For capital assets placed in service in recent years, the Modified Accelerated Cost Recovery System or the so-called MACRS system has been the law. Under this complex set of depreciation rules there are three attributes one must determine about each piece of property to be depreciated in order to properly apply the rules. These are: the applicable recovery period; the applicable depreciation method, and the applicable convention. We will discuss these attributes one at a time.
Recovery Period
The recovery period is an arbitrarily assigned period of years over which the property will be depreciated for tax purposes. Almost never does this recovery period bear any proportional relationship to the actual physical life of the asset, hence the use of the terminology “accelerated” in the name of the depreciation system. In reality, recovery periods are dictated by the IRS in Revenue Procedure 87-56. This revenue procedure classifies property into like groups call ‘assets classes’.
In the context of business aviation, there are two assets classes of concern: Asset Class 00.21 encompasses aircraft and helicopters used in business or corporate environments and prescribes a five-year MACRS recovery period and a six-year recovery period for those taxpayers electing the straight line method. Asset Class 45.0 encompasses assets used in air transport and commercial aircraft (the airlines and charter aircraft) and prescribes a seven-year MACRS recovery period and a twelve-year recovery period for those taxpayers electing the straight line method.
Depreciation Methods
There are currently two depreciation methods available for federal regular income tax purposes: the MACRS method and the ADS method, otherwise known as the straight-line method.
MACRS Method: for federal regular tax purposes (as opposed to federal alternative minimum tax purposes, see below), MACRS (the default method) is determined by a complicated 200% double declining balance formula that is beyond the scope of this article. It is far easier to relate to this method in terms of percentage tables. The annual percentage is simply multiplied times the taxable basis of the asset and thus the depreciation is calculated for that year. There are many nuances to this calculation and readers are well advised to utilize computerized tools in making reliable calculations as opposed to doing this on the back of an envelope. See Depreciation Table below.
ADS Method: also for federal regular tax purposes, taxpayers may elect to depreciate capital assets under the Alternative Depreciation System which is a straight-line depreciation methodology. Utilizing this method simplifies the calculation and avoids the tax preference created by utilizing the MACRS method discussed above. To calculate depreciation under this method, simply divide the asset’s taxable basis by the applicable recovery period for the property in question, 6 years for business or corporate aircraft and 12 years for commercial aircraft.
Conventions
The inclusion of “conventions” in the depreciation rules is a way of adjusting the first year depreciation available depending on the time of year the asset is placed in service. After all, the MACRS methodology represents a fairly rapid write-off of the assets cost as it is and Congress wanted to make sure that you could not place an asset in service very near the end of the year and also get a full-year MACRS deduction. That would just be too much! So they devise this silly set of rules. There are (you guessed it) two conventions: The Half-Year Convention and The Mid-Quarter Convention.
The Half-Year Convention generally applies to most aircraft depreciated under MACRS and it assumes the aircraft is placed in service in the middle of the applicable tax year. Under this convention, one half of the otherwise available depreciation amount calculated under the MACRS formula is deductible in the 1st year and the remaining one half is deductible in the year after the end of the applicable recovery period. In other words, even though under MACRS the recovery period is 5 or 7 years, the depreciation deduction under the Half-Year Convention is spread out over 6 or 8 years, which ever applies. If that does not confuse you, just wait.
The Mid-Quarter Convention only applies in the circumstance in which more than 40 percent of the aggregate capital additions for the year occur in the fourth quarter of the year. In many companies, the addition of an aircraft will most likely place you in this position. Under the mid-quarter rules, each individual asset is deemed to have been placed in service at the mid-point of the quarter in which it was placed in service regardless of the actual date it was acquired. As with the half-year convention, under the mid-quarter convention that portion of the otherwise available calculated 1st year depreciation amount not deductible because of the application of the mid-quarter convention is available in the year after the end of the applicable recovery period.
Depreciation Tables
Alternative Minimum Tax
For federal income tax purposes as well as in many states there exists an alternative minimum tax (“AMT”) system which operates parallel to and in conjunction with the federal regular income tax system. This taxing system was implemented by Congress in order to prevent certain high income taxpayers who also had a high volume of sophisticated deductions from avoiding income tax altogether. A discussion of the AMT System is beyond the scope of this paper but suffice it to say that depreciation deductions under the AMT system are based on MACRS 150% double decline balance formula versus the 200% double declining balance formula used for regular tax purposes. The difference between the regular tax calculation based on the 200% DDB formula and the 150% DDB formula for AMT is the preference amount.
In the event this discussion leaves you thoroughly confused or should you have questions, please do not hesitate to call our office.
Depreciation Methods