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Cost Segregation ATG - Chapter 6.3 - Depreciation Overview

Note: Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to return to either the previous chapter or the Table of Contents or to proceed to the next chapter.

Chapter 6.2 | Table of Contents | Chapter 6.4

Special Topics - Chapter 6.3 – Depreciation Overview

INTRODUCTION

In order to compute depreciation for assets subject to a cost segregation study, one must use the proper property classification.  The property classes control the applicable recovery period for assets, which are determined by statute or by reference to class lives.  In order to determine the proper class lives, assets must be categorized into their appropriate asset classes.  Cost segregation studies generally produce listings or groups of assets, based on asset classes under the Modified Accelerated Cost Recovery System (MACRS).  This chapter provides a summary of the applicable authorities and available guidelines for classifying property into their appropriate classes as well as guidelines for computing depreciation deductions by using the proper depreciation method, recovery period, and convention.

MACRS

Internal Revenue Code § 167(a) provides a depreciation allowance for the exhaustion, wear and tear of property used in a trade or business or held for the production of income.  The depreciation deduction provided by § 167(a) for tangible property placed in service after 1986 generally is determined under § 168, the Modified Accelerated Cost Recovery System.  MACRS prescribes two methods for determining depreciation allowances: (1) the general depreciation system in § 168(a) (“GDS”); and (2) the alternative depreciation system in § 168(g) (“ADS”).  A taxpayer generally must use GDS unless the taxpayer is specifically required to use ADS or the taxpayer elects to use ADS.  Under either depreciation system, the depreciation deduction is computed by using a prescribed depreciation method, recovery period and convention.

DEPRECIATION PERIODS AND CONVENTIONS

GDS contains ten property classes, based on the recovery period of an asset (3, 5, 7, 10, 15, 20, 25, 27.5, 39, or 50 years).  Applicable depreciation methods include the 200% declining balance method, 150% declining balance method, and straight-line method.  The depreciation methods under GDS are generally not elective, but a taxpayer may make an irrevocable election to use a less accelerated method under certain circumstances.  However, 27.5-year property (residential rental property), 39-year property (non-residential real property), 50-year property (railroad grading or tunnel bore), and certain 15-year property (i.e., qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) must be depreciated using straight-line depreciation.

ADS must be used for the following property: 1) listed property used 50 percent or less for business; 2) tangible property used predominantly outside the United States; 3) tax-exempt use property; 4) tax-exempt bond financed property; and 5) certain other finite categories of property that are not common.  In addition, a taxpayer may make an irrevocable election to use ADS for any class of property eligible for depreciation under GDS for a particular tax year.  The recovery periods under ADS are generally longer than the recovery periods under GDS, and the straight-line method must be used.

For purposes of either GDS or ADS, there are three possible conventions: Half-year, mid-month, and mid-quarter conventions.

  1. The half-year convention applies to property other than residential rental property, nonresidential real property, and railroad grading and tunnel bores.  Under this convention, the recovery period begins or ends on the midpoint of the tax year that the property is placed in service or disposed of. 
  2. The mid-month convention applies to residential rental property, nonresidential real property, and railroad grading and tunnel bores.  Under this convention, the recovery period begins on the midpoint of the month that the property is placed in service.
  3. The mid-quarter convention applies to property (other than residential rental property, nonresidential real property, and railroad grading and tunnel bores) if more than 40% of the aggregate bases of such property is placed in service during the last three months of the tax year.  Under this convention, the recovery periods for all property placed in service, or disposed of, during any quarter of a tax year begin on the midpoint of the quarter.

Note: Under all conventions, there is no depreciation deduction allowed for property placed in service and disposed of in the same tax year. 

RECOVERY PERIODS

For purposes of either GDS or ADS, the applicable recovery period is determined by statute or by reference to class life.

The recovery period of residential rental property, nonresidential real property, and railroad grading and tunnel bore are established by statute. See §§ 168(c) and 168(g)(2)(c).

