Transcript General
Module 10
Cost Recovery Deductions
Cost Recovery Topics
Depreciation
Accelerated
Cost Recovery System
Modified Accelerated Cost Recovery System
Amortization
Depletion
Economics of Cost Recovery
Expenditure benefits more than 1 tax year
§263 denies a current deduction
Cost recovery allows deduction over time
Tax policy issues
Marginal
efficiency of capital affected by tax
savings
Recovery
periods
Recovery methods
Cost Recovery Tax Savings
Assumptions
$10,000
asset
35% marginal tax rate
10% interest rate
Cost Recovery Tax Savings
Assumptions
$10,000
asset
35% marginal tax rate
10% interest rate
M e th o d o f
C o st R e c o v e ry
A fte r-ta x N P V
D e d u c tio n
E x p en se
$ 3 ,5 0 0
A c c e le ra te d
$ 2 ,9 7 7
(o v e r 5 y e a rs)
S tra ig h t lin e
(o v e r 5 Y e a rs)
$ 2 ,7 8 6
o f
The Depreciation Allowance:
Basic Requirements
Key Learning Objective
Basic requirement
Qualifying
property
Placed in service
Depreciable basis
Qualifying Property
Limited (Exhaustible) Useful Life
Qualifying Use of Property
Trade
or Business
Income-Producing Activity
Placed in Service (PLIS)
PLIS when taxpayer can demonstrate
Readiness
Availability
Capacity
to perform
Date PLIS can effect amount of cost
recovery
Change
in tax law
Affect modifying convention
Cost Recovery Basis
Initial basis
Purchased
property
Constructed property
Personal property converted to business use
Subsequent changes in basis
Capital
improvements
Depreciation “allowed or allowable”
Return of capital
Compliance Query: Conversion
from Personal to Business Use
Purchased home for $125,000
IF FMV = $112,000 at conversion
What
is basis for depreciation?
IF FMV = $150,000 at conversion
What
is basis for depreciation?
Solution to Compliance Query:
Conversion from Personal Use
Get lower of basis or FMV
Basis if converted when FMV = $112,000
$112,000--lose
decline in value during personal
use
Basis if converted when FMV = $150,000
$125,000--no
appreciation
step up for unrealized
MACRS--The Basic Rules
Key Learning Objectives
Class life
Depreciable basis
Recovery method
Modifying convention
Class Life = Recovery Period
Equipment
5 & 7 year classes
Most
common
Tangible equipment
Some
animals &
specialized equipment
apartments
& rental houses
Non-residential
39
year
In service after 8-9-93
31.5
10,15,20
Specialized
Generally
3 year class
Real Estate
Residential--27.5 year
uses
year
In service before 8-8-93
Class Life
Rev. Procs. 87-56 & 88-22
IRS provides information as to class life
Assets used in all businesses
Classes
Assets used in particular activities
Classes
00.11 - 00.4
01.1 - 80.0
Equipment with no class life given
Use 7 years
Research Query:
MACRS Recovery Periods
This year Sea Drilling
Installed
sidewalks around its office building
Purchased five floating drilling platforms for
at-sea exploration.
See Rev. Proc. 87-56 in the OnPoint Service
to determine recovery periods.
Solution--Research Query
Sidewalks -- MACRS life of 15 years
used
in all business activities
listed in Class 00.3
Drilling platforms -- MACRS life of 5 years
used
in specific activities
listed in Class 13.0
TaxPoint:
Class 57.0-- 7 Gets You 5
Class 57.0 reads as follows:
Distributive Trades
and Services: Includes
assets used in wholesale and retail trade, and
personal and professional services. Includes
section 1245 assets used in marketing
petroleum and petroleum products
If used in a “distributive trade or service,” an
asset normally classified as 7-year property
would get 5-year class life.
