P pt ch 08

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Individual Income Taxes

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Chapter 8

Depreciation, Cost Recovery, Amortization, and Depletion

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The Big Picture (slide 1 of 2)

• Dr. Cliff Payne purchases and places in service in his dental practice the following fixed assets during the current year:

Office furniture and fixtures $ 70,000Computers and peripheral equipment 67,085Dental equipment 475,000

• Using his financial reporting system, he concludes that the depreciation expense on Schedule C of Form 1040 is $91,298.

Office furniture and fixtures ($70,000 X 14.29%) $10,003Computers and peripheral equipment ($67,085 X 20%) 13,417Dental equipment ($475,000 X 14.29%) 67,878

$91,298

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The Big Picture (slide 2 of 2)

• In addition, during the current year, Dr. Payne purchased another personal residence for $300,000– He converts his original residence to rental property.

• He also purchased a condo for $170,000 near his office that he is going to rent.

• Has Dr. Payne correctly calculated the depreciation expense for his dental practice? – Will he be able to deduct any depreciation expense for his

rental properties?• Read the chapter and formulate your response.

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Cost Recovery

• Recovery of the cost of business or income-producing assets is through:– Cost recovery or depreciation: tangible assets– Amortization: intangible assets– Depletion: natural resources

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Nature of Property

• Property includes both realty (real property) and personalty (personal property)– Realty generally includes land and buildings permanently

affixed to the land– Personalty is defined as any asset that is not realty

• Personalty includes furniture, machinery, equipment, and many other types of assets

• Personalty (or personal property) should not be confused with personal use property– Personal use property is any property (realty or personalty)

that is held for personal use rather than for use in a trade or business or an income-producing activity

• Write-offs are not allowed for personal use assets

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General Considerations(slide 1 of 3)

• Basis in an asset is reduced by the amount of cost recovery that is allowed and by not less than the allowable amount– Allowed cost recovery is cost recovery actually taken

– Allowable cost recovery is amount that could have been taken under the applicable cost recovery method

• If no cost recovery is claimed on property – The basis of the property must still be reduced by the

amount that should have been deducted • i.e., The allowable cost recovery

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• If personal use assets are converted to business or income-producing use– Basis for cost recovery and for loss is lower of

• Adjusted basis or

• Fair market value at time property was converted

– Losses that occurred prior to conversion can not be recognized for tax purposes through cost recovery

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• MACRS applies to:– Assets used in a trade or business or for the

production of income– Assets subject to wear and tear, obsolescence, etc.– Assets that have a determinable useful life or

decline in value on a predictable basis– Assets that are tangible personalty or realty

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The Big Picture - Example 3Cost Recovery Basis for Personal Use Assets

Converted to Business Use• Return to the facts of The Big Picture p. 8-1.• Five years ago Dr. Payne purchased his personal residence for

$250,000. – This year Dr. Payne found a larger home that he acquired for his

personal residence. – Unfortunately he cannot sell his original residence and recover his

purchase price of $250,000. • The residence was appraised at $180,000.

• Instead of continuing to try to sell the original residence, Dr. Payne converted it to rental property. – The basis for cost recovery of the rental property is $180,000 because

the fair market value is less than the adjusted basis. – The $70,000 decline in value is deemed to be personal (since it

occurred while the property was held for personal use by Dr. Payne) and therefore nondeductible.

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MACRS-Personalty

• MACRS characteristics: MACRS Personalty .

Statutory lives: 3, 5, 7, 10 yrs 15, 20 yrs

Method: 200% DB 150% DB

Convention: Half Yr or Mid-Quarter

DB = declining balance with switch to straight-line

Straight-line depreciation may be elected

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Half-Year Convention

• General rule for personalty

• Assets treated as if placed in service (or disposed of) in the middle of taxable year regardless of when actually placed in service (or disposed of)

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Example: Half-Year Convention

• Purchased and placed an asset in service on March 15 (Tax year end is December 31)– Treated as placed in service June 30– Six months cost recovery in year 1 (and year

disposed of, if within recovery period)

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Additional First-Year Depreciation (slide 1 of 2)

• 50% additional first-year depreciation has been allowed for several years– The Small Business Jobs Act of 2010 extended additional first-year

depreciation for one more year• Effective for qualified property acquired and placed in service before