  • Residential rental property has a recovery period of 27.5 years for purposes of GDS and 40 years for purposes of ADS.
    • § 168(e)(2)(A) defines "residential rental property" as any building or structure if 80 percent or more of the gross rental income is rental income from dwelling units. 
  • Nonresidential real property has a recovery period of 39 years (or 31.5 years if the property was placed in service before May 13, 1993) for purposes of GDS and 40 years for purposes of ADS.
    • § 168(e)(2)(B) defines "nonresidential real property" as § 1250 property which is not residential rental property or property with a class life of less than 27.5 years.
  • Railroad grading and tunnel bore have a recovery period of 50 years for purposes of both GDS and ADS. §§ 168(c) and 168(g)(2)(c).

§ 168(i)(12) provides that the terms “§ 1245 property” and “§ 1250 property” have the meanings given such terms by § 1245(a)(3) and § 1250(c), respectively.

§ 1245(a)(3) provides that "§ 1245 property" is any property which is or has been subject to depreciation under § 167 and which is either personal property or other tangible property (not including a building or its structural components) that was used as an integral part of certain activities

§ 1250(c) defines "§ 1250 property" as any real property, other than § 1245 property, which is or has been subject to an allowance for depreciation.  In other words, § 1250 property encompasses all depreciable property that is not § 1245 property.

§ 1245(a)(3) provides that "§ 1245 property" is any property which is or has been subject to depreciation under § 167 and which is either personal property or other tangible property (not including a building or its structural components) that was used as an integral part of certain activities.  Such activities include manufacturing, production, or extraction; furnishing transportation, communication, electrical energy, gas, water, or sewage disposal services.  Certain other "special use" property also qualifies as § 1245 property, but is not relevant to this discussion.  It is important to note that a building or its structural components is specifically excluded from the definition of § 1245 property.

Treasury Regulation (Treas. Reg.) § 1.1245-3 defines "tangible personal property," "other tangible property," "building," and "structural component" by reference to Treas. Reg. § 1.48-1.  This regulation relates to former § 48 which was enacted in 1962 along with §§ 1245 and 1250.  § 48 allowed an investment tax credit (ITC) based on the "applicable percentage" of the investment in tangible depreciable property placed in service during the taxable year.  The ITC (§ 48) was later repealed in 1986.  See the previous chapter, Legal Framework, for a description of the provisions set forth in Treas. Reg. § 1.48-1.

CLASS LIVES

§ 168(i)(1) provides that the term "class life" means the class life (if any) that would be applicable with respect to any property as of January 1, 1986, under former § 167(m) as if it were in effect and the taxpayer were an elector.  Prior to its revocation, former § 167(m) provided that in the case of a taxpayer who elected the asset depreciation range system of depreciation, the depreciation deduction would be computed based on the class life prescribed by the Secretary which reasonably reflects the anticipated useful life, and the anticipated decline in value over time, of the property to the industry or other group.

Treas. Reg. § 1.167(a)-11(b)(4)(iii)(b) sets out the method for asset classification under former § 167(m).  Property is included in the asset guideline class for the activity in which the property is primarily used, regardless of whether the activity is insubstantial in relation to all the taxpayer's activities.  Thus, for depreciation purposes, a taxpayer may be engaged in more than one activity.  If a taxpayer uses assets in more than one activity, the cost of the asset is not allocated between the two activities; rather, the total cost of the asset will be classified for depreciation purposes according to the activity in which the asset is primarily used.  This determination may be made in any reasonable manner.  Note that in Revenue Procedure (Rev. Proc.)  97-10, 1997-1 C.B. 628, either a gross receipts test or a square footage test was used to determine whether a building was primarily used as a retail motor fuels outlet.

For example, assume that a taxpayer owns and operates a hotel/casino complex.  The taxpayer is engaged in two business activities: casino operations and hotel operations.  Assets used by the taxpayer in its casino operations are includible in the activity category that includes casino operations (asset class 79.0 Recreation of Rev. Proc. 87-56).  Assets used in hotel operations are includible in the activity category that includes hotel operations (asset class 57.0 Distributive Trades and Services of Rev. Proc. 87-56).  If a particular asset is used in both activities, the total cost of the asset will be classified for depreciation purposes according to the activity in which the asset is primarily used; the cost of the asset is not allocated between the two activities.  The determination of primary use may be made in any reasonable manner.  For additional information, see IRS FSA 200203009.

