The Tax Reform Act of 1986 set up a depreciation system designed to equalize tax burdens on different types of assets. The recovery period for nonresidential structures was, however, lengthened in 1993. Economic conditions and practices that may bear on this issue have also changed. Lately, there has been some interest in reexamining this depreciation structure. For example, H.R. 4328 , The Omnibus consolidated and Emergency Supplemental Appropriations Act of 1998, mandated the Treasury Department to study current tax depreciation rules and how they relate to tax burdens. This report provides background information relating to tax depreciation of structures, including a discussion of the methods of measuring economic depreciation. The first section of this report provides a description and history of the treatment of structures under the depreciation system. The second section discusses the very complex problems associated with estimating economic depreciation rates and reviews the evidence from the economics literature on these rates. The third section compares, in light of evidence on economic depreciation, the tax burdens on equipment and alternative types of structures, how that tax burden has changed, and what changes, given economic depreciation estimates, would be necessary to restore equal tax burdens across basic asset categories. The fourth section of the paper discusses whether leverage should be taken into account in setting up depreciation rules (an argument which has been made in the past) and the evidence on leveraging rates across assets. The final section presents a brief conclusion. Under current law, nonresidential structures (such as stores and office buildings) are depreciated at a straight-line rate (equal amounts of the cost of acquiring or constructing the structure deducted in each period) over a period of 39 years. That is, for a building that costs $100,000, $2,564 (or 1/39 th ) is written off in each of the following 39 years. Residential structures are depreciated over 27.5 years. In both cases, the write-off periods are relatively long and the methods relatively slow by historical standards. Although the depreciable life for new properties was 40 years prior to 1971, during most of that period rapid methods of depreciation were available. These methods included sum-of-years-digits (SYD) and various declining balance (DB) methods. Double declining balance (DDB), for example, allows a first year writeoff that is twice as large as straight line. This same rate is applied to the undepreciated balance (rather than the original cost, as in the case of straight line methods ) so that depreciation amounts decline over time. This method would never allow the complete writeoff of assets, and taxpayers were allowed to switch to a straight-line writeoff (of the remaining balance over the remaining years). It was optimal to make this switch at the half-way point for DDB, and earlier for slower DB methods. Sum-of-years digits (where the share written off is the number of years of life remaining divided by the sum of the years in the life) is similar to double declining balance with a switch to straight-line in its pattern. The value of a depreciation allowance depends on how quickly deductions are made because payments in the future must be discounted to reflect the fact that a payment in the future is less valuable than one currently (since the current payment can be invested at interest). One can compare the value of depreciation allowances with different write-off periods and methods by summing up the present values of all of the payments. These present values depend on the interest rate. Table 1 shows the historical methods, tax lives (either prescribed or based on survey data), and present values of depreciation deductions as a share of investment, at a constant 10% discount rate. In the case of commercial real estate, the present values are smaller and the depreciation lives and methods produce writeoffs that are smaller than any time since 1954. A similar results is found for residential real estate. Although tax lives for residential structures tend to be shorter than other periods (except for 1981-86), the straight line method used is less beneficial to owners than previous methods. This assessment of history is somewhat over-simplified. Since buildings are sold from time to time, the treatment of capital gains and the rules for used buildings also have an effect on the level of tax burden assigned to buildings. For example, under current law, used assets are treated the same as newly constructed buildings, which was not always the case in the past. Component depreciation, which allows different elements of a building to be depreciated over different periods of time made assessment of depreciation rules in the past more difficult. Finally, the value of depreciation depends on the discount rate, which in turn depends on the level of inflation; during periods of high inflation, such as the late seventies and beginning of the 1980s, depreciation tended to be understated, other things equal. (As will be discussed subsequently, however, the effect of inflation on the tax burden on real estate tends to be smaller than the effect on shorter lived assets). Economic depreciation deductions reflect the part of the gross flow of income from an asset that represents the return of principal (since the asset is deteriorating). Economic depreciation also reflects that change in the market value of the asset due to the decline in productivity and/or remaining useful life of the asset. Finally, if tax deductions match economic depreciation deductions (either in each year or in total present value), the effective tax burden on an asset's returns is equal to the statutory tax rate. Determining the tax burden therefore requires an empirical estimate economic depreciation. No empirical method is entirely satisfactory. However, the following discussion outlines three major empirical approaches: vintage price comparisons, comparisons of rents, and perpetual inventory methods. There is also the approach taken by the Bureau of Economic Analysis in the National Income Accounts, which estimates useful life, with a distribution of retirement ages and with each set of assets within that distribution depreciated at a straight line rate. This method has components that are not based on empirical evidence, such as the depreciation method. Note that economic depreciation only fulfills its function of correctly measuring income if it is indexed for inflation. Depreciation is the change in the value of the asset in each period. If one could directly observe the potential sales price as an asset ages, economic depreciation could be determined. The vintage price approach is based on that fundamental. If assets were homogeneous, or if comparable assets were available, then depreciation could be determined simply by examining the prices of assets of different ages. There are several important problems and limitations with this approach. Some are more serious with real estate than with other assets, while others are less serious. Real estate is not a homogeneous asset. Properties can differ many ways that affect their value: number of square feet, number of floors, locations, and many other attributes. Real estate can be maintained well or poorly; properties with major renovations may have different values from those without major renovations. It is not easy to separate the structure from the land. Researchers normally use a hedonic index in which these characteristics are controlled for, although data are not always available for controls. Thus the value of any asset will depend on a whole range of characteristics, one of which is age. The effect of age on the asset value is, therefore, the measure of depreciation. Several specific problems have been identified with this approach aside from the general complications of heterogeneity. (1) Censored Sample Bias . Using data on used asset prices will generally underestimate depreciation (other things equal) because of a "censored sample bias." All this means is that the assets that have completely depreciated and been scrapped are absent from the sample, and thus true depreciation will be greater than measured by the estimates based on survivors. This effect can be corrected by multiplying the value of the asset at each age by its probability of survival. Many studies of depreciation have not made this adjustment. (2) The Lemons Problem . The used asset market tends to have a larger share than average of "lemons." This effect is most obvious in the used car markets: owners tend to keep their cream puffs and trade in their lemons. The owners know more about their cars than the buyers. Buyers, without personal knowledge of the characteristics of the cars tend to expect used cars to be lemons, which lowers the price and makes it even more undesirable to sell higher-quality assets. This lemons problem tends to overstate depreciation; however, it is much less likely to be a problem in markets where there are sophisticated buyers (as is likely in many real estate transactions) or where there are many other reasons for selling than unloading "lemons." (3) Vintage Value . There may be some unmeasured variable associated with particular year of construction which cannot be disentangled from depreciation. For example, if older structures were constructed more soundly, used asset values will understate depreciation, because the effect of age on value reflects two offsetting effects—a fundamental difference in the old and new structure and the effect of depreciation. Another example is when a particular vintage of structures is in particular demand (e.g. Victorian structures) because of tastes in the marketplace; such anomalies can make it more difficult to interpret the effect of the age variable and produce estimates not suitable for measuring the deterioration of new assets without those features. (4) Effect of Tax Rules. When tax depreciation does not match economic depreciation at every point in time, the tax rules themselves can alter measures of depreciation. The precise effects depend on the tax rules for new versus used assets, which have varied over time. In general, allowing the same tax life for new assets as used assets will cause depreciation to be overestimated. However, most existing depreciation studies covered years in which there were different rules for new and used assets. (5) Age-Related Heteroskedasticity .