The Three Forms of Depreciation of Personal Property
When it comes to a business’ personal property assessments, there are three forms of depreciation: physical, functional obsolescence, and economic obsolescence. Personal property tax is based on the value of an asset and there are multiple methods for reducing the overall personal property tax for assets where obsolescence may exist but has not been properly accounted for in the value.
Assessors typically value personal property using a measured mass appraisal cost approach technique, which means they depreciate the asset’s historical cost per the company records to arrive at a taxable value. This approach almost never encompasses all forms of depreciation and may result in a company being over assessed and paying more than their fair share of property tax.
Commonly, state guidelines for assessing property require that assessors consider all three forms of depreciation. They are:
Physical depreciation is the normal wear and tear that assets experience over time. Often there are extreme variations between states on how they assess depreciated property as well as the salvage value, otherwise known as the floor value.
Assets depreciate over a typical life cycle and physical depreciation tables attempt to calculate this loss in value over a period of its useful life. However, depreciation can occur more rapidly in some instances such as bedroom furniture in hotels or shelving in a retail store.
Functional obsolescence is a loss in value caused by conditions specific to the property, such as design flaws, less than ideal materials, or processes that result in inadequacy, overcapacity, or excess operating expenses.
Some examples of functional obsolescence may be a particular production line becoming too expensive to operate due to it being highly inefficient, or an older computer lacking the processing power to run the latest versions of software.
Economic obsolescence occurs as a result of outside factors that impact a company’s ability to compete, thrive and survive in the marketplace. Economic forces and environmental changes that affect the supply and demand relationship between a company and the marketplace cause this type of obsolescence.
Some of these outside factors could include an economic downturn and its impact on companies’ ability to finance capital investments. Another example would be the effect of e-commerce on Big Box retailers. As more sales move online, the instore fixtures lose economic utility since the sale of the inventory can occur without them. Lastly, political reforms such as those relative to healthcare and financial institutions, impact pricing and operating costs for many companies.
Calculating the valuation of these assets is highly complex. As a result, assessors overlook additional obsolescence – often due to a lack of resources, and not having complete clarity on the full spectrum of issues that may affect an asset’s value. Economic obsolescence may be very subtle and difficult to recognize without fully examining the many elements of the financial metrics of a company. For example, revenues may be increasing, yet profit margins and net income are declining due to factors such as higher competition, escalating costs of conducting business, and regulatory constraints.
More on Economic Obsolescence
For those considering economic obsolescence as part of their strategy to reduce their personal property tax burden, it’s important to understand how to identify its existence within your company’s operations, and how to communicate the claim’s validity to state and local assessors.
Industries frequently impacted by economic forces that could experience economic obsolescence include:
- Publishing, because of a shift toward digital media, overcapacity, and lower demand for print media.
- Defense, due to government funding restrictions, sequestration, and the phasing out of legacy programs.
- Retail, because of the change in consumer purchasing behavior toward e-commerce and away from brick-and-mortar locations.
- Healthcare, as a result of healthcare reform which has affected pricing and operating costs.
- Manufacturing, because of fluctuating prices of material, labor rates, changes in demand, environmental regulations, and technological changes.
- Energy, due to deregulation, technological change, and change in demand.
Determining if Economic Obsolescence Exists
One place to start is to read industry journals and to review your company’s 10-K. This will help identify and rank the various issues affecting your company. These possible issues include the impact of the overall economy, environmental concerns, the cost of raw materials, an increase in labor production costs, reduced demand for products or services, overcapacity in the industry, and declining profit margins/diminishing rate of return.
A good portion of the data you need can be found in your company’s financial statements. Altus Group recommends conducting the research for your company and for your top three to five competitors, over a period of at least three to five years. Where the obsolescence is not unique to your company, the point is to prove that the external force is impacting all companies within an industry and is not simply a matter of your company’s inability to effectively manage its resources – a common rebuttal from assessors.
Quantifying Economic Obsolescence
There’s no universal way to calculate or quantify economic obsolescence for every situation, which is why assessors often find it difficult to understand and accept. Try to determine what factor is most representative and demonstrate the impact on your business, product line, or service.
It could be a decline in revenue due to the company being forced to meet competitive pricing to keep customers. It could be a decline in sales, production values, or customers. At the same time, you could have growing revenue overall, but declining sales in a specific segment of the business. Take the example of a publishing company, which is experiencing a decline in print sales, but experiencing a rise in digital publication sales. This is a case where overall revenue is growing, but the economic value of the printing equipment has declined.
In reality, very few taxpayers bring forward economic obsolescence claims, which makes assessing jurisdictions more reluctant to grant them and set a precedent. Therefore, it’s important to educate the jurisdiction about the fundamentals of economic obsolescence and the taxpayer’s specific situation.
If your claim is rejected, there is typically an informal and formal appeal, followed in most states by a litigation process. Be prepared to walk the appropriate property tax appeals authority through the basics of what obsolescence means, citing any agency cases or statutory guidelines that exist for that jurisdiction to bolster your claim’s credibility. Almost all state assessing guidelines allow for economic obsolescence to be considered but it falls on the taxpayer to both request the adjustment and make sure the assessing jurisdictions are abiding by their own guidelines for valuing property.
Connect with us
Want to learn more? Let us know what you're interested in and one of our team members will be in touch.
Megan LusbyLusbybu-state-local-tax personal-property-taxpersonal-property-tax-consultingpersonal-property-tax-commercial-real-estatehunt-valleySenior Director, Property Tax
Last updated on September 4th, 2019 at 05:43 pm