ADS: When its Required and How it Affects Taxpayers
Under the current regulations, business property that is placed into service after 1986 must use the Modified Accelerated Cost Recovery System (“MACRS”) to calculate the depreciation expense for the business property in which is the wear-and-tear expense is allowed. MACRS consists of two separate systems for depreciation: the General Depreciation System (“GDS”) and the Alternative Depreciation System (“ADS”). GDS is far more common and well known compared to ADS. In addition, GDS is generally the preferred system utilized by taxpayers for a few different reasons including typically having shorter recovery periods, quicker recovery methods, and is eligible for bonus depreciation. Although there are situations when a taxpayer may elect to use ADS, most taxpayers only use the alternative system when it’s mandatory.
The Alternative Depreciation System is required in the following circumstances:
- Tangible property used predominantly outside the United States
- Residential, non-residential real property and qualified improvement property owned by a Real Property Trade or Business that elected out of the 163(j) business interest limitation
- Tax-exempt use property leased to tax-exempt entity
- Tax-exempt bond-financed property
- Listed property (such as car or truck) used 50% or less in qualified business use
- Farmers’ property who elects to deduct preproductive period costs of certain plants
- Property with a recovery period of 10-years or more which is owned by an “electing farm business” that made the election out of the 163(j) business interest limitation
Our team has seen the listed election out of the 163(j) business interest limitation make a major impact on taxpayers. It has especially amplified since the Qualified Improvement Property (“QIP”) “glitch” was fixed by the CARES Act. The election out requires all Real Property to be depreciated using ADS for large taxpayers who made the election out. This is especially considerable for taxpayers that frequently make interior improvements to their non-residential properties that can be classified as QIP. One of the major advantages of QIP is that it’s bonus eligible when utilizing GDS. However, QIP is considered Real Property and must be depreciated using ADS when the election out is made, and therefore not eligible for bonus. This requirement significantly reduces the amount of depreciation that is allowed in the first year of the asset’s life and often times surprises taxpayers when the initial depreciation expense is much lower than what was expected from the asset class. Although QIP is required to use ADS when the 163(j) election out is made, 5-year personal property, 7-year personal property, and 15-year land improvements are still depreciated using GDS and are bonus eligible. It is imperative to have proper tax planning such as using a cost segregation study to classify property into bonus eligible 5, 7 or 15-year lives to help generate accelerated depreciation deductions that cannot be produced from QIP when the election out is made.
Take for example how this can impact a company that makes improvements to office and retail properties. During the 2022 tax year, a taxpayer that previously made an election out of the 163(j) business election is in the 30% tax bracket and contributes $5 million in tenant allowances to construct a number of office and retail suites at their existing properties. Without a study, the taxpayer was able to identity roughly $1.5 million that can be classified as 20-year QIP. However, with a cost segregation study, the provider was able to identify $2 million in 20-year QIP and $1 million in bonus eligible 5-year property. Without using a study, QIP produced $19k in 2022 accelerated depreciation deductions and equates to roughly a $5.6k increase in first year cash flow. By using a study, the reclassification of QIP and personal property generates roughly $1 million in 2022 accelerated depreciation and an increased first year cash flow of $300k. This is an extremely large difference in depreciation for 2022 that can be left on the table if not planned correctly.
When ADS is required to be utilized, tax planning can become quite a challenge. If not carefully planned, there could be a material impact on the tax situation for taxpayer and could wind up with a larger tax bill than anticipated. It is best to discuss with a depreciation expert such as the McGuire Sponsel team to ensure that you’re utilizing the depreciation systems correctly.
Craig Fouts is a senior manager for the Fixed Asset Services practice. As a Certified Public Accountant, Craig serves as a technical lead in cost segregation.
Fouts has significant experience managing projects from start to finish in a wide variety of industries. Craig’s knowledge & experience allow him to produce accurate results that increase cash flows and optimize depreciation deductions in a timely manner.