Quick History of Depreciation 1913
To have a better understanding of cost segregation studies and its complexities, it is important to first learn the legal framework and history behind why property taxpayers allocate costs. O’Connor will prepare you for a cost segregation study by educating you on asset clarification, depreciation, and investment tax credit (ITC) based on the IRS Cost Segregation Audit Technique Guide.
For the first 20 years after 1913, when the present income tax system was introduced, taxpayers had freedom to determine their own depreciation allowances. As long as the taxpayer’s policy met with accounting standards, there was flexibility for the amount that might be written off annually as an allowance for the cost of tangible property.
Internal Revenue Services (IRS) regulations, known as the Treasury Regulations or tax regulations, are regulations set by the IRS to interpret the Internal Revenue Code (IRC). By 1934, the Treasury Regulations (Treas. Reg.) were altered so taxpayers had to provide proof and sustain the depreciation deduction claimed. Meaning, taxpayers become responsible for providing all information of the cost and assets related to the depreciation claimed. Whichever depreciation method the taxpayer selects, it must be reasonable given the operational circumstances in effect during the taxable year.
What Are Depreciation Deductions?
Depreciation deductions were first authorized by the IRC, title 26. All federal tax rules, including those pertaining to income and property taxes, are codified in the Internal Revenue Code (IRC). Using the depreciation method, depreciation deductions is an allowance for the wear and tear of property used, whether for business, trade, or to produce income. A property’s tax deduction increases with its shorter useful life. For this reason, it is favorable for taxpayers to magnify the cost allocated to § 1245 tangible property, since depreciation deductions will likely reduce tax liability.
Bullet F Pamphlet 1920: Composite and Component Method
In 1920 a pamphlet, Bullet F, was issued and defined depreciation as “the gradual reduction in the value of property due to physical deterioration, exhaustion, wear, and fear through use in trade or business” (page 5). At the time of its release, Bullet F had no scheduling of suggested average lives. Bullet F was first revised in 1931 and with this came a few changes. The IRS did not agree with the use of a composite rate (the average rate of depreciation for the group of assets) of depreciation, instead they advocated for depreciation by items having similar characteristics and useful life. The first proposed average life schedule was released, and it included useful life estimates for assets used by enterprises or industries. Therefore, the taxpayer took on more responsibility for depreciation deductions, rather than the service.
In 1942, Bullet F underwent a second revision, which included a guide for useful life. The guide contained various types of properties based on the taxpayer’s business. The newly revised pamphlet described two procedures for calculating depreciation for buildings: the composite and component method.
The composite method is a chart that provides a composite rate for 14 types of buildings and includes various equipment already installed. The component method is when taxpayers had the option to depreciate different types of building equipment separate from the structure. A list was provided for the useful life of installed building equipment. In addition, Bullet F permitted taxpayers to depreciate individual or combined assets into accounts that are classified, group, or composite, and to depreciate the account as a single asset. This means that assets can be separated into parts and depreciated separately.
Depreciation Changes and Codification 1954 – 1956
Depreciation laws had major changes in 1954 with the authorization of new methods of depreciation. The addition of 1.167(d), which permitted written agreements between the IRS and taxpayers on the useful life and rate of depreciation, was one significant modification. In 1956, Treas. Reg. 1.167(a)-7(a) was codified; it is the ability to depreciate on an account basis. The regulations centered on the duration of the property’s usage in the taxpayer’s business. Additionally, a policy was approved with the intention of recalculating estimated useful life in cases where there is a substantial change and a clear justification for doing so.
Guideline Life System
In 1962, the Guideline Life system and Revenue Procedure (Rev. Proc.) 62-21, 1962-2 C.B. 418 was put into place, superseding Bullet F. Under this new system, assets were grounded into 75 broad industrial and general classifications and a guideline life was established for each. The system required taxpayers to meet a reserve ratio test or complex provision. The Rev. Proc. started treating assets as a class instead of individual assets. The Rev. Proc. listed 13 types of buildings along with their respective guideline lives.
Between 1966 – 1968, there were more changes made, specifically from Revenue Ruling (Rev. Rul.) 66-111, 1966-1 C.B. 46. Rev. Rul. addressed the component method of depreciation used for real property. Within the timespan, several rulings were passed to determine whether the component method could be used to allocate real property into separate component accounts. By the end of 1968, it was decided that it was not proper to use the component method for depreciation. Rev. Proc. 62-21 decided the component method may only be used when all the assets of the guideline class are included in the same guideline class for the overall composite life used for depreciation.
Asset Depreciation Range (ADR) System
In 1972, Rev. Proc. 72-10, 1972-1 C.B. 721 was enacted and presented the Class Life Depreciation Range (ADR) system for tangible assets used after 1970. The ADR system was put into place to minimize any disputes about useful life, repair and maintenance expenses, salvage value, and removed the reserve ratio test. Depending on the business and taxpayer, all tangible assets were grouped into guideline classes. The asset guideline set forth in Rev. Proc. 72-10 was later replaced by Rev. Proc. 77-10, 1977-10 C.B. 548 and updated the asset guideline classes.
Let O’Connor Help You
O’Connor’s blog series based on the IRS Cost segregation guide will educate and help you, as a taxpayer, to have a better understanding of cost segregation and how it works. Learning the history of depreciation will help taxpayers understand asset classification, cost recovery models, and define relevant terms. In upcoming blogs, O’Connor will go over tests to distinguish 1245 and 1250 property, how cost segregation applies to building systems, and current cost recovery systems. Choose to work with O’Connor’s cost segregation team to help you in the process of a successful cost segregation study for your property.