Depreciable (Recovery) Basis
Salvage value always ignored
Equipment (equipment)
Reduction
for §179 Election
Reduction for 50% of certain business credits
Realty
Exclusion
of any land costs
Reduction for rehabilitation credits
MACRS Recovery Methods
200% declining balance
3,5,7,10
year classes of equipment
150% declining balance
15
and 20 year classes of equipment
Conversion to straight-line allowed
Straight-line
All
realty
Modifying Convention
Year of Acquisition
Equipment
General rule--half-year convention
Exception--mid-quarter convention IF
More
than 40%
In service in last quarter
Realty
Mid-month convention
The Four Quarters of Mid-Quarter
Applies to all assets according to quarter
placed in service
Table 10-3-A. MACRS 5-Year property
Year
1
2
3
4
5
6
Midyear
First
quarter
Second
quarter
Third
quarter
Fourth
quarter
20.00% 35.00% 25.00% 15.00% 5.00%
32.00
26.00
30.00
34.00 38.00
19.20
15.60
18.00
20.40 22.80
11.52
11.01
11.37
12.24 13.68
11.52
11.01
11.37
11.30 10.94
5.76
1.38
4.26
7.06
9.58
Compliance Query:
Modifying Convention
A calendar year taxpayer places in service:
D a te
M a rc h
O c to b e r
D ecem ber
A sse t T y p e
C o st
M a c h in e
(N o c la ss life )
W a re h o u se
$ 2 5 0 ,0 0 0
C o m p u te r
(C la ss life = 5 )
$ 1 0 0 ,0 0 0
$ 1 0 ,0 0 0
Solution to Compliance Query:
Modifying Convention
First test for mid-quarter
The
warehouse is ignored for the 40% test
4th quarter divided by all Equipment acquisitions
10,000 ÷ 260,000 = 3.8%
This
is less than 40%
The half-year convention applies
Solution--Compliance Query
Appropriate MACRS Deduction
Machine ($250,000 x .1429) . . . . . $35,725
Computer ($10,000 x .20) . . . . . .
2,000
Warehouse ($100,000 x .00535) . .
535
The mid-month convention applies to buildings.
Note that the tables other than five -year are on the
TaxPoint disk.
Compliance Query:
Modifying Convention
If we reverse the month of acquisition for the
equipment that our calendar year taxpayer places
in service, we get a different answer for the
computer and equipment but not the building.
Date
December
October
March
Asset Type
Cost
Machine
(No class life)
Warehouse
$ 250,000
Computer
(Class life = 5)
$100,000
$ 10,000
Solution to Compliance Query:
Modifying Convention
First test for mid-quarter
The
warehouse is ignored for the 40% test
4th quarter divided by all equipment acquisitions
250,000 ÷ 260,000 = 96.2%
This
is more than 40%
The mid-quarter convention applies
The Four Quarters of Mid-Quarter
The computer was placed in service in March, so it is first
quarter mid quarter 5-year property--35%.
The equipment is fourth quarter, mid quarter 7 year, so this
table doesn’t apply. You will find 3.57% in the 7 year 4th
quarter mid-quarter table on the disk.
Table 10-3-A. MACRS 5-Year property
Year
1
2
3
4
5
6
Midyear
First
quarter
Second
quarter
Third
quarter
Fourth
quarter
20.00% 35.00% 25.00% 15.00% 5.00%
32.00
26.00
30.00
34.00
38.00
19.20
15.60
18.00
20.40
22.80
11.52
11.01
11.37
12.24
13.68
11.52
11.01
11.37
11.30
10.94
5.76
1.38
4.26
7.06
9.58
Solution--Compliance Query
Appropriate MACRS Deduction
Machine ($250,000 x .0357) . . . . . $8,925
Computer ($10,000 x .35) . . . . . . . . 3,500
Warehouse ($100,000 x .00535) . . . . 535
The mid-month convention applies to buildings.
Note that the tables other than five -year are on the
TaxPoint disk.
Compliance Query: MACRS
Deduction in Year 2, (no disposition)
Do not leave the column you started in!
