The American College: HS 321 Income Taxation Chapter 11 Cost Recovery Deductions.

The American College: HS 321Income Taxation

Chapter 11

Cost Recovery Deductions

Chapter 11 Overview

State the pre-ACRS history of cost recovery, and explain how accelerated cost recovery systems (ACRS and MACRS) allow the recovery of investment capital for income tax purposes.

Explain how the accelerated cost recovery systems of ACRS & MACRS allow the recovery of investment capital..

Chapter 11 Overview - Continued

Explain depreciation recapture and the election to expense certain depreciable business assets.

Describe cost recovery limitations on certain depreciable assets collectively known as listed property, and explain the concept of amortizing certain intangible assets.

Learning Objective

Explain what is meant by cost recovery, recovery method, and recovery period; identify the four basic conditions for the allowance of cost recovery deductions.

Purpose of Depreciation Deduction

Recovery of capital investment in qualifying property a) used in a trade or business or b) held for the production of income.

Non qualifying property such as raw land, inventory.

Date property placed in service determines the cost recovery method and cost recovery period.

Learning Objective

Describe methods for computing depreciation deduction for pre-ACRS assets and distinguish depreciation from obsolescence.

History of Depreciation Methods Pre-1981

1971 class life system with ADR or facts and circumstances

1981–present: ACRS/MACRS Eliminates estimates and salvage value Shortens recovery period TRA ’86: MACRS effective 1/1/87

Calculating Depreciation

Four Methods for Calculating Depreciation

1. Straight line

2. Declining balance

3. Sum of the years digits method

4. Any other consistent method

Straight line Depreciation

Cost of property divided by estimated useful life.

EXAMPLE….20 year property purchased for $10,000 yields 20 equal depreciation deductions of $500.

The adjusted basis is being reduced each year by the depreciation deduction of $500.

Declining Balance Method Fixed percentage of the unrecovered cost of the

asset is deducted each year.

EXAMPLE 20 year asset would depreciate at 5%. Under declining balance method up to 10% is depreciation each year.

In year 1, the deduction is 10% of basis.

In year 2 and following it is 10% of remaining basis until full cost recovery.

Sum of the Years Digits

Similar to a declining balance method

Numerator is number of years of useful life for the year of deduction.

Denominator is the sum of the numbers representing each year of property’s useful life.

Example 5 year property depreciates at

5/15, 4/15, 3/15, 2/15, 1/15

Any Other Consistent Method

Any method so long as not resulting in depreciation greater than that under declining balance method during the first 2/3 of asset’s useful life.

Must be based on actual use of the property.

Used for assets undergoing initial intense periods of use.

Obsolescence Deduction

Loss of economic usefulness of property due to abnormal causes rather than usual wear and tear.

Deduction is allowed in addition to depreciation.

Learning Objective

Explain how the accelerated cost recovery systems of ACRS and MACRS allow the recovery of investment capital for income tax purposes.

ACRS and MACRS

Cost Recovery Systems

ACRS

Property placed into service between 1/1/1981 – 12/31/86

MACRS

Property placed into service after 12/31/1986.

Recovery Periods for MACRS

5 year class…..autos, computers.

7 year class…..business equipment, office furniture; most heavy machinery.

27.5 year class…..residential real estate like apartment buildings.

39 year class…..nonresidential real estate like office buildings.

Recovery Method for MACRS Double Declining Balance Method

Example – Autos

MACRS

150% Declining Balance Method

Examples –

15 year property such as land improvements

20 year property such as municipal sewers.

MACRS

Straight line depreciation

Examples –

Residential Real Estate

Nonresidential real estate

Operation of MACRS

The depreciation deduction for nonresidential real property placed into service during the month of April would be calculated per Table 11-4 ---

1.819% of $150,000 = $2,728.50.

Cost Recovery Conventions

Cost Recovery Conventions

Purpose is to determine how much cost recovery is allowed for the year the asset is placed into service.

Cost Recovery Conventions –Half-Year Rule

Half-Year Convention for Assets in property classes fewer than 20 year.

The equivalent of 6 months depreciation (not 12) is allowed in year property placed in service; remaining 6 months are depreciated in year of disposition or in last year of the recovery period.

Cost Recovery Convention –Mid-Quarter Rule

If >40% of aggregate bases of all TPP placed in service during the year is placed in service in the last 3 months of the year, a mid-quarter convention will apply.

