Understanding the legal background and rationale for property taxpayer cost allocation is crucial for comprehending cost segregation studies and their intricacies. Based on the IRS Cost Segregation Audit Technique Guide, O’Connor will educate you about asset clarity, depreciation changes, and how it can get you ready for a cost segregation investigation.
Accelerated Cost Recovery System: 1981
In 1981, Congress put into place the Accelerated Cost Recovery System (ACRS) – a cost recovery method – to simplify depreciation rules to allow greater deductions over shorter periods of time. By adding a statutory percentage to the cost of the recovery property, ACRS permitted depreciation deductions over a defined recovery period. A statutory percentage or tax rate is the rate mandated by law on taxable income that falls within a given tax bracket. With the introduction of ACRS came many changes, for example the removal of salvage value and the concept of useful life. Under ACRS, cost recovery of assets was faster and provided a total of six recovery periods. Between 1981 and 1886 many properties during this time were eligible for ACRS. Other changes that came from ACRS was preventing component depreciation as a method for calculating depreciation for buildings.
According to ACRS, starting on the later of the date the building is brought into service or the component is placed into service, the depreciation deduction for any building component must be calculated in the same way as the deduction permitted for the structure. This new system brought along several changes to depreciation; however, it was beneficial for many taxpayers since it allowed for greater deductions overall.
Modified Accelerated Cost Recovery System: 1986
In 1986, ACRS was modified by congress and was later renamed Modified Accelerated Cost Recovery System (MACRS). With the modification came new changes and improvements to the system. For example, MACRS repealed ACRS § 168(f)(1), which related specifically to components of § 1250 class property. MACRS was a cost recovery method that was based on the applicable depreciation method, recovery period, and convention outlined in § 168.
The applicable depreciation method is the most straightforward and reliable approach for calculating depreciation, because it makes sense when working with an item whose value declines consistently over time at the same pace.
With the modification of ACRS, MACRS provided two depreciation systems:
1. General Depreciation System (GDS) – a method used to compute personal property’s depreciation. GDS allowed for the use of tax depreciation known as the declining – balance – method.
2. Alternative Depreciation System (ADS) – a method of calculating the depreciation of certain types of assets in certain conditions. The ADS technique lowers the annual depreciation expenditure reported by using the straight-line approach to compute depreciation over a longer time period than the GDS method.
In order to calculate depreciation deductions for later years, MACRS also needed the necessary basis modifications. Additionally, it amended other ACRS regulations, such as property classifications. For structures and structural elements, the recovery time increased significantly under MACRS. The applicable depreciation method, convention, and recovery time were impacted by the property’s MACRS classification in addition to the new depreciation methods. Each item of property depreciated under MACRS is assigned to a property class. Class lives for MACRS are outlined in Rev. Proc. 87-56, 1987-2 C. B. 674. A property class establishes the item’s recovery period. Statutes or class lives are used to calculate the applicable recovery periods for MACRS.
Rev. Proc. 87-56, 1987-2 C. B. 674 established two broad categories of depreciable assets:
1. Asset classes 00.11 through 00.4 consist of specific assets used in all business activities.
2. Asset classes 01.1 through 80.0 consist of assets used in specific business activities.
By the end of 1986, MACRS continued preventing component depreciation as a method for calculating depreciation for buildings. MACRS enacted § 168(i)(6), improvements made to real property are depreciated using the same recovery period applicable to the underlying property, assuming the underlying property was placed in service at the same time the improvements were made. Improvements to § 1245 property and §1250 property. In the next blog, O’Connor will discuss the terms “§ 1245 property” and “§1250 property” and the meanings given by §1245(a)(3) and §1250(c).
Since the early 1930’s, depreciation regulations have encountered many modifications and changes so as to benefit taxpayers. Depreciation helps taxpayers increase cash flow by reducing reportable income. A good cost segregation study is an excellent tool for property owners to maximize depreciation and improve cash flow. The IRS Cost Segregation Audit Technique Guide, provides up-to-date information and resources for a quality study.
How Can O’Connor Help You
As a taxpayer, you will learn more about cost segregation and its operation from O’Connor’s blog series, which is based on the IRS Cost Segregation Guide. Taxpayers will have a better understanding of asset categorization, cost recovery, and depreciation methods by studying the history of depreciation. In upcoming blogs, O’Connor will discuss how to differentiate between §1245 and §1250 property tests and how cost segregation affects building systems. Work with O’Connor’s cost segregation experts to assist you in conducting a successful cost segregation study for your real estate.