Machine ($250,000 x .2755) . . . . . $ 68,875
Computer ($10,000 x .26) . . . . . . . .$ 2,600
Warehouse ($100,000 x .02564) . . $ 2,564
Note that the tables other than five -year are on the
TaxPoint disk.
Modifying Convention
Year of Disposition
Applies
to both equipment & realty
Use same convention as in year acquired
If
mid-month, count the months, subtract 1/2 month,
divide by 12
If mid-year, use 1/2
If mid-quarter, count the quarters, subtract 1/2
quarter, divide by 4
Compliance Query MACRS
Deduction in Year 3, (sell in July)
Do not leave the column you started in!
Machine
($250,000 x .1968 x 2.5 ÷ 4) . . . . $30,750
Computer
($10,000 x .1560 x 2.5 ÷ 4) . . . . . .$975
Warehouse
($100,000 x .02564 x 6.5÷12) . . . . $1,389
Compliance Query:
Once More, on Your Own
Mac Co. a calendar-year corporation
Placed in service in October
$250,000 of computers
only
assets acquired that year
What is the recovery deduction for Year 1?
If Mac sells the computer in June, of Year 3
what is the year 3 recovery deduction?
Solution--Compliance Query:
Once More, on Your Own.
Solution Year 1: 5 year/ mid-quarter property
$250,000 x .05 = $12,500
Solution Year 3: still 5 year/mid-quarter
$250,000 x .2280 x (1.5/4) = $21,375
Mid-quarter,
divide by 4
count the quarters, subtract 1/2 quarter,
MACRS - Special Elections
Key Learning Objectives
The requirements for the §179 election
The two straight-line recovery methods
available under MACRS
§179 Immediate Expensing
Election
Qualifying personal property
equipment used in an active trade or business
Year of acquisition only
$20,000 maximum annual election -- 2000
$ for $ phaseout of $ 20,000 for acquisitions
over $200,000
Can’t create a loss with §179 deduction
Tax Planning Query
Make a §179 Election?
Minor Co. a calendar-year corporation
PLIS a $15,000 computer in April
(the only asset acquired that year).
Taxable income for the current year is $500
before considering MACRS recovery
Minor had profits of $120,000 in each of the
preceding five years.
What factors should Minor consider in
evaluating a §179 election?
Solution--Tax Planning Query
Make a §179 Election?
Key Factor--Expected profitability in future
Electing §179
Expense $15,000
Deduction limited to
$500 (limited to
taxable income)
$14,500 may be carried
to the next year
Not Electing §179
MACRS deduction =
$3,000 ($15,000 x .05)
creating an NOL
NOL may be carried
back to the third prior
tax year
Refund = $975
($2,500 x .39)
Tax Planning Query:
Place In Service This Year or Next?
Meta Co. a calendar-year corporation
Put in service in February
$120,000
equipment (only acquisition to date)
Meta wants to acquire $83,000 of furniture
Should Meta placed the furniture in service
in
December or January of the next tax year?
What factors should Meta consider in
deciding when to buy the furniture?
Solution--Tax Planning Query
Place In Service This Year or Next?
If placed in service in December
Total acquisitions = $203,000
Maximum
§179 = 17,000. (20,000 - 3000)
Expensed property not used in test for mid-quarter
Could expense either equipment or furniture
If
equipment, then mid-quarter
83,000 ÷ (203,000-17,000) = 44.6%
If furniture, then half year
(83,000-17,000) ÷ (203,000-17,000) = 35.5%
Solution--Tax Planning Query
Place In Service This Year or Next?
If placed in service in January of next year
Then for the current year
Maximum §179 is $ 20,000 (assumes 2000)
The half-year convention will apply
no
acquisitions in fourth quarter
MACRS Straight-Line Options
Acquisition year conventions apply
Must make election by class by year
Straight-line over the MACRS life
Straight-line over the class life
Alternative depreciation system (ADS)
Major
exceptions to the class life rule:
Autos
and computers (5 years)
equipment with no class life (12 years)
Realty (40 years)
Compliance Query:
Which MACRS Elections?