January 1, 2011

• Most recently, the Tax Relief Act of 2010 extended additional first-year depreciation for 2011 – Increases the percentage from 50% to 100%– Effective for qualified property placed in service after Sept. 8, 2010

and before Jan. 1, 2012• The Act also extends additional first-year depreciation for

2012, but at the 50% rate– Effective for qualified property placed in service after Dec. 31, 2011

and before Jan. 1, 2013

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Additional First-Year Depreciation (slide 2 of 2)

• Additional first-year depreciation allows an additional percentage (50% or 100%) of cost recovery in year asset is placed in service

• Qualified property includes most types of new property other than buildings– Property that is used but new to the taxpayer does

not qualify

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Example: Additional First-Year Depreciation

Maple Company acquires a 5-year class asset on April 25, 2012, for $20,000. Maple’s cost recovery deduction for 2012 is computed as follows:

50% additional first-year

depreciation ($20,000 X .50) $10,000

MACRS cost recovery

[($20,000 - $10,000) X .20 (Table 8.1)] 2,000

Total cost recovery $12,000

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The Big Picture - Example 8MACRS With Additional First-Year

Depreciation

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Mid-Quarter Convention

• Applies when more than 40% of personalty is placed in service during last quarter of year

• Assets treated as if placed into service (or disposed of) in the middle of the quarter in which they were actually placed in service (or disposed of)

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Example: Mid-Quarter Convention

• Business with 12/31 year end purchased and placed in service the following used 5-year class assets:

• Asset 1: on 3/28 for $50,000, and

• Asset 2: on 12/28 for $100,000

• More than 40% placed in service in last quarter; therefore, mid-quarter convention used:

• Asset 1: $50,000 × (.20 × 200% × 10.5/12) = $17,500, or

$50,000 × 35% (Table 8.2) = $17,500

• Asset 2: $100,000 × (.20 × 200% × 1.5/12) = $5,000, or

$100,000 × .05 (Table 8.2) = $5,000

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The Big Picture - Example 11Mid-Quarter Convention

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MACRS-Realty (slide 1 of 2)

• MACRS characteristics: MACRS Realty Residential Rental Nonresid. RealtyStatutory lives: 27.5 yrs 31.5 yrs or 39 yrsMethod: Straight-lineConvention: Mid-month

• Residential rental real estate – Includes property where 80% or more of gross rental

revenues are from nontransient dwelling units – e.g., Apartment building

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MACRS-Realty (slide 2 of 2)

• Mid-month Convention– Property placed in service at any time during a

month is treated as if it was placed in service in the middle of the month

– Example: Business building placed in service April 25 is treated as placed in service April 15

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Optional Straight-line Election

• May elect straight-line rather than accelerated depreciation on personalty placed in service during year– Use the class life of the asset for the recovery

period– Use half-year or mid-quarter convention as

applicable– Election is made annually by class of property

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Farm Property (slide 1 of 2)

• Generally, for farm assets use:– MACRS 150% declining-balance method for

personalty• MACRS straight-line method is required for any tree or

vine bearing fruits or nuts

– Straight line method over the normal periods (27.5 years and 39 years) for real property

– If the election is made to not have the uniform capitalization rules apply, alternative depreciation system (ADS) straight-line method must be used

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Farm Property (slide 2 of 2)

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Leasehold Improvement Property (slide 1 of 3)

• If lessor is owner of leasehold improvement property, depreciation is calculated as follows:– Real Property – Use straight-line method over 27.5 or 39

year statutory recovery periods

– Tangible personal property – Use the shorter MACRS lives and accelerated methods

• When these improvements are disposed of or abandoned by the lessor due to lease termination– Property is treated as disposed of by the lessor

– A loss can be taken for the unrecovered basis

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• If lessee is owner of leasehold improvement property– Costs of leasehold improvements are recovered in

accordance with the general cost recovery rules• Cost recovery period is determined without regard to

the lease term

– Any unrecovered basis in the leasehold improvement property not retained by the lessee is deducted in the year the lease is terminated

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• Tax Relief Act of 2010 allows for 50% additional first-year depreciation for qualified leasehold improvements – A qualified leasehold improvement is an

improvement to an interior portion of a nonresidential building by the lessee or lessor, and

– Placed in service more than 3 years after date building was first placed in service.

