Units-of-Production Method of Depreciation
Author: Rick Carrier Jr
Many taxpayers do not realize the depreciation options the federal tax code and regulations provide them. The options available are more than simply choosing to use Section 179 or "bonus" depreciation. One option many taxpayers overlook is the ability to select a method based on the useful life of an asset, as opposed to typical depreciation over a set number of years, commonly referred to as an asset's class life.
One method of "useful life" depreciation is calculated based on the estimated units an asset could produce. This method of useful life depreciation is referred to as units-of-production depreciation. The units the asset produces could be anything from feet drilled or mined to cubic yards of available space filled.
As with most exceptions to tax code norms, the IRS does impose restrictions on use of the units-of-production depreciation method. The useful life of the asset must be estimable and finite, based on the unit of measure selected. The election must be made on the return filed for the year the asset is placed in service, and once the units-of-production method of depreciation is elected, it must be used for the asset's entire life.
One potential benefit of using the units-of-production depreciation method is the possibility of depreciating an asset faster than is allowed by class life depreciation. This is possible when all the asset's units are produced in a period of time shorter than the asset's required class life. Another benefit is the asset's depreciation expense more closely matches the revenue the asset generates. In terms of record keeping, it is easier to track an asset's depreciation for alternative minimum tax (AMT) and most state income tax purposes because the AMT and most state depreciation will match federal depreciation when using the units-of-production method.
Potential disadvantages of the unit-of-production method include the possibility of delaying the start of depreciation and depreciation being stopped if the asset is not in use due to work delays; unlike class life depreciation methods, the asset must be in use for depreciation expense to be claimed. The in-use requirement could result in delayed recognition of depreciation expense if the asset is ready to be used but sitting idle. After the asset has been placed in service and is being depreciated, the asset must remain in service and be producing "units of production" for the asset's depreciation expense to continue to be recognized. In short, any delays in work will result in delayed recognition of depreciation expense. Also, a deceleration of depreciation (when compared to class life depreciation) could result if the asset will be used for a time period greater than its class life. For example, the class life of most construction equipment is five years. If an asset has a productive period of eight years, the class life depreciation method would allow for faster recognition of depreciation expense.
Companies most often employ units-of-production depreciation for specialty equipment and natural resource extraction equipment. However, there are other circumstances in which taxpayers could benefit from the units-of-production depreciation method. For more information on units-of-production depreciation, contact your BKD advisor.