Melon Corp. a calendar-year corporation
PLIS a $29,000 machine in March 2000
(the only asset acquired this year)
The machine does not have a class live
Melon elects §179
What is the TOTAL cost recovery under
Regular
MACRS recovery
Straight-line MACRS recovery
Alternative Depreciation System (ADS)
Solution--Compliance Query
Which MACRS Elections?
§179 deduction = $20,000
Remaining basis = $ 9,000
No class live so MACRS = 7 and ADS = 12
MACRS = $1,286 ($9,000 x .1429)
MACRS SL = $ 643 ($9,000 x 1/7 x .5)
ADS SL = $ 375 ($9,000 x 1/12 x .5)
TOTAL deduction increased by $ 20,000 in
each case
MACRS--Special Restrictions
Key Learning Objectives
The anti-churning rules
Restrictions applicable to listed properties
Including
special limits on automobiles
MACRS computations for alternative
minimum tax (AMT) purposes
Anti-churning Rules
Prevent Perceived Abuse
Prevents using sales between related parties
to change depreciation methods when tax
law changes
If related party sale occurs, the transaction
is ignored, old recovery method continues
Listed Property Rules: Personal
Use Can Limit Recovery
Applies only to equipment
Subject to restriction if Qualified Business
Use (QBU) < 50%
QBU
generally limited to non-employee
trade/business use
Listed Property Rules: Personal
Use Can Limit Recovery
Straight line over CLASS LIFE used in any
year QBU < 50%
Test must be applied each year
Recapture
applies if MACRS used prior to
failing the business usage test
Compliance Query:
Change in QBU
Sue Adams , a calendar-year taxpayer
Placed in service in March
$10,000 computer
the only asset acquired this year
§179 NOT elected
For Year 1 QBU = 90%.
For Year 2 QBU = 40%.
What are Sue’s recovery deductions?
Solution--Compliance Query
Change in QBU
Year 1
MACRS recovery =
$1,800
($10,000 x .2 x .9)
($10000 ÷ 5 x 2 x .9)
Note ADS would have
been $900
($10,000 ÷ 5 x .9)
Year 2
ADS straight-line
recovery = $800
($10,000 x 1/5 x .40).
$900 recaptured as
additional income
This is the difference
between MACRS Yr 1
(1800) & ADS Yr 1 (900)
Luxury Auto Rules--Everyone
Bought a $15,300 Car in 1999
Limits for autos placed into service in 2000
First
year
Second year
Third year
Remaining years
$3,060
$5,000
$2,950
$1,775
(15,300 x .20)
(15,300 x .32)
Luxury Auto Rules
IBM follows them too!
Indexed annually for inflation
Limit is reduced by personal use
Limit applies to recovery and §179 election
Special rules for leased autos
Compliance Query: Recovering
the Cost of Autos
Deck’s Realty, a calendar-year taxpayer
Placed in service in May, 1999
$40,000 auto (the only asset acquired that year)
QBU = 80%
What is the 1999 cost recovery deduction?
Solution to Compliance Query:
Recovering the Cost of Autos
Car is half year, five year property
MACRS and §179 are available
If this was not a car, without §179, the
deduction would be
40,000
x .2 x .8 = 6,400
But auto rules limit deduction to
$2,448
(3,060 x .80)
Alternative Minimum Tax
Cost Recovery
Alternative Depreciation System (ADS)
Equipment--150% DB over class life
Realty--Straight-line over 40 years
ADS--150% & SL OK for regular tax
To
slow down deduction
To reduce record keeping
Election on class by class,
year-by-year basis
TaxPoint: Possible Taxpayer
Depreciation Records
Regular federal income tax
Alternative minimum tax
Earnings and profits determination
Adjusted current earnings determination
State income tax
Financial accounting records
Regulatory agency mandated methods
Compliance Query
Name That Method!
Technoid Corporation, 12/31 year end.
Put in service in May $20,000 of