Recovery Period or Useful Life for US Federal Tax Depreciation
The Financial Accounting Standards Board promulgates a set of Generally Accepted Accounting Principles (GAAP) that essentially provide for the proper accounting and reporting of economic value and profitability. From a GAAP point of view, depreciation appears on the income statement and is a non-cash item. Depreciation reduces net profit, but not cash flow. Accumulated depreciation reduces the value of net fixed assets as well as equity.
Useful Life is a component of calculating depreciation for Financial Reporting or GAAP and was the topic of the following posting: https://moneysoft.com/useful-life-of-fixed-assets-for-tax-and-reporting-purposes.
While GAAP is largely concerned with the proper financial reporting, the Internal Revenue Service seeks to ensure the proper calculation and payment of one’s tax obligations in a timely manner consistent with the Internal Revenue Code (IRC).
- Tax depreciation allows for the recovery—over time—of the investment made in a fixed asset. While depreciation is NOT a cash cost, it is deductible against taxable income. The result is a reduction in Federal Income taxes payable.
The main components that go into calculating depreciation for tax purposes are: cost, service date, recovery period (useful life), method and convention. This article will focus on the Useful Life or Recovery Period of fixed assets for tax purposes.
The determination of an asset’s useful life for financial reporting under GAAP is a matter of management judgment. This generally works for reporting purposes. However, for tax purposes, the concept of “reasonable judgment” determined by the management of a business opens the door to contention and disputes between the IRS and taxpayers.
- In order to avoid disagreements arising from the subjective nature of management’s “reasonable judgment,” the IRC prescribes a “recovery period” based on the Class-Life into which an asset is categorized. The recovery period (useful life) is established by the Tax Code including Revenue Rulings and Procedures.
Modified Accelerated Cost Recovery System
The Modified Accelerated Cost Recovery System, or MACRS, as set forth in IRC Section 168 is the current law that governs most Federal Tax depreciation. MACRS is used for most tangible property placed into service in 1986 and later, with a few exceptions, and utilizes the Class-Life system to assign useful lives. In the Class-Life system, fixed assets fall into certain classes that have pre-defined recovery periods. The taxpayer is responsible for identifying the category into which the asset falls in the appropriate table.
There are two MACRS Class-Life Tables according to:
- (1) asset description (i.e., office furniture, fixtures and equipment) and
(2) the industry or activity in which the asset is utilized (i.e., agriculture or construction). There is a “catch all” description at the end of the industry/activity table for assets that are not elsewhere covered.
Aside for description information and class ID codes, the tables provide three columns for each asset class:
- 1. Class-Life
2. General Depreciation System (GDS).
3. Alternative Depreciation System (ADS)
The Class-Life, as the name implies, is the Life of all the assets within a given class. However, the Class-Life is generally not the same as a recovery period, which is used for calculating depreciation. The recovery periods are stated in either the GDS or ADS columns.
The GDS is generally used unless the Tax Code requires otherwise or you make an election to use the ADS.
- Examples of property where the use of ADS is required include property used in foreign countries and “listed property” (certain automobiles, trucks and other property) that is used 50% or less in a business.
You are also required to use the ADS recovery period when re-computing depreciation for Alternative Minimum Tax.
In addition, the recovery period or useful life is mitigated in a sense by Bonus Depreciation and Section 179 Expensing. If an asset qualifies, is within the limits and you elect to take both or either Bonus and Section 179, then depreciation is accelerated in the first year of an asset’s life. This reduces or eliminates (in the case of 100% bonus or 179) the effect of the recovery period on depreciation.
Misapplying the useful life tables and such can overstate or understate taxable income and one’s tax obligation. This can result in overpayment or underpayment of taxes. Overpayment is cash out and even if you file an amended return and get a refund, you still have an opportunity cost for your funds. Underpayment subjects one to penalties.
It is essential that you consult a professional for advice and guidance on any tax, accounting or legal matters. You will want to work with your tax accountant for guidance in applying the tables.