The Arbitrary Nature of Depreciation Asset Classes

May 21, 2014

The IRS issued a new ruling on the asset class for the depreciation of biofuel equipment, that is, equipment used in the creation of ethanol. The ruling places ethanol fuel equipment into class 49.5 which grants it a recovery period of seven years for equipment, and shifts to ten years under certain conditions, predominately foreign use (see section 168(g) for additional examples).

While important, I don’t want to focus on the classification of this asset and whether or not it is in the right or wrong asset class (should it be a three-year asset with the race horses or a seven year asset with the office furniture?). Instead, I want to discuss how this serves as an excellent example of the arbitrary nature of depreciation schedules, in the absence of full expensing.

Depreciation: What Goes Where?

The IRS code has nine different asset classes ranging from three years to 39 years for commercial buildings. Every time a new asset is created (e.g. ethanol equipment), it’s up to the IRS to determine where the place the asset.  

In this process, the IRS attempts to place an asset within a class that best reflects the useful life of a piece of equipment. For example, maybe a farmer buys a combine tractor and uses it for seven years before it breaks down. The IRS would likely place that asset in the category for seven year assets where it places all agricultural machinery and equipment.

The issue is that not all assets are the same, even within the same category. A farm combine is very different than a farm tractor. A computer is not the same as a copier. Carpet is not the same thing as furniture. Desks are not the same thing as safes. Yet, each of these comparisons are treated the same when it comes to depreciation. There is even variation among assets that are seemingly equivalent.

The useful life of a piece of ethanol equipment will vary based on who made it, who operates it, the type of environment in which it is used, and the type of work for which it is used. Not all biofuel equipment will last seven years and some may last even longer.

Technology also creates an issues for the generic grouping of assets.

Technological advances can quickly make types of assets obsolete. According to the IRS, computers have an asset life of 5 years, but computers today are far different than those from five years ago. In fact, we recently needed to update the computers in our office and they were no more than two years old.

When individuals and firms need to purchase updated equipment to keep up with progress, the tax code shouldn’t create a barrier. Unfortunately, our tax code’s treatment of capital investment does.

The Economics of Depreciation

The arbitrary nature of depreciation isn’t the only issue with how the tax code treats capital investment. It also has an economic effect.

By requiring businesses to write off capital investments over multiple years, long asset lives makes investment in capital more expensive.

If a person purchases a piece of biofuel equipment for $100 and but for tax purposes must depreciate it over seven years, she will only be able to account for $91 of that investment, assuming no inflation.

Let’s say she uses that equipment and makes $100 in revenue over that time period. Over the seven years she will have spent $100 to purchase her equipment and made $100 in revenue, but the depreciation schedule will only allow her to account for $91 of those costs, assuming no inflation. Because of this, she will pay taxes on $9 in supposed profits, even though she made nothing ($100 in revenue minus $100 in costs).

This has a damaging impact on investment by understating costs and overstating profits.

The correct treatment of purchases of capital (i.e. anything from computers to barns) is full expensing.

Under full expensing, those who purchase equipment are able to fully account for the costs in the year in which they are incurred. This has the benefit of increasing investment, growth, jobs, and wages.

To top it off, full expensing also has the added benefit of eliminating the arbitrary nature of our current depreciation regime.

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