Purpose of the rule is to prevent the taxpayer from claiming 6 months depreciation for property placed in service during the last 3 months of the year.

Alternative Recovery Periods Under MACRS

Taxpayer may elect straight line treatment if property otherwise eligible for the declining balance method

Taxpayer may elect 150% declining balance method for property otherwise eligible for 200% declining balance method.

Implications of Depreciation on Basis to Property

Basis must be reduced by allowable depreciation regardless of whether the taxpayer claims the depreciation deduction on the tax return.

Learning Objective

Explain the concepts of depreciation recapture and the section 179 expensing of certain depreciable business assets.

Depreciation and Recapture

Recapture When some assets are sold or disposed of at

a gain, part of the gain may be “recaptured” by adding it to ordinary income. Depreciation recapture is limited to the lesser

of the gain realized or the depreciation already taken.

Recapture rules for personalty are under section 1245; real estate under section 1250.

Recapture

Rules under sections 1245 and 1250 Sale of most TPP and real estate for a gain —

recapture is lesser of the realized gain or the depreciation already taken

Personal (Sec. 1245) Property: Full recapture

Section 1250

Section 1250

Rules Realty (Sec. 1250): Only excess depreciation

recaptured on ACRS property. Post 1986 realty (Sec. 1250): “Special” 25% rate

applies to capital gain attributed to depreciation upon sale.

Expensing: Section 179

A Key Deduction: Expensing Section 179

General rule for Section 179 Businesses may expense, rather than capitalize

and depreciate, some asset depreciable personal property.

Real estate ineligible for Section 179 Expensing. Property held for the production of income also

ineligible for Section 179.

Expensing Under Section 179

Deductible amounts are $500K for 2011 and $125K for 2012.

Phaseout begins at $2.0 M in 2011 and $500K in 2011.

Amortization of Intangibles

Learning Objective

Explain the amortization of certain intangible assets; describe the cost recovery limitations on certain depreciable assets collectively known as “listed property,” and.

Amortization of Intangibles

Amortize using SL method, over useful life (Sec. 197).

Examples: Goodwill and Covenants not to compete Amortize over 15 years, SL Effective as of August 11, 1993

Listed Property: Section 280F

Limitations for Some Property Used for Both Personal & Business Use

(a.k.a. “Listed Property” Section 280F)

“Luxury” automobiles: Section 280F limits both MACRS depreciation and Section 179 expensing.

A “luxury” auto is a passenger car excluding taxis and rental cars

Limitations for Some Property Used for Both Personal & Business Use

(a.k.a. “Listed Property” Section 280F) “Listed property does NOT include: Trucks, vans,

and “heavy land yachts” (i.e., Hummers) weighing over 6,000 pounds, ambulances, hearses, and vehicles used in transporting services (limo services).

Limitations for Some Property Used for Both Personal & Business Use

(a.k.a. “Listed Property” Section 280F) Listed property

Passenger automobiles (under 6,000 pounds) Other property used for transportation

(motorcycles, boats, planes) Computer or peripheral equipment unless used

exclusively in a regular business establishment (includes home offices under Sec. 280A)

Limitations for Some Property Used for Both Personal & Business Use

(a.k.a. “Listed Property” Section 280F)

Listed property Property used for entertainment, recreation or

amusement, unless used in a regular business establishment

Limitations for Some Property Used for Both Personal & Business Use

(a.k.a. “Listed Property” Section 280F)

Limitations: If “qualified business use” ≤50% in year the listed

property is placed in service No Sec. 179 expensing ADS depreciation required

(i.e., straight-line depreciation)

Limitations for Some Property Used for Both Personal & Business Use

(a.k.a. “Listed Property” Section 280F)

Limitations: “Qualified Business Use”

Includes only T/B use (business for which Sec. 162 authorizes deductions)

But, use of assets for production of income is included in calculating depreciation

Limitations for Some Property Used for Both Personal & Business Use

(a.k.a. “Listed Property” Section 280F)

“Luxury” automobiles: Section 280F limits both MACRS depreciation and Section 179 expensing.

Limitations for Some Property Used for Both Personal & Business Use

(a.k.a. “Listed Property” Section 280F)

Cost recovery limitations significantly limit depreciation. The maximum limitations represent 100% business/production use.

End of Chapter 11