Alongside the changes made to asset depreciation classifications, bonus depreciation and section 179 expensing, the Tax Cuts and Jobs Act of 2017 (TCJA) brought with it changes to and new applications for the Alternative Depreciation System.
Subsequent to the passing of The Tax Reform Act of 1986, business assets purchased and used after 1986 are required to use the Modified Accelerated Cost Recovery System (MACRS) depreciation system. Within that general system, there are two specific depreciation systems a business can use to depreciate the assets purchased — the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). Generally, it is most common to see businesses use GDS because unlike ADS which only allows straight-line depreciation, GDS allows straight-line depreciation in addition to two accelerated depreciation methods — 200% declining balance and 150% declining balance. In addition, the depreciable lives of assets are generally shorter using GDS when compared to ADS. Due to its general disadvantages, ADS tends to be adopted mainly by taxpayers required to use it.
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Application of ADS
As previously mentioned, businesses will generally elect to use ADS in the event they are required to do so. An election to use ADS is permanent and once made a taxpayer cannot revert back to GDS. With the passing and implementation of the TCJA, the factors and situations in which a taxpayer would be required to depreciate property placed in service under the ADS method have changed. Below are some of the types of property and scenarios in which the use of ADS is now required:
- Nonresidential real property, residential real property, and qualified improvement property held by an electing real property trade or business under the parameters of IRC Section 163(j)(7)(B) related to the business interest limitation.
- Any property with a recovery period of 10 years or more under the GDS method that is held by an electing farming business under the parameters of IRC Section 163(j)(7)(C) related to the business interest limitation.
- Any tax-exempt use property.
- Any tax-exempt bond-financed property.
- Certain property of an electing real property trade or business.
- Certain property of an electing farm business.
- All property used predominantly in a farming business and also placed in service in any tax year that the business didn’t apply the uniform capitalization rules to certain farming costs.
- Any property imported from a foreign country for which an Executive Order (EO) is in effect because the country maintains trade restrictions or engages in other discriminatory acts.
Making the Election to Depreciate Property Under ADS
In a year in which a taxpayer is either required to elect or voluntarily electing to use the ADS method of depreciation, this can be done by completing Part III of Form 4562. In the year the election is made, it generally is required to cover all property in the same property class that is placed in service during the year, i.e. all 5-year property.
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When making the election to depreciate assets placed in service under the ADS method, the recovery period of the assets is required to be shifted to the ADS recovery periods. Some of the more common changes in recovery periods taxpayers may come across are:
- Office Furniture, Fixtures, and Equipment: 7 years to 10 years
- Information Systems (including Computers): No change from 5 years
- Land Improvements: 15 years to 20 years
- Pre-2018 Residential Rental Property: 27.5 years to 40 years
- Post-2017 Residential Rental Property: 27.5 years to 30 years
- Nonresidential Rental Property: 39 years to 40 years
With the advent of the TCJA and under the parameters of IRC Section 163(j), electing real property trades or businesses are now required to use ADS but ONLY on nonresidential real property, residential real property, and qualified improvement property. Meanwhile, electing farming businesses must use ADS to depreciate any property with a recovery period of 10 years or more. Rev. Proc. 2019-08 provides guidance to these taxpayers as to how to switch to ADS for assets placed in service before AND after December 31, 2017 via a “change in use”.
A change in use in this case would require electing real estate or farming businesses to determine the depreciable basis of applicable assets as of 1/1/18 and calculate depreciation on that depreciable basis over the years still remaining as if the assets were placed in service using ADS recovery periods. Whether pre-TCJA qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property are required to be depreciated under ADS remains a point of contention among tax professionals.
Evidently, adopting ADS pre-and post-TCJA can be a confusing and arduous task.
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