax effect these differently is because over the last 5 years, you have been realizing a tax shelter of the depreciation. so lets call this depreciation “phantom” depreciation since it didn’t exactly happen (ie, you ended up selling the building for higher than the purchase price anyways)… and we all know, gov’t don’t like to miss out on their taxes
hope this helps!