The existing depreciation system was developed over 30 years ago, when desktop computers had a capacity of 512k, and there were no cell phones, tablets, or Chromebooks™. Class lives and recovery periods for business assets are now outdated and have resulted in a bias between investments in different industries, according to the Congressional Budget Office (CBO). For example, the effective marginal tax rate on investments in computers and software is nearly 40%, while the rate on railroad track and mining structures is about 15%.
Senate Finance Committee Ranking Member Ron Wyden (D-Oregon) believes it is time for a major change. To this end, he has released draft legislation, the Cost Recovery Reform and Simplification Act of 2016, which would create a completely new, simplified method of cost recovery, the A-MACRRS system. (AKA the Accelerated Mass Asset Cost Recovery and Reinvestment System.) Under the proposal, the 100 existing depreciation categories would be collapsed into 6 “pools”, greatly reducing the number of necessary calculations and simplifying the recordkeeping. Now, depreciation is done on an asset-by-asset basis, although some grouping is allowed. Accelerated depreciation would still be available, and like-kind exchange treatment would be expanded. Write-offs of straight-line assets, such as real estate, would not change much, however.
Property Would Be Pooled
Currently, taxpayers are required to calculate depreciation on every single asset, every year. This results in thousands of calculations for some businesses, and a special burden on small businesses, whose recordkeeping requirements may outstrip their resources. Wyden’s plan would combine machinery and equipment into six pools based on current accelerated depreciation schedules and allow taxpayers to compute depreciation with only six calculations for their entire business under a single unified method. This method would apply not only for regular tax purposes, but also for the Alternative Minimum Tax and Earnings and Profits calculations. The pooled system is mapped to the current system in the tables1 below.
1 The Tables are contained in the Finance Committee’s Discussion Draft Summary.
2 Footnote 2 in the original table states that the percentages are designed to make the proposal revenue-neutral.
Using the A-MACRRS rates above, the computation would work this way. At year-end, each final pool balance would be multiplied by its applicable declining balance percentage to determine the year’s depreciation deductions.
Computing the Pool Balance, Transitions
The new system would begin immediately, and businesses would transition to the new system by transferring the remaining adjusted basis of all capital assets into each of the six pools. The balance in each pool would be increased each year by the amount of new assets placed in service and would be decreased by the proceeds of any asset sales from that pool for the year. Taxpayers also would no longer have to use the mid-year or mid-quarter convention. Instead, the entire depreciation deduction for an asset would be available the first year the asset was placed in service.
Example of Pooled Assets Computation
The following example is adapted from the Joint Committee on Taxation’s explanation of the Wyden proposal. Only one asset pool is illustrated for this example.
Facts: The taxpayer owns a $1,000 light truck used 100 percent for business. As of January 1, 2017, the taxpayer has a pool balance of $1,000 in Pool 2 (which includes light trucks as 5-year property). On April 1, 2017, the taxpayer sells the light truck for $500 and acquires a new light truck for $1,500.
Pool 2 Computation for 2017: The beginning balance of Pool 2 is $1,000. The taxpayer sold the light truck for $500 and acquired another light truck for $1,500. The balance of Pool 2 is reduced by the proceeds of the sale of the old truck and is increased by the basis of the new truck.
$1,000 Pool 2 Balance at beginning of 2017
-$ 500 proceeds from sale of truck
+$1,500 cost of new truck
$2,000 Pool 2 balance before depreciation
0.34 x $2,000 = $680 is the Pool 2 depreciation allowed for 2017.
The taxpayer recognizes no loss on the sale of the old truck. However, the taxpayer is permitted to continue to recover the remaining basis in the old truck, thus recognizing the loss over time. The $680 of depreciation is deducted from the balance of Pool 2, resulting in an adjusted balance of $1,320 for 2018.
No More Recapture, Like-Kind Exchanges
Not only are the regular depreciation rules simplified, but many other requirements for sales or other dispositions of depreciated property are wrapped into a unified approach. For example, when assets in a pool are sold, instead of a separate sales computation for each asset involving recapture and gains computations, the taxpayer would simply reduce the pool balance by the amount of the sales proceeds.
The rigid like-kind exchange rules for asset classes also can be avoided with the pooling regime. Under the pooling plan, deferral of gain is allowed when one asset is disposed of and a replacement asset is acquired, as long as the replacement asset is in the same pool category. The pooling of exchanged assets would benefit many smaller businesses who now cannot take advantage of the existing like-kind exchange rules.
Allocating Business and Personal Use
It is increasingly common in today’s society for taxpayers to use assets both for business and for personal use. Think cell phones, laptops, and vehicles. The Wyden proposal would replace the complicated allocation requirements with a dramatically simplified framework. Assets with 50% or more business use would be eligible for depreciation under the normal rules. If an asset was used less than 50% for business, the business use amount of the depreciation would be included in the asset pool. Also, the complex “luxury automobile” rules would be replaced with a simple limit on the depreciable basis of any vehicle. Finally, the draft would remove laptop computers used mostly for business as “listed property.” When property is designated as “listed property” by the IRS, strict rules and limits apply to its deduction.
Bonus Depreciation and Expensing Preserved
The recent extension of bonus depreciation and the permanent expansion of expensing would remain unchanged.
Buildings and Other Real Property
The rules for depreciation of real property would change little under Wyden’s bill. It includes a straight-line cost recovery system for buildings, water utility property, and railroad grading or tunnel bore. The recovery period for water utility property would be 25 years, residential real property would be 27.5 years, nonresidential real property would be 39 years, and railroad grading or tunnel bore would be set at 50 years.
Updates Going Forward
Over the time span since the current depreciation rules were put in place, the Treasury Department’s hands have been tied because it had no authority to change class lives to reflect new types of assets. To remedy this situation, the Wyden proposal authorizes and requires the Treasury Secretary, in consultation with the Secretary of Commerce, to update asset pool
assignments based on economic assessments of an asset’s useful life and technical obsolescence, under an accelerated depreciation schedule. This would happen every five years and must be reported to Congress.
“You shouldn’t need a PhD in advanced mathematics to navigate the tax code when deciding to invest in a new computer or pick-up truck,” Wyden observed in describing the need for change. “This proposal addresses the lopsided rules and complexity, putting the tax code to work for small businesses and growing industries,” according to his press release. With the $40 trillion in productive capital assets in the U.S. economy and with $2.5 trillion added every year, a simplification of the current depreciation system could have a dramatic, positive effect on the way U.S. taxpayers do business.
About the blogger
Lucia Nasuti Smeal is a guest blogger on tax topics for Frazier & Deeter. Smeal is an attorney, a tax Professor with Georgia State University’s J. Mack Robinson College of Business, and former editor of Tax Notes Today, published by Tax Analysts. Smeal also worked as a legislative analyst for the Congressional Research Service and is a former member of the U.S. Capitol Periodical Press Corps. She is a frequent speaker on current tax developments and has trained tax professionals at the IRS, major law firms, accounting firms and professional publishers.