The Accelerated Cost Recovery System (ACRS) established by the Economic Recovery Tax Act of 1981, along with the modifications in 1986 (MACRS), provide a radical departure from previously acceptable tax depreciation methods. A system that was once closely allied to the financial accounting concept of depreciation was changed to a mechanical computation that ignores such time-honored accounting concepts as useful life and salvage value.
Prior to 1981, tax depreciation computations somewhat mirrored financial accounting depreciation, in that the cost of an asset (less reduction for estimated salvage value) was written off over the estimated useful life of the asset using either a constant charge (straight-line) or an accelerated method. An overview of these methods is provided in the Appendix, since these computations still apply to assets placed in service prior to 1981. Likewise, the Appendix also contains a brief review of the original ACRS rules, which continue to apply to depreciable assets placed in service after 1980 and before 1987.
The Modified Accelerated Cost Recovery System (MACRS), RIA - Para. L-8100.
Four factors are necessary to determine cost recovery deductions under the MACRS procedure. These are (1) class life, (2) depreciable basis after credit reduction, (3) acquisition year assumption, and (4) recovery method. Each of these factors are discussed in the following sections.
MACRS Class Life
In general, the MACRS rules (referred to as the general depreciation system) classify property into the two broad categories of personalty (six different classes) and realty (two different classes). The six recovery classes of personalty are divided into 3, 5, 7, 10, 15, or 20-year categories. The major categories of personalty within each category are summarized in Figure 10-1. The notation class life in Figure 10-1 generally refers to the former midpoint life of the asset under the Asset Depreciation Range (ADR) System, a procedure insitituted in 1971 under the old depreciation rules. In general, this number represents an average expected useful life for the asset, as specified by Rev. Proc. 87-56, 1987-2 CB 674, and modified by Rev. Proc. 88-22, 1988-1 CB 785.
MACRS Recovery Periods - Personalty
Rev. Proc. 87-56 classifies personalty according to either (1) functional use (across all taxpayers) or (2) industries (specific assets of an industry). As to the former category, the most common MACRS classifications for general depreciation system purposes are automobiles (5 years), computers and technological equipment (5 years), and office furniture, fixtures, and equipment (7 years).
Furthermore, most items of machinery and equipment (as classified by industry) have class lives of 10 years, which places them in the 7-year MACRS "general depreciation" recovery category. Also note that personalty with no ADR class life given is classified by default as 7-year MACRS property.
Historical Note: The MACRS Concept of "Class Life"
Extract - Rev. Proc. 87-56 Property Classifications
For the current tax year, taxpayer buys and places in service in the taxpayer's trade or business: office desks, a mini computer, a heavy-duty truck, a single purpose horticultural structure, and an over-the-road tractor. Under the Table of Class Lives (reproduced in the Depreciation Tables section), these properties have class lives (in years) and are assigned to asset classes as follows:
|Property||Asset Class||Class Life|
|Single purpose hort. Structure||01.4||15|
Under MACRS, the office desks and the single-purpose horticultural structure are 7-year MACRS property; the mini computer and the heavy-duty truck are 5-year property; and the over-the-road tractor is 3-year MACRS property.
Office of Depreciation Analysis: the Ultimate Bureacracy
The MACRS rules
provide for two recovery classes of realty:
residential and nonresidential realty. Residential
realty is always assigned a recovery period of 27.5 years, and commercial realty is
assigned a recovery period of either 39 years (if placed in service after May 12, 1993) or
31.5 years (if placed in service after 1986 and on or before May 12, 1993). Residential
realty is defined as any building or structure if at least 80% of the gross rental income
of the building is derived from dwelling units6
(e.g., a residential apartment complex). All other realty is classified as non-residential
realty (e.g., commercial buildings, such as office buildings and factories).
Definition of Residential Rental or Nonresidential Real Property-Sec. 168 (e) (2)
Real Estate Depreciation Tax Tip
When is a hole in the ground a depreciable asset?
Zebra Holdings Corporation purchased a downtown building on May 6 of the current year. A total of 60% of the rents are from commercial tenants, and 40% are from condominium dwelling units. For MACRS purposes, the building is classified as nonresidential realty, and is assigned a recovery period of 39 years.
Once an asset is properly classified under MACRS it is necessary to determine the cost recovery basis of the asset. As discussed in the preceding section of this module, the tax basis is generally the total cost of the property (with certain exceptions for personal property converted to a business use). However, it may also be necessary to reduce this basis for (1) any Sec. 179 expensing election and (2) any credits applicable to the property.
As discussed in the next section, an election under Sec. 179 to expense a portion of the cost of personalty reduces the adjusted basis of that personalty. In addition, certain types of personalty qualify for special energy credits, as discussed in Module 17. Sec. 50(c)(3) provides that 50% of such credits must reduce the original cost recovery basis of the asset.
