Introduction
Taxpayers engaged in business or investment activities may generally deduct “ordinary and necessary” expenses as broadly defined in IRC § 162(a). Depreciation of property used in the course of a farming business or held for the production of income is allowed under IRC § 167, with IRC §168 providing specifics.
Depreciation Defined
For income tax purposes, depreciation is the recovery of the cost of property used in a “trade or business” [IRC §167(a)(1)] or “property held for the production of income” (investment). [IRC § 167(a)(2)] Depreciation is allowed to be deducted by the taxpayer due to reasons of exhaustion and wear and tear of the property. “Wear and tear” under the Internal Revenue Code includes a reasonable allowance for obsolescence. [IRC §167(a)] IRC §168 directs taxpayers to use the applicable and allowable rules for depreciation of their business or investment property.
Example: Juanita operates a successful truck farm raising various vegetables and fruits. In the current year, Juanita purchased a tractor which she uses to cultivate her farmland. Juanita paid $35,000 for the tractor. Since she is engaged in the business of farming, she may recover the purchase cost of the tractor using any of the allowable recovery methods to be discussed later.
Depreciation deductions are not allowed for any personal activities or use.
Modified Accelerated Cost Recovery System
Since January 1, 1987, taxpayers have been using the depreciation system which was enacted as a result of the Tax Reform Act of 1986. This system, the Modified Accelerated Recovery System (MACRS), is applicable to most tangible personal property which taxpayers use in their business or investment activities. Historically, other systems have been used to recover costs of tangible property since 1916; MACRS will be the focus of this discussion.
MACRS made changes to asset class recovery periods (class lives) which were enacted as part of the Economic Recovery Tax Act of 1981. While ERTA had a policy goal to encourage capital formation in the U.S., a negative consequence was reduced public revenues from exceptionally short recovery periods. This led to increasing federal deficits.[1]
MACRS has three depreciation systems in place which are available to be used by farmers and ranchers in their agricultural businesses. These are discussed below in more detail. Taxpayers and tax professionals must be aware that under certain circumstances MACRS cannot be used to recover the cost of tangible property. These circumstances are:
- Property placed into service prior to January 1, 1987,
- Property subject to the anti-churning rules, which is property owned or used by certain individuals (related parties) in 1986,
- Intangible property, e.g., good will,
- Films, videotapes, and recordings, and,
- Certain partnership or corporate property acquired in a non-taxable transfer.
Historical Depreciation
Accelerated Cost Recovery System
The Accelerated Cost Recovery System (ACRS) was a result of the tax reform efforts during the Reagan Administration beginning with the Economic Recovery Tax Act of 1981. Addressing depreciation class lives by making the recovery periods shorter was an effort to incentivize taxpayers, including farmers, to invest in capital goods. For example, tractors under ACRS had a recovery period of three years in contrast to a 7-year recovery period under MACRS in 1987. If an asset was placed in service by a taxpayer prior to January 1, 1987, ACRS must be used to recover the asset’s cost less any residual salvage value. MACRS recognizes salvage value; however, salvage value is set at zero for its purposes.
Asset Depreciation Range System
Guidance in the early-to mid-20th century allowed taxpayers to use any reasonable period. This, however, made for unlimited methods and was burdensome to the entire tax system. During the summer of 1971 IRS issued guidance to taxpayers and tax practitioners regarding ways to determine recovery periods of assets which could be depreciated. The guidance introduced the Asset Depreciation Range System (ADR). The 1971 Revenue Act solidified ADR by giving it legal authority to be used. The initial guidance from IRS provided that ADR applied exclusively to machinery and equipment, however, the act included buildings and land improvements. ADR evolved further to become a Class Life System (CLS). This system, by its name, only had class lives, no ranges were applicable. Thus, depreciation simplification was in its infancy. Ten years later with the passage of ERTA the concept of class lives was further structured to be the norm relative to the calculation of depreciation values. Subsequently, with the Tax Reform Act of 1986, the class lives which are commonly used today were established. There have been minor changes over time with the passage of legislation since 1986 and the adoptions of MACRS as the depreciation system to be used by taxpayers such as farmers and ranchers.
MACRS Depreciation Methods
Under MACRS there are two sub-systems taxpayers may use to depreciate (recover the cost of tangible business or investment) property. Either the General Depreciation System (GDS) or the Alternative Depreciation System (ADS) may be used by the taxpayer. IRS issued guidance through three Revenue Procedures in the late 1980’s which help taxpayers make the necessary calculations for allowable depreciation. Rev. Proc. 87-56, 1987-2 CB 674 provides guidance establishing MACRS class lives. Rev. Proc. 87-57, 1987-2 CB 687 provides guidance by creating optional tables using percentages to calculate allowable recovery amounts. Lastly, Rev. Proc. 89-15, 1989-1 CB 816 provides necessary rules to calculate depreciation in a short tax year.
The General Depreciation System provides for a choice between three methods to calculate the annual allowable depreciation. The recovery-periods for GDS using the class life system are: 3-, 5-, 7-, 10-, 15-, 20-, 25-, 27.5-, and 39-years. These methods are listed below.
- 200 percent-declining balance method allows the farmer/rancher to “load” depreciation in the first half of the class life and then converts to straight-line values. The conversion to straight-line occurs when the allowable deprecation is greater when compared to the declining balance calculation. For assets falling in the 27.5- and 39-year asset classes, straight-line calculations are used.
- 150 percent-declining balance method is like the 200 percent-declining balance method, except that the depreciation calculations are not as large in the early part of the class life before converting to straight-line values.
- Straight-line method simply divides the cost of the depreciable property by the appropriate class life resulting in the allowable yearly depreciation amount.
Example: To illustrate, in part, the flexibility for tax management purposes, assume that Bob who operates a cattle ranch buys a new piece of equipment in 2020 and pays $40,000. Since it is new, the applicable class life is 5-years and half-year convention is used (discussed later). Bob’s default depreciation will be 200 percent-declining balance which in the first year is $8,000 ($40,000 x 0.20). If Bob elects to use 150 percent-declining balance, then his first year allowed depreciation is $6,000 ($40,000 x 0.15). However, if Bob elects GDS straight-line depreciation, then his first year allowed depreciation is $4,000 [($40,000/5)/2].
The Alternative Depreciation System provides farmer/rancher taxpayers an opportunity to choose a longer life over which to recover the cost of tangible business property. ADS requires the use of straight-line depreciation over lengthened class lives, thus, slowing down the cost recovery of personal property used in business. Young or beginning farmers and ranchers may benefit from such an election in an effort to match deductions and income across taxable years.
The ADS class lives are generally longer when compared to the GDS system. The class lives under GDS are: 3-, 4-, 5-, 6-, 7-, 10-, 12-, 15-, 20-, 25-, 30-, and 40-years.
Example: Bob, in the GDS example above, elects to use ADS to depreciate the $40,000 piece of equipment he bought for use on his cattle ranch. The ADS life for the equipment is now 10 years in contrast to 5 years under GDS. Thus, Bob’s first year ADS depreciation would be $2,000 [($40,000/10/2].
Readers can see that the first-year’s range using MACRS depreciation for the Bob’s new equipment is $8,000 to $2,000 dependent upon the choice he makes relative to recovering the cost of the property. Bob makes this decision in the first year of his ownership of the equipment as he manages his ranch business. Generally, Bob’s decision is irrevocable.
Elections
Conventions
An issue of importance to farmers and ranchers and their tax professionals is the determination of the amount of the first year’s allowable depreciation. Fortunately, IRS provides simplified rules that help make the calculation for the first year. To make explicit what might be implicit, IRS rules allow for the full recovery of personal property used in the course of trade or business, however, not every piece of equipment is purchased by every farmer or rancher on the exact same day. Thus, the concept of conventions was established to create “fairness” when calculating depreciation amounts, particularly for the first year.
Half-year
Under half-year convention, the farmer/rancher is allowed one-half of the first year’s calculated depreciation. This recognizes that all taxpayers are on the same footing as to the allowable amount deducted. Therefore, an asset within the five-year recovery life will be depreciated over six years in which the sixth year captures the “last half” of the first year’s depreciation not taken at that time.
Example: Mandy operates a cut-flower farm. In June, she purchased a used irrigation system for her flower beds at a cost of $15,000. Because the irrigation system is used, the MACRS class life is seven years. Thus, using the percentage tables, the allowable first year’s depreciation is $2,143.50 [$15,000 x 0.1429]. In the eighth year, Mandy, is allowed $669 depreciation to finish the cost recovery of the irrigation equipment. [$15,000 x 0.0446] Remember, that MACRS double-declining balance method recovers the majority of the equipment’s cost in the first four years and converts to straight-line in year five with 8.93 percent of purchase price.
Mid-quarter
Generally, mid-quarter convention is triggered when the farmer/rancher purchases 40 percent or more of his or her depreciable assets in the fourth quarter of the business’s tax year. When mid-quarter convention is required, the depreciation of assets acquired by purchase begins with a mid-quarter adjustment based on the quarter in which they were acquired.
Example: Had Mandy purchased her irrigation system in mid-October, her fourth quarter, then the first year’s allowable depreciation would be $535.50 [$15,000 x 0.0357] using the MACRS percentage table.
Mid-month
Mid-month convention is applicable to cost recovery of residential and non-residential (commercial) buildings. As discussed earlier, 27.5- and 39-year assets use straight-line method to calculate allowable depreciation. Therefore, the mid-month calculation is one-half of the first month’s depreciation amount.
Example: Juan purchased a farm in July. The farm included a home, which is occupied by tenants. Juan plans to continue using the home as a rental property. The home qualifies as a residential rental property and has a MACRS 27.5-year recovery period. The farm’s appraisal valued the home at $100,000. The monthly depreciation allowed is $303.03 [($100,000/27.5)/12] Thus, the mid-month convention allows $151.52 for July’s allowable depreciation amount; for the months of August through December, each month is allowed $303.03 which yields a total first year’s depreciation for Juan of $1,666.67. [$151.52 + ($303.03 x 5)].
Depreciation Begins
Throughout the discussion thus far, the question of when depreciation starts hasn’t been directly addressed. The IRC uses the terms such as “placed into service” or “available for service” to provide guidance as to when depreciable property may be listed on a depreciation schedule (capital account listing) and allowable depreciation taken as an ordinary and necessary business or investment expense. Generally, the date when the asset is acquired is an indication of when the property in question is placed into service.
Example: Shawna trades her 2007 pickup used in her farming business on May 18, 2020, for a 2020 pickup. It can be assumed that the 2020 pickup was placed into service on May 18, 2020, as Shawna’s drive from the dealership to the farm would be business mileage.
However, not all situations may be as clear cut as in Shawna’s case. A farmer purchasing a combine in late December to take advantage of favorable pricing and year-end tax planning should be cautious. While the combine may be delivered and on the farm before December 31st, was it used to harvest grain? In such a case, the combine was not placed into service because all of the acres of grain were harvested at the time the combine was purchased. The combine was merely driven into the equipment shed and stored for the winter until the following year. A possible solution is for the farmer to leave a field to harvest with the newly acquired combine.
Similarly, purchasing equipment such as a packing line for an orchard business in the fall (with assembly of the new packing line by the orchard employees over the winter as a means to keep them employed) raises the “placed in service” question. If the current year’s harvest was already graded and packed out when the parts for the new packing line arrived, then the packing line is placed into service in the subsequent year when the new crop is picked.
Taxpayers and their tax professionals should communicate clearly relative to end-of-year tangible property purchases to accurately determine when the asset is placed into service.
“Allowed and Allowable”
In this introductory discussion, the terms “allowed” and “allowable” have been used in the context of calculating the depreciation expense for farm and ranch businesses. IRS rules provide methods to calculate the depreciation that are for “ordinary and necessary” business or investment activities. These are “allowed” as expense deductions against business or investment income for the tax year being reported by the farmer or rancher.
What happens if the taxpayer forgets to include specific property in the annual depreciation totals, or, if the tax practitioner makes an error? IRS generally then takes the position that the depreciation foregone would have been “allowable” – and as such, the taxpayer must reduce the cost of the property as if depreciation would have properly been taken. Fortunately, IRS provides for corrections to such mistakes which will be discussed in detail in a subsequent article.
Therefore, farmers and ranchers should clearly communicate with their tax professionals about all of their property purchases through the course of the tax year to prevent the error of under-reporting the depreciation expense and paying more income or self-employment tax than necessary.
Further Topical Depreciation Discussions
This introduction to the complicated topic of depreciation is supported with more in-depth topical discussions in other articles on this site. Farm and ranch personal property are examined in the context of class life, income tax planning and farm management opportunities. Separate discussions explaining the IRC §179 expense election, bonus depreciation, listed property, correcting depreciation errors, and more can be accessed to answer specific questions which farmers/ranchers and their advisers may have relative to their unique fact patterns.
[1] Commerce Clearing House, 1991 Depreciation Guide Featuring MACRS, page 12.