Rev Proc 87-56: Depreciation Rules and Asset Classifications Explained

The IRS provides guidelines to help businesses determine how long they can depreciate assets for tax purposes. Revenue Procedure 87-56 outlines asset classifications and assigns specific recovery periods. Understanding these rules is crucial because depreciation affects taxable income and financial planning.

This guidance helps taxpayers categorize assets correctly, ensuring compliance with tax laws while maximizing deductions.

Applicability of This Tax Guidance

Revenue Procedure 87-56 applies to businesses and individuals who claim depreciation deductions on assets used in a trade or business or for income-generating activities. The IRS uses this framework to standardize recovery periods, ensuring consistency in tax reporting. This is particularly relevant for companies investing in equipment, machinery, vehicles, and other depreciable property.

These classifications work alongside the Modified Accelerated Cost Recovery System (MACRS), the primary depreciation system in the U.S. since the Tax Reform Act of 1986. Under MACRS, assets are assigned recovery periods based on their use and industry classification. Businesses must refer to Rev. Proc. 87-56 to determine the correct asset category before applying the appropriate depreciation method. Misclassification can result in incorrect deductions, IRS audits, and penalties.

This guidance is also essential for tax planning and financial forecasting. Understanding recovery periods allows businesses to estimate future depreciation expenses, which impact taxable income and cash flow projections. For example, a company purchasing manufacturing equipment must account for its depreciation schedule when planning capital expenditures and tax liabilities. Proper classification ensures businesses maximize deductions while staying compliant with IRS regulations.

Asset Classification Groups

Revenue Procedure 87-56 categorizes assets based on their nature and business use, determining the appropriate recovery period under MACRS. Proper classification ensures accurate depreciation calculations and compliance with IRS rules.

Tangible Assets

Tangible assets include physical property such as machinery, vehicles, furniture, and equipment. These assets fall into specific classes based on function and industry. Office furniture and fixtures typically fall under the seven-year property class, while automobiles and light trucks have a five-year recovery period.

Manufacturing equipment is generally classified under a five- or seven-year recovery period, depending on its specific use. Assets used in plastic production are classified under a five-year recovery period, while those used in fabricated metal manufacturing may have a seven-year life. Businesses must carefully review IRS guidance to ensure proper classification, as misidentifying an asset can lead to incorrect deductions and potential tax penalties.

Certain Real Estate

Real estate assets have longer depreciation periods due to their extended useful lives. Nonresidential buildings, such as office spaces and retail stores, are typically depreciated over 39 years under the General Depreciation System (GDS). Residential rental properties, including apartment buildings, have a 27.5-year recovery period.

Land itself is not depreciable, but improvements such as parking lots, sidewalks, and fences may qualify for shorter recovery periods, often 15 years. Businesses must distinguish between building structures and land improvements to ensure accurate depreciation calculations. Leasehold improvements—modifications made to rental properties by tenants—may have different recovery periods depending on the nature of the improvement and eligibility for bonus depreciation.

Special Categories

Certain assets fall outside standard classifications and have unique recovery periods. Qualified technological equipment, such as computers and peripheral devices, is typically depreciated over five years. This category includes servers, printers, and networking hardware used in business operations.

Agricultural assets have varying recovery periods depending on their function. Farm machinery and equipment, such as tractors and irrigation systems, generally fall under a five-year recovery period, while specialized assets like grain bins and fences may have longer schedules.

Public utility property, such as water treatment facilities and electrical distribution systems, is classified separately, with recovery periods ranging from 15 to 50 years. Businesses in specialized industries must carefully review IRS classifications to ensure compliance and optimize tax benefits.

Depreciation Methods

The IRS allows businesses to recover asset costs over time through depreciation, with the chosen method significantly impacting tax liabilities and financial planning. Under MACRS, two primary methods are used: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS).

GDS is the default method, using accelerated depreciation to take larger deductions in the earlier years. This is typically done using the 200% or 150% declining balance method before switching to straight-line depreciation when it becomes more beneficial. For example, a business purchasing a $50,000 piece of equipment under a five-year GDS schedule may claim $10,000 or more in depreciation in the first year alone, depending on applicable conventions and bonus depreciation rules. This front-loaded approach helps businesses offset initial costs and reduce taxable income sooner.

ADS applies straight-line depreciation over a longer recovery period. This method is required for specific asset types, such as tax-exempt use property or assets used predominantly outside the U.S. Some businesses opt for ADS voluntarily to smooth out expenses, particularly if they prefer consistent deductions rather than an accelerated schedule. A company with stable cash flows, for instance, may choose ADS for real estate holdings to align depreciation expenses with long-term revenue projections.

Determining Class Life

Establishing the correct class life for an asset is essential for applying depreciation rules accurately. The IRS assigns each type of property a designated lifespan, dictating how deductions are calculated over time. These class lives, outlined in Appendix B of IRS Publication 946, are based on studies of asset durability and economic usefulness. While the recovery period under MACRS is often shorter than an asset’s actual service life, the assigned class life provides a structured framework for tax reporting and financial planning.

Determining an asset’s class life requires analyzing its functional use within a business. For example, a corporate jet used for executive travel falls under a different classification than an aircraft used for commercial freight. Similarly, telecommunications infrastructure, such as fiber optic cables, is assigned a different lifespan than traditional electrical distribution systems. The IRS distinguishes assets based on industry-specific guidelines, meaning businesses must align classifications with the appropriate North American Industry Classification System (NAICS) codes when filing tax returns.

Handling Reclassifications

Businesses sometimes need to reclassify assets due to changes in use, industry shifts, or IRS audits. If an asset is misclassified, adjustments must be made to ensure compliance with depreciation rules. The IRS may require a correction, impacting prior tax filings and future deductions.

Reclassifications often occur when a company repurposes equipment or real estate. For instance, if a warehouse is converted into office space, its depreciation schedule may need adjustment from a 39-year nonresidential property classification to a different category based on its new function. Similarly, if machinery initially classified under a seven-year recovery period is later determined to belong in a five-year category, the company must recalculate depreciation and possibly amend prior tax returns. Businesses can make changes using Form 3115, Application for Change in Accounting Method, which allows adjustments without triggering penalties in most cases.

Documentation Needs

Maintaining thorough records is necessary for substantiating depreciation claims and ensuring IRS compliance. Businesses must keep detailed documentation supporting asset classifications, recovery periods, and depreciation calculations, including purchase invoices, asset descriptions, service records, and modifications affecting an asset’s useful life.

Proper documentation is particularly important in the event of an IRS audit. If a company cannot provide adequate records to justify depreciation deductions, the IRS may disallow the claimed expenses, leading to additional tax liabilities and penalties. Businesses should also retain records of reclassifications, including supporting evidence such as engineering reports, industry guidelines, or IRS rulings that justify a change in asset classification. Digital asset management systems can help streamline record-keeping by organizing depreciation schedules, tax filings, and supporting documents in a centralized location.