Depreciation 301: The industry matters just as much as the class

My last thriller about depreciation focused on cost classification the identification of short-lived assets often included in the depreciable cost of building. Now I'll have you on the edge of your chairs with some more oft-missed aspects of the tax depreciation rules.

Determining the depreciable life of real property is straightforward. If it is residential property,it is depreciated over 27.5 years. If it is commercial property, it is depreciated over 39 years.

Determining the depreciable life of items of tangible personal property is not as simple. Most taxpayers are familiar with the depreciation lives three, five and seven years. The problem is assigning the right life.

Two factors go into the determination of the correct life. The first is the nature of the property, i.e. a computer, office furniture, a vehicle, etc. The second factor is the one most often missed the industry in which the property is used.

The IRS issued guidance on determining the correct depreciable life in Revenue Procedure 87-56. It first lists 13 categories of property for which the depreciable life is assigned regardless of the activity in which the property is employed. Those categories include computer equipment, airplanes, automobiles, buses, trucks, trailers and trailer-mounted containers, land improvements, and industrial steam and electric generation equipment.

The depreciable life of tangible personal property not included in one of the 13 categories is determined based on the activity in which the property is used. One of the most common is asset class 57.0, distributive trades and services. The IRS defines that asset class as "includes assets used in wholesale and retail trade, and personal and professional services. Includes section 1245 assets used in marketing petroleum and petroleum products." The depreciation lives assigned to this class are five years for regular tax purposes and nine years for alternative minimum tax depreciation. Thus, for all retail establishments, wholesalers and service providers, tangible personal property should be depreciated over five years, not seven.

Asset class 15 is construction and assigns lives of five years for regular tax and six years for alternative minimum tax. As often as not, I find contractors using seven- and 12-year lives for their equipment instead of the correct ones. For a heavy-highway or excavation contractor with millions of dollars of heavy equipment, the difference between a seven-year life and a five-year life can cause the acceleration of millions of dollars of depreciation. Also, the alternative minimum tax is affecting more and more taxpayers, and the difference between a 12-year life and a six-year life can have a significant impact on alternative minimum tax liabilities.

I can see it in my mind taxpayers all over northern Nevada frantically digging in the file cabinet for a copy of their tax return. They are flipping through it looking for the depreciation detail. Now they are screaming in agony. There it is, a seven-year life assigned to all their personal property. Despair not; I come with good news to go with the bad.

For the purpose of determining the gain from the sale of property, the Internal Revenue Code requires taxpayers to reduce the cost basis of their property by the amount of depreciation deductions allowed, but "not less than the amount allowable." That's right. If you claimed less depreciation than was "allowable" because you used too long a depreciation life, for the purpose of determining a gain on sale you have to reduce the property's basis by the higher depreciation amount even if you never claimed the deduction.

Hold on. Don't plunge that knife into your heart. The good news is next. Because of the harsh results that could occur from the application of the rules, the "kinder and gentler" IRS issued two Revenue Procedures (2002-9 and 2002-54) in 2002 allowing taxpayers the opportunity to claim the missed depreciation deductions. The procedures provide an automatic consent procedure permitting a taxpayer who claimed less than the depreciation or amortization allowable in a given year to change accounting methods for depreciation and claim the remaining amount through a catch-up adjustment.

There you have it, Depreciation 301 in less than 700 words.

Bruce W. Thee, CPA, is director of taxation for Mark Bailey & Co., CPA's a Reno-based public accounting and audit firm. Contact him at bruce@markbaileyco.com