Asset classifications are based on how the asset is primarily used.  In the case of a lessor of property, the asset class for such property is determined as if the property were owned by the lessee.  See Treas. Reg. § 1.167(a)-11(e)(3)(iii) and the following court cases for additional information and consideration.

  • Clajon Gas Co. L.P. v. Commissioner, 354 F.3d 786 (8th Cir. 2004), rev’g 119 T.C. 197 (2002):  Pipelines leased to producers to transport natural gas fell under the asset class for producing natural gas regardless of ownership.
  • Saginaw Bay Pipeline Co. v. United States, 338 F.3d 600 (6th Cir.2003), rev’g 124 F.Supp.2d 465 (E.D. Mich. 2001):  Every natural gas carriage pipeline which functions as a gathering pipeline is in the methane gas production process irrespective of the primary business of the owner of that pipeline.
  • Duke Energy Natural Gas Corp. v. Commissioner, 172 F.3d 1255 (10th Cir.1999), rev’g 109 T.C. 416 (1997):  Based on the asset's primary use, the classification of natural gas gathering systems constituted as assets used in the production of natural gas.

As stated earlier, GDS contains ten property classes, based on the recovery period of an asset.  For those classes of property not established by statute, the applicable recovery period is determined by reference to class life.  See § 168(e)(1).  It is also worth noting that Qualified Indian reservation property, however; generally have shorter applicable recovery periods.  See § 168(j)(1)-(2).

REVENUE PROCEDURE 87-56

Revenue Procedure 87-56, 1987-2 C.B. 674, sets forth the class lives of property that are necessary to compute the depreciation allowances under § 168 (MACRS).  The revenue procedure establishes two broad categories of depreciable assets:

  1. Asset classes 00.11 through 00.4 that consist of specific assets used in all business activities.
  2. Asset classes 01.1 through 80.0 that consist of assets used in specific business activities.

The same item of depreciable property can be described in both an asset category (asset classes 00.11 through 00.4) and an activity category (asset classes 01.1 through 80.0).  In this situation, the item is classified to the asset category unless it is specifically excluded from the asset category or specifically included in the activity category.  For additional guidance see below:

  • Norwest Corporation & Subsidiaries v. Commissioner, 111 T.C. 105 (1998) (item described in both an asset and an activity category (furniture and fixtures) should be placed in the asset category)
  • Rev. Rul. 2003-81, 2003-2 C.B. 126 (an asset included in both an asset category and an activity category is placed in the asset category, unless it is specifically excluded from the asset category or specifically included in the activity category).

Revenue Procedure 87-56 contains tables of class lives and recovery periods. To properly utilize Rev. Proc. 87-56, the following steps are suggested:

  1. Check Asset Classes 00.11 through 00.4 that consist of specific assets used in all business activities to see if it contains a description of the asset in question. 
    1. Refer below to Step 2 (if the asset is described in an asset category) or to Step 3 (if the asset is not listed in an asset category).
  2. If the subject asset is described in one of the asset categories, then check asset classes 01.1 through 80.0 that consist of assets used in specific business activities to find the activity to which the property relates or in which it is primarily being used. 
    1. If the activity is described in one of the activity categories, read the text (if any) under the title to determine if the property is specifically included in the activity category. 
    1. If it is, then use the recovery period shown for the activity category following the description of that activity. 
    1. If the property is not specifically included in the activity category, or if the property is specifically excluded from the activity category, then use the recovery period shown in the appropriate asset category.
  3. If the asset is not listed in an asset category, then find the activity to which the property relates or in which the property is primarily being used, and use the recovery period shown in the appropriate column following the activity category description. 
    1. If the property is not listed in an asset category and the activity to which it relates is not included in one of the activity categories, then the property should be categorized in "Certain Property for which Recovery periods Assigned (Personal Property/§ 1245 Real Property With No Class Life)."  Property in this category generally has a recovery period of 7 years for GDS or 12 years for ADS.  Please note that there are very few assets that fall under this default category.

EXAMPLES

The following examples illustrate the use of Rev. Proc. 87-56 for determining the proper asset recovery period.  See also Appendix B of IRS Publication 946.

Example 1: Richard Green is a paper manufacturer.  During the year, he made substantial improvements to the land on which his paper plant is located.  Assume that these land improvements are depreciable property.  He checks the asset categories and finds land improvements under Asset Class 00.3 Land Improvements.  He then checks the activity categories and finds his activity, paper manufacturing, under Asset Class 26.1, Manufacture of Pulp and Paper.