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Election to Expense Assets -Section 179 (slide 1 of 5)

• General rules– Can elect to immediately expense up to $139,000

of business tangible personalty placed in service in 2012

– Cannot use § 179 for most realty or production of income property

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• Section 179 general rules– Amount expensed reduces depreciable basis– Any elected § 179 expense is taken before

additional first-year depreciation is computed• The base for calculating the standard MACRS

deduction is net of the § 179 expense and the additional first-year depreciation (50% in 2012).

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• Annual limitations:– Expense limitation ($139,000 for 2012) is reduced

by amount of § 179 property placed in service during year that exceeds $560,000

• Example: In 2012, taxpayer placed in service $575,000 of § 179 property. – The § 179 expense limit is reduced to $124,000

• [$139,000 – ($575,000 – $560,000)]

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• Annual limitations:– Election to expense cannot exceed taxable income (before

§ 179) of taxpayer’s trades or businesses• Any amount expensed under § 179 over taxable income limitation

may be carried over to subsequent year(s)

• Amount carried over still reduces basis currently

– The § 179 amount eligible for expensing in a carryforward year is limited to the lesser of

• The statutory dollar amount ($139,000 in 2012) reduced by the cost of § 179 property placed in service in excess of $560,000 (in 2012) in the carryforward year, or

• The business income limitation in the carryforward year.

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Example: Taxpayer buys 5-year property for $164,000 on August 15, 2012 and elects immediate expensing of the maximum amount. The total deduction for the year is calculated as follows:

§ 179 expense $139,000

Standard MACRS calculation

[($164,000 - $139,000) X .20] 5,000

Total cost recovery allowed in 2012 $144,000

Assumes election is made to not take additional first year depreciation.

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Listed Property (slide 1 of 4)

• There can be substantial limits on cost recovery of assets considered listed property

• Listed property includes the following:– Passenger automobile– Other property used as a means of transportation– Property used for entertainment, recreation, or

amusement– Computer or peripheral equipment– Cellular telephone

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• To be considered as predominantly used for business, business use must exceed 50%

• Use of asset for production of income is not considered in this 50% test

• However, both business and production of income use percentages are used to compute cost recovery

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• To be considered as predominantly used for business (cont’d)

• If 50% test is met, then allowed to use statutory percentage method of cost recovery with some limitations

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• If asset is not used predominantly for business i.e., business use does not exceed 50%– Must use straight-line method– If business use falls to 50% or lower after year

property is placed in service, must recapture excess cost recovery

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Passenger Auto Cost Recovery Limits (slide 1 of 7)

For autos placed in service in 2011, cost recovery limits are:Year Recovery Limitation

1 $3,060 2 4,900 3 2,950Succeeding years until the cost is recovered 1,775

• If a passenger auto used predominantly for business qualifies for additional first-year depreciation– First-year recovery limitation is increased by $8,000

• Limit increases from $3,060 to $11,060 ($3,060 + $8,000).

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• Limits are for 100% business use– Must reduce limits by percentage of personal use

• Limit in the first year includes any amount the taxpayer elects to expense under § 179

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Example: Taxpayer acquired an auto in 2011 for $30,000 and used it 80% for business

2011 cost recovery allowance: ($30,000 × 20%) × 80% $4,800

But deduction is limited to $3,060× Business use % × 80%Cost recovery allowance $2,448

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• Limit on § 179 deduction – For certain vehicles not subject to the statutory

dollar limits imposed on passenger automobiles the § 179 deduction is limited to $25,000

• The limit applies to sport utility vehicles with an unloaded GVW rating of more than 6,000 pounds and not more than 14,000 pounds

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• Listed property that fails the >50% business usage test in year property is placed in service must be recovered using the straight-line method– Such property does not qualify for additional first-year

depreciation

• If the >50% business usage test is failed in a year after the property is placed in service, straight-line method must be used for remainder of property’s life– Cost recovery of passenger auto under straight-line listed

property rule still subject to annual limits

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• Change from predominantly business use– If the business use percentage falls to 50% or

lower after the year the property is placed in service, the property is subject to cost recovery recapture

– The amount recaptured as ordinary income is the excess cost recovery

• Excess cost recovery is the excess of the cost recovery deductions taken in prior years using the statutory percentage method over the amount that would have been allowed if the straight-line method had been used

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• Leased autos subject to inclusion amount rule– Using IRS tables, taxpayer has gross income equal

to each lease year’s inclusion amount– Purpose is to prevent avoidance of cost recovery

dollar limits applicable to purchased autos by leasing autos

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Alternative Depreciation System (ADS) (slide 1 of 2)

