Useful Life, Class Life, and Recovery Period

According to IRS Publication 946: How to Depreciate Property, in order for property to be depreciable it must meet all of the following requirements:

  • “It must be property you own.”
  • “It must be used in your business or income-producing activity.”
  • “It must have a determinable useful life.”
  • “It must be expected to last more than one year.”

Of the four requirements, the last two both relate to time. Given this importance, what time should be used when depreciating an asset? The asset’s useful life? A shorter period? The same period for both book and tax financials? Like many other finance and tax related questions, the answer is that it depends.

Publication 946 defines three terms associated with the life of an asset:

  1. Useful Life: “An estimate of how long an item of property can be expected to be usable in trade or business or to produce income.”
  2. Class Life: “A number of years that establishes the property class and recovery period for most types of property under the General Depreciation System (GDS) and Alternative Depreciation System (ADS).”
  3. Recovery Period: “The number of years over which the basis of an item of property is recovered.”

Useful Life

Useful life is simply an estimate of how long the asset will last for your particular company. If you’re a construction company, a pneumatic nail gun may last you less than one year; however, if you’re a software company that happens to have a nail gun, it might last 30 years.

According to FASB ASC paragraph 360-10-35-3, “Depreciation expense in financial statements for an asset shall be determined based on the asset’s useful life.” Therefore, the useful life is:

  1. An estimate of how long the asset will last for your company
  2. Used to calculate book depreciation

Class Life

Do a quick google for class life and most results will lead you to believe that the class life is the period over which you depreciate an asset for tax basis—that’s not true! The Economic Recovery Tax Act (ERTA) of 1981 established property class lives, effectively bucketizing assets into classes with a single useful life assigned to each property class as the class life. Instead of depreciating over the class life, assets were depreciated on a shorter period known as the recovery period using the Accelerated Cost Recovery System (ACRS).

ACRS was used for tax purposes until it was replaced by the Modified ACRS (MACRS) in 1986 when the Tax Reformed Act of 1986 was passed. Similar to ACRS, MACRS uses a shorter recovery period for depreciating assets.

Recovery Period

When referring to assets, people often refer to one of nine property classes, which are listed in Chapter 4 of IRS Publication 946:

  1. 3-year property
  2. 5-year property
  3. 7-year property
  4. 10-year property
  5. 15-year property
  6. 20-year property
  7. 25-year property
  8. Residential rental property, 27.5-year property
  9. Nonresidential rental property, 39-year property

Here’s the dirty little secret—the year used for the property classes is the number of years for the recovery period not the class life. Actually this isn’t very dirty and it’s not very secret if you reference reputable sources, such as IRS Publication 946, instead of relying on websites that don’t provide references.

So now you know that 7-year property is referring to assets in the property class with a recovery period of 7 years. More correctly, this is the recovery period under the General Depreciation System (GDS).

What’s GDS? A topic for another post, that’s what it is.