If Richard had only looked at the asset categories, he would have erroneously selected Asset Class 00.3, Land Improvements, and would have incorrectly used a recovery period of 15 years for GDS or 20 years for ADS.  However, Richard uses the recovery period under Asset Class 26.1 Manufacture of Pulp and Paper, because it specifically includes land improvements.  Thus, the land improvements have a 13-year class life and a 7-year recovery period for GDS.  If he elects to use ADS, the recovery period is 13 years.

[Note: It is presumed in this example that the subject land improvements are directly associated with the factory site or production process, for example, effluent ponds or canals necessitated by the production process, or parking lots utilized by employees directly involved with the production process. However, those land improvements that are more closely associated with non-production activities, such as administrative or retail activities of the taxpayer, would be categorized in Asset Class 00.3 Land Improvements and have a 15-year recovery period under GDS. See Rev. Rul. 2003-81, 2003-2 C.B. 126.]

Example 2: Sam Plower produces rubber products.  During the year, he made substantial improvements to the land on which his rubber plants are located.  Assume that these land improvements are depreciable property.  He checks the asset categories and finds land improvements under Asset Class 00.3.  He then checks the activity categories and finds his activity, producing rubber products, under Asset Class 30.1, Manufacture of Rubber Products.  Reading the headlines and descriptions under Asset Class 30.1, Sam finds that it does not specifically include land improvements.  Therefore, Sam uses the recovery period for Asset Class 00.3 Land Improvements.  Thus, the land improvements have a 20-year class life and a 15-year recovery period for GDS.  If he elects to use ADS, the recovery period is 20 years.

Example 3: Pam Martin owns a retail-clothing store.  During the year, she purchased a desk and a cash register for use in her business.  She checks the asset categories and finds office furniture under Asset Class 00.11 Office Furniture, Fixtures, and Equipment.  Cash registers are not specifically listed in any of the asset categories.  She then checks the activity categories and finds her activity, retail store, under Asset Class 57.0 Distributive Trades and Services, which includes assets used in wholesale and retail trade.  The description for this asset class does not specifically list office furniture or a cash register.

She looks back at the asset categories and uses Asset Class 00.11 for the desk, since it constitutes office furniture.  Thus, the desk has a 10-year class life and a 7- year recovery period for GDS.  If she elects to use ADS, the recovery period is 10 years.  For the cash register, Pam uses Asset Class 57.0 Distributive Trades and Services, because cash registers are not specifically listed in one of the asset categories but are assets used in retail business.  Accordingly, the cash register has a 9-year class life and a 5-year recovery period for GDS.  If she elects to use the ADS method, the recovery period is 9 years.

ADDITIONAL REFERENCES FOR DETERMINING THE PROPER ACTIVITY CATEGORY FOR PROPERTY

The Standard Industrial Classification Manual (SIC) published by the Office of Management and Budget can provide insight into the content of the asset classes described in Rev. Proc. 87-56.  Care must be exercised because SIC does not make use of the same classification techniques and depreciation concepts of Rev. Proc. 87-56.  While SIC has precise categorization by primary business activity using language very similar to that found in Rev. Proc. 87-56, the revenue procedure departs dramatically from the categorization scheme of SIC by establishing two broad categories of depreciable assets: (1) asset classes 00.11 through 00.4 that consist of specific assets used in all business activities; and (2) asset classes 01.1 through 80.0 that consist of assets used in specific business activities. However, the asset class numbers for the specific business activities described in Rev. Proc. 87-56 are largely taken from SIC.

Additionally, it may be helpful to look at the North American Industry Classification System (NAICS).  NAICS was introduced in 1997 to replace the SIC system and more closely reflects the many new industries that have propagated since the establishment of the SIC system in 1937, including many service industries currently under-represented in the SIC system.  Although the manner of categorization is similar under both SIC and NAICS, the category codes are vastly different, which is why the Service generally does not look to NAICS for insight purposes.  However, NAICS can be helpful (because of its expanded description of service industries) in determining in which one of two activity categories, a particular asset should be categorized.

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