• ADS is an alternative depreciation system that is used in calculating depreciation for:– Alternative minimum tax (AMT)– Assets used predominantly outside the U.S.– Property owned by the taxpayer and leased to tax

exempt entities– Earnings and profits

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Alternative Depreciation System (ADS) (slide 2 of 2)

• Generally, use straight-line recovery without regard to salvage value– For AMT, 150% declining balance is allowed for

personalty– Half-year, mid-quarter, and mid-month

conventions still apply

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Amortization (slide 1 of 2)

• Can claim amortization deduction on § 197 intangibles– Use straight-line recovery over 15 years (180

months) beginning in month intangible is acquired

• Section 197 intangibles include acquired goodwill, going-concern value, trademarks, trade names, etc.

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Amortization (slide 2 of 2)

• Startup expenditures are also partially amortizable under § 195– Treatment is available only by election

• Allows the taxpayer to deduct the lesser of:– The amount of startup expenditures, or

– $5,000, reduced by the amount startup expenditures exceed $50,000

– Any amounts not deducted may be amortized ratably over 180-months beginning in month trade or business begins

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Depletion (slide 1 of 4)

• Two methods of natural resource depletion– Cost: determined by using the adjusted basis of the

resource and allocating over the recoverable units– Percentage: determined using percentage provided

in Code and multiplying by gross income from resource sales

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• Cost depletion– Depletion is computed on a per unit basis– Per unit amount is determined by dividing the

basis of the resource by the estimated recoverable units of resource

• Number of units sold in year × per unit depletion = depletion for year

– Total depletion can not exceed total cost of the property

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• Percentage depletion– Depletion is computed by using the statutory

percentage rate for the type of resource– Rate is applied to the gross income from the

property

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• Percentage depletion– Percentage depletion cannot exceed 50% of the

taxable income (before depletion) from the property

– Percentage depletion reduces basis in property– However, total percentage depletion may exceed

the total cost of the property• Example: Property with zero basis but still generating

income

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Intangible Drilling Costs (IDC)

• Intangible drilling costs include – Costs for making the property ready for drilling– Costs of drilling the hole

• Treatment of IDC– Expense in the year incurred, or– Capitalize and write off through depletion

• It is generally advantageous to write off IDC immediately

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The Big Picture - Example 47

Tax Planning• Return to the facts of The Big Picture p. 8-1.• In January 2012, Dr. Payne purchased residential rental property for

$170,000 ($20,000 allocated to the land, $150,000 to the building). – He made a down payment of $25,000 and assumed the seller’s mortgage for

the balance. • Since the property was already occupied, Dr. Payne continued to receive

rent of $1,200 per month from the tenant. • Assume any losses generated by the property are currently deductible and

he is in the 28% tax bracket. • During 2012, Dr. Payne’s expenses were as follows:

Interest $10,000Taxes 800Insurance 1,000Repairs and maintenance 2,200Depreciation ($150,000 X .03636) 5,454Total $19,454

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The Big Picture - Example 47

Tax Planning• The deductible loss from the rental property is computed as follows:

Rent income ($1,200 X 12 months) $ 14,400Less expenses (see above) (19,454)Net loss ($ 5,054)

• But what is Dr. Payne’s overall position for the year when the tax benefit of the loss is taken into account?

• Considering just the cash intake and outlay, it is summarized below:Intake—Rent income $14,400Tax savings [28% (income tax bracket) X $5,054 (loss from the property)] 1,415 Net Intake $ 15,815Outlay—Mortgage payments ($1,000 X 12 months) 12,000Repairs and maintenance 2,200 Net Outlay (14,200)Net cash benefit $ 1,615

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Refocus On The Big Picture

• Evidently, Dr. Payne’s accounting system uses MACRS because $91,298 of depreciation is the correct amount. – The computers and peripheral equipment are 5-year property.– The furniture and fixtures and the dental equip. are 7-year property.

• Based on the IRS tables, the following percentages are used to calculate first year depreciation expense:

5-year property 20.00%7-year property 14.29%

• Dr. Payne will also be able to deduct depreciation on the house he converted from personal use to rental use and on the rental house that he purchased.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 56

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

P pt ch 08

Documents

cost recovery recovery

cost recovery basis

nature of property property

rental property

cost of business

months cost recovery

personal residence

personalty assets