717 / How is depreciation on property placed in service after 1986 calculated?

Generally, the Accelerated Cost Recovery System (ACRS) was modified for property placed in service after 1986. An election could be made to apply the post-1986 ACRS to property that was placed in service between July 31, 1986 and January 1, 1987 (unless such property would have been subject to the anti-churning rules if it had been placed in service after 1986).¹ If real property is acquired before 1987 and converted from personal use to a depreciable use after 1986, the post-1986 ACRS is to be used.²

The post-1986 ACRS deduction is calculated by applying to the basis of the property either (1) a declining balance method that switches to the straight line method at a time which maximizes the deduction or (2) a straight line method.³ The initial basis in the property is the basis of the property upon acquisition (usually the cost of the property, see Q 692), reduced by the amount, if any, elected for amortization or an IRC Section 179 deduction (see Q 725), and further reduced by any basis reduction required in connection with taking the investment tax credit (see Q 7893).⁴ The basis of the property is reduced each year by the amount of the depreciation allowable.⁵ Optional depreciation tables set out in Revenue Procedure 87-57 may be used in place of the methods above.⁶ Because land cannot be depreciated, the cost basis of improved land must be allocated between the land and improvements.⁷ The ACRS deduction is limited in the case of certain automobiles and other “listed property” placed in service after June 18, 1984. See “Limitations,” ( Q 726).

The classification of property by recovery period and depreciation method is as follows:⁸

3 years 200% DB*	class life of 4 years or less, certain horses, qualified rent-to-own property
5 years 200% DB*	class life of more than 4 but less than 10 (e.g., heavy trucks, buses, offshore drilling equipment, most computer and data handling equipment, cattle, helicopters and non-commercial aircraft, automobiles and light trucks)
7 years 200% DB*	class life of 10 or more but less than 16 (e.g., most office furnishings, most agricultural machinery and equipment, theme park structures, most railroad machinery, equipment and track, commercial aircraft), motorsports entertainment complexes, Alaska neutral gas pipelines, property without a class life and not otherwise classified under TRA ‘86
10 years 200% DB*	class life of 16 or more but less than 20 (e.g., vessels, barges and similar water transportation equipment, petroleum refining equipment)
15 years 150% DB*	class life of 20 or more but less than 25 (e.g., industrial steam and electric generation/distribution systems, cement manufacturing equipment, commercial water transportation equipment (freight or passenger), nuclear power production plants)
20 years 150% DB*	class life of 25 or more (e.g., certain farm buildings, railroad structures and improvements, telephone central office buildings, gas utility production plants and distribution facilities), but excluding real property with class life of 27.5 years or more
27.5 years straight line	residential rental property
39 years straight line	nonresidential real property (class life of 27.5 years or more)
50 years straight line	railroad grading or tunnel bore
* Declining balance method switching to the straight line method at a time to maximize the deduction. Substitute 150 percent DB for 200% DB if 3-, 5-, 7-, or 10-year property is used in a farming business. An election can be made to use the straight line method instead of the declining balance method. Also, with respect to 3-, 5-, 7-, and 10-year property, an election can be made to use 150 percent DB.

Property is assigned to various class lives in Revenue Procedure 87-56.⁹ These class lives
can also be found in IRS Publication 946. The Tax Reform Act of 1986 assigned certain property to recovery periods without regard to their class life (e.g., automobiles and light trucks).

Intangible property that is depreciable is subject to special recovery periods. If computer software is depreciable, the deduction is calculated using a straight line method over 36 months.¹⁰ Computer software acquired after August 10, 1993 is generally depreciable if it:

1. is a program designed to cause a computer to perform a desired function, (but generally not a database); and


2. either (a) is readily available for purchase by the general public, is subject to a nonexclusive license, and has not been substantially modified, or (b) is not acquired in a transaction involving the acquisition of assets constituting a trade or business.¹¹

Certain mortgage servicing rights may be depreciated over 108 months using the straight line method.¹²