Tin Corporation spends $45,000 on solar energy property that qualifies for a special 10% energy credit. Tin must reduce the cost recovery basis of such property by $2,250, or 50% of the qualifying $4,500 credit. Tin's cost recovery basis in the solar energy property is $42,750, or $45,000 less $2,250.
The cost recovery basis of realty is also generally determined under the basic rules described in Section 1. However, Sec. 47 provides a special tax credit for either 10% or 20% of certain qualified expenditures incurred in rehabilitating a building. If a taxpayer qualifies for this credit, Sec. 50(c)(1) requires that the adjusted basis of the building (which includes such expenditures) be reduced by 100% of the allowable credit.
Marx Corporation purchased an old office building during the year for $300,000, and incurred $400,000 of renovation expenses that qualify for a 10% Sec. 47 credit, or $40,000. Marx's adjusted basis in the building will be $660,000, the total expenditure of $700,000 less 100% of the $40,000 rehabilitation credit.
The Applicable Conventions, RIA - Para. L-8701.
The general acquisition year assumption for personalty is the half-year convention, which assumes that the personalty was placed into service in the middle of the tax year. Thus, one-half year's depreciation is allowed in the year of acquisition, and one-half year will also be allowed in the year following the last full year of cost recovery under MACRS. Likewise, one-half year is allowed in the year of disposing the property, if during the MACRS life.
Brass Corporation, a calendar-year corporation, places in service $200,000 of computers (5-year MACRS personalty) on March 1, 2000. In applying the MACRS half-year convention, Brass will deduct one-half year of depreciation in 2000, a full year's depreciation in the years 2001-2004, and one-half year in the year 2005. If Brass were to sell the asset in 2003, they would deduct one-half year of depreciation on their 2003 return.
Under the original ACRS rules, taxpayers would often bunch their asset purchases near the end of the tax year in order to obtain a half-year's depreciation on such purchases under the above rules. In order to discourage such practices, Congress enacted Sec. 168(d)(3), which imposes a mid-quarter acquisition year assumption on all purchases of personalty during the tax year if more than 40% of such asset purchases were placed in service in the last 3 months of the tax year. The mid-quarter convention assumes that the asset was placed in service in the middle of the quarter, not the middle of the year.
If Brass Corporation in the previous example had placed all of its personalty in service in the last quarter of 2000, the mid-quarter convention would be used. Only 1 1/2 months of depreciation would be deducted in 2000, a full year's depreciation would be deducted in the years 2001-2004, and 10 1/2 months of depreciation would be deducted in the year 2005. If Brass were to sell the personalty in April, 2003, 4 1/2 month's depreciation would be allowed in that year (since the assets are presumed to have been sold in the middle of the second quarter of the year).
Sec. 168(d)(2) specifies a "mid-month" convention for both residential and nonresidential realty. Thus, such acquisitions are presumed to be placed in service in the middle of the month. As was true with personalty, a partial deduction based on the mid-month convention is also allowed in the year of disposition, if such disposition occurs before the end of the MACRS recovery period.
TRX Company, a calendar-year taxpayer, places a new business warehouse in service on May 28, 2000. In computing the MACRS deduction on this property, TRX will deduct 7 1/2 months of depreciation on its 2000 return, since the warehouse is presumed to have been placed into service in the middle of May. If TRX sells the warehouse on September 3, 2007, they will deduct 8 1/2 months depreciation on their 2007 return (since it is assumed that the warehouse was sold in the middle of September of that year).
The cost of depreciable property placed in service after 1986 is recovered using one of three permissable recovery methods:
(1) the 200% declining-balance method (available for the 3-, 5-, 7-, and 10-year personalty recovery classes)
(2) the 150% declining-balance method (available for the 15- and 20- year personalty classes), and
(3) the straight-line method (required for both residential and nonresidential realty).
Salvage value is ignored under MACRS, and the cost recovery computations are to reflect the applicable acquisition year assumption (half-year, mid-quarter, or mid-month convention). When the accelerated method is used (i.e., for personalty), a switch to the straight-line method is made at the optimum point.7
Optional MACRS Recovery Tables
Tables 10-1 through 10-5 disclose the five possible MACRS recovery tables for personalty. Table 1 is based on the half-year acquisition year assumption, and Tables 2 through 5 are based on the mid-quarter convention and represent each of the four possible quarters that an asset could be placed into service. Recall that the latter convention must be used if more than 40% of the personalty acquisitions were placed in service in the last quarter of the year.
Table 10-1: MACRS Personalty Mid-Year Convention
Table 10-2: MACRS Personalty Mid-Quarter Convention (Placed in Service First Quarter)
Table 10-3: MACRS Personalty Mid-Quarter Convention (Placed in Service Second Quarter)
Table 10-4: MACRS Personalty Mid-Quarter Convention (Placed in Service Third Quarter)
Table 10-5: MACRS Personalty Mid-Quarter Convention (Placed in Service Fourth Quarter)
Molson Company, a calendar-year taxpayer, placed into service an $80,000 computer on February 1 and a $20,000 printer on December 1, 2000. Assuming that these are Molson's only acquisitions of personalty during the tax year, the half-year convention applies, since only 20% of the personalty was acquired in the last quarter. Reference to Table 10-1 for 5-year personalty, mid-year convention reveals a recovery factor of .20 for the first year. Their cost recovery deduction for the year of acquisition will be $20,000, computed as follows:
Table 10-1 reflects the mid-year convention.
Assume that Molson Company sold the $20,000 printer on May 1, 2002. The full year recovery factor for 5-year property in the third year is .1920 (Table 10-1); however, this must be adjusted to reflect a half-year convention in the year of sale. Thus, Molson's cost recovery deduction for the printer in 2002 will be $1,920 ($20,000 x .1920 x 1/2).
Example - Assume the same facts as the earlier example for Molson Company,
except that placed in service dates are reversed (i.e, the $80,000 computer
was placed in service on December 1 and a $20,000 printer was placed in service
on February 1, 2000). Under these circumstances, the mid-quarter
convention applies, since more than 40% of the personalty
was acquired in the last quarter of the year. The computed MACRS deduction is
$11,000, shown as follows:
Table 10-2 reflects the mid-quarter convention, assuming that the asset was placed in service in the first quarter of the tax year.
Table 10-5 reflects the mid-quarter convention, assuming that the asset was placed in service in the fourth quarter of the tax year.
Assume that Molson Company sold the $20,000 printer on May 1, 2002. The full year recovery factor for 5-year property in the third year is .1560 (Table 10-2); however, this must be adjusted to reflect a mid-quarter convention in the year of sale. Thus, Molson's cost recovery deduction for the printer in 2002 will be $1,170 ($20,000 x .1560 x 4.5/12).
In certain instances the mid-quarter rule can be used to a taxpayer's advantage. For example, assume that BRX Corporation, a calendar-year taxpayer, placed in service $59,000 of 5-year MACRS property in January and $41,000 of 5-year MACRS property in December. Since more than 40% of the acquisitions of personalty were placed into service in the last quarter of the year, the mid-quarter rule applies and the MACRS deduction is $ 22,700. (Use Tables 10-2 and 10-5.)
Applying the half-year rule to these facts, the cost recovery deduction would be only $20,000 ($100,000 x .20 - see Table 10-1). The deduction is actually larger with the mid-quarter rule.
Research Problem #2
Quiz Question 2
Tables 10-6 through 10-8 of Appendix A disclose the three possible MACRS recovery tables for realty. All three recovery tables are based on a straight-line recovery method with a mid-month acquisition year assumption, and columns are provided for each of the twelve possible months that an asset could be placed in service. For example, the first-year factor in Table 10-6 for residential realty placed into service in the first month of the taxable year is .03485. This factor is the product of 1/27.5 times 11.5/12; the former fraction is the annual straight-line rate for property with a recovery period of 27.5 years, and the latter reflects the assumption that the asset was placed in service in the middle of the first month, thus qualifying for 11.5 months of cost recovery in the first recovery year.
Table 10-6 MACRS Realty 27.5-year Residential Rental Property
Table 10-7 MACRS Realty 31.5-Year Nonresidential Rental Property
Table 10-8 MACRS Realty 39-Year Residential Rental Property
Example - Drexel Company, a calendar-year taxpayer, placed into service a $100,000 residential apartment building on February 1, 2000 and a $200,000 nonresidential office building on December 1, 2000.
Assuming that these are Drexel's only acquisitions during the tax year, their
cost recovery deductions will be computed from Tables 10-6 (residential realty)
and 10-8 (nonresidential realty placed in service after May 12, 1993), respectively.
Table 10-6 MACRS Realty 27.5-year Residential Rental Property
Table 10-8 MACRS Realty 39-Year Nonresidential Rental Property
Assume that Drexel Company sold the $100,000 apartment building on November 3, 2002. The full year recovery factor for the third year is .03636 (Table 10-6); however, this must be adjusted to reflect a mid-month convention in the year of sale. Thus, Drexel's cost recovery deduction for the apartment building in 2002 will be $6,363 ($200,000 x .03636 x 10.5/12). Note that the mid-quarter rule assumes a disposition in the middle of the fourth quarter.
The depreciation for any additions to, or improvement of, any real property is determined in the same manner as the depreciation deduction for the underlying real property would be determined if the underlying real property were placed in service at the same time as the addition or improvement.8 Subject to this rule, the addition or improvement is depreciated as separate property.9
RIA illustration: A calendar year taxpayer bought and placed in service a residential apartment complex in '80 and another one in '85. In the current tax year, taxpayer made additions and improvements to both properties. The current tax year additions and improvements are 27.5-year class property for purpose of MACRS depreciation. If the '80 and '85 properties were factories, then the current tax year additions and improvements would be 39-year class properties for purposes of MACRS depreciation.
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