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How Will Proposed Changes to Depreciation Affect Already Closed Deals?

Senator Baucus, Chairman of the Senate Finance Committee has proposed some remarkable changes to the depreciation methods provided in the Internal Revenue Code.  

 

For personal property, we NOW have property by property depreciation, using pretty fast MACRS (or "modified accelerated cost recovery system") depreciation.  For example, for 5-year property (which is already an acceleration, since most 5-year property has a far longer life than 5 years), the CURRENT write off is to 20%-32%-19%-11%-11%-6% in the first six years.  Depreciation takes SIX years, because of the "mid-year convention" that treats property as placed in service in the middle of the year.

 

The PROPOSED “pool” depreciation method would put property in one of four pools.  The following is an OVERSIMPLIFIED summary; the lists are far longer, and no doubt, more intricate --

 

Pool 1 -- cars, computers, software, 38% (note that personal use cars have their own set of special limitations)

 

Pool 2 -- buses, trucks, agriculture, animals, telephone and broadcasting, manufacture of wood, most rubber and plastic and vehicles, t18%

 

Pool 3 -- furniture, some boats and vessels, planes and manufacture of planes, manufacture of train cars and locomotives, oil and gas drilling, clothing, chemical, certain rubber and plastic, glass, metal, leather manufacturing, printing,  12%

 

Pool 4 -- Train cars and locomotives, land improvements, utility distribution, some water transportation and dry docks, solar and wind energy, 5%

 

What is really different is how the PROPOSED cost recovery works for these pools.  Instead of simply recovering the cost of an item over some number of  years, these methods apply the percentage indicated to the total adjusted capital expended in the particular pool. 

 

For example, if your only asset was a $1M wind turbine, and you never bought anything else, then you would deduct 5% of $1M in the first year (that would be $50,000), and then 5% of WHAT WAS LEFT, or $950,000 in the second year (that would be $47,500).  Obviously, this is an extraordinary change from the old method, which would allow a $200,000 deduction in the first year, and a $320,000 deduction in the second, and even more, if "bonus depreciation" applied.

 

For real estate, the change is from 27.5 year for residential rental and 39 years for other buildings, to 43 year straight line.  On a percentage basis, this means that residential rental is going from a 3.6% depreciation deduction per year to 2.3% per year.

 

There's a second, equally remarkable change -- THESE METHODS WILL GO INTO EFFECT ON 1/1/15, REGARDLESS OF WHEN THE PROPERTY WAS PLACED IN SERVICE. 

 

For example, suppose you had a building that cost $2.75M, and you were deducting $100K per year, and after three years, the adjusted basis was $2.45M.  On 1/1/15, your depreciation deduction would switch over to 43-year straight line, on the current adjusted basis of $2.45M, or $57K per year; quite a change!

 

In the tax credit world, this may or may not be covered by an adjuster; many more investors have tax credit adjusters than have depreciation adjusters. 

 

Our understanding is that this proposal is intended to raise several hundred billion dollars of revenue that can then be used to buy down the maximum tax rate to 28%.  However, these changes are  so large that you have to wonder if the proposal will survive to final legislation. 

 

Undoubtedly, there will be more to follow! 

 

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