Saturday, June 20, 2009

United States District Court holds that depreciation is not a discontinuing expense

In my last post I discussed the United States District Court of the District of Massachusetts case of Vermont Mut. Ins. Co. v. Petit. The case concerns the fair rental value of units that have been destroyed by fire.

Under the terms of the insurance policy at issue the fair rental value awarded to the insureds following a fire is decreased by "any expenses that do not continue while that part of [the Property] rented or held for rental is not fit to live in." Such discontinuing expenses include cleaning and maintenance fees, since the owners do not have to pay such fees after the property has been destroyed by fire.

The court held that depreciation is not a discontinuing expense. In other words, the insurance award would not be lowered by the amount of depreciation the insureds report on their tax returns.

The insurer argued that depreciation is a discontinuing expense because depreciation is an expense that affects income, as demonstrated by the insureds' tax returns.

The court disagreed. It stated that depreciation "is not a cash expense, but 'an accounting function to spread the cost of an asset over its useful life.'" It noted that depreciation would not affect the insureds' cash flow on a month-to-month basis. "Moreover, because depreciation is an accounting factor for tax purposes, including it as a discontinuing expense would lead to 'inconsistent results . . . depending solely on whether the insured took depreciation in his tax return.'"

Finally, the court noted that depreciation was effectively accelerated because it was deducted from the insureds' property damages recovery. Also deducting it from their rental income would amount to double-counting.

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