Certain rights that are not acquired in a transaction involving the acquisition of a trade or business are subject to special rules for depreciation. Depreciation deductions for (1) rights to receive tangible property or services under a contract or a government grant; (2) interests in patents or copyrights; or (3) certain contracts of fixed duration or amount, are to be defined in the regulations.¹³

Regulations generally require the amortization of the right to receive property under a contract or government grant by multiplying the basis of the right by a fraction. The numerator of the fraction is the amount of property or services received during the taxable year and the denominator is the total amount to be received under the contract or government grant. For a patent or copyright, the deduction is generally equal to the amount paid during a taxable year if the purchase price is paid on an annual basis as either a fixed amount per use or a fixed percentage of revenue from the patent or copyright, otherwise it is depreciated either ratably over its useful life or by using the income forecast method. The basis of a right to an unspecified amount over a fixed duration of less than fifteen years is amortized ratably over the period of the right.¹⁴

In the years in which property is acquired or disposed of, depreciation is limited to the portion of the year in which the property is considered to be held under the following conventions: Residential rental property, nonresidential real property, and railroad grading or tunnel bore are treated as placed in service (or disposed of) on the mid-point of the month in which placed in service (or disposed of). Property, other than such real property, is generally treated as placed in service (or disposed of) on the mid-point of the year in which placed in service.

However, the mid-quarter convention (instead of the mid-year convention) applies to depreciable property placed in service during the taxable year if the aggregate bases of property placed in service during the last three months of the taxable year exceeds 40 percent of the aggregate bases of property placed in service (or disposed of) during the taxable year (“the 40 percent test”). “Aggregate bases” is defined as the sum of the depreciable bases of all items of depreciable property taken into account in applying the 40 percent test.

For taxable years ending after January 30, 1991, property not taken into account in applying the test include the following: (1) real property subject to the mid-month convention (described above), and (2) property placed in service and disposed of in the same taxable year. Conversely, property that would be taken into account in applying the 40 percent test includes: (1) listed property (discussed in Q 726) placed in service during the taxable year, and (2) property placed in service, disposed of, subsequently reacquired, and again placed in service in the same taxable year (but only the basis of the property on the later of the dates that the property is placed in service is considered).¹⁵ The IRS provided some relief from the mid-quarter convention if a taxpayer’s third or fourth quarter included September 11, 2001.¹⁶

Regardless of whether the mid-year convention or the mid-quarter convention applies, no depreciation deduction is available for property placed in service and disposed of in the same year.¹⁷

Property subject to the mid-month convention is treated as placed in service (or disposed of) on the mid-point of the month without regard to whether the taxpayer has a short taxable year (i.e., a taxable year that is less than 12 months). The mid-quarter 40 percent test is also made without regard to the length of the taxable year. Thus, if property (with exceptions, as noted in the preceding paragraphs) is placed in service in a taxable year of three months or less, the mid-quarter convention applies regardless of when such property was placed in service (i.e., 100 percent of property has been placed in service in the last three months).¹⁸

In the case of a short taxable year and with respect to property to which the mid-year or mid-quarter convention applies, the recovery allowance is determined by multiplying the deduction that would have been allowable if the recovery year were not a short taxable year by a fraction, the numerator of which equals the number of months in the short taxable year and the denominator of which is 12.¹⁹ Proposed regulations under IRC Section 168(f)(5) (as in effect prior to TRA ’86) provided that a taxable year of a person placing property in service did not include any month prior to the month in which the person began engaging in a trade or business or holding recovery property for the production of income.²⁰ Presumably, this principle would continue to apply after TRA ’86.

Unit of Production Method

Instead of using ACRS, a property owner may elect to use the unit of production method of depreciation (if appropriate) or any other method not expressed in a term of years.²¹ For example, under the unit of production method, the depreciation deduction for a machine that, it is estimated, will produce 1,000,000 shoes (units) before wearing out, and that produces 250,000 units in the first year, would be:

(250,000 ÷ 1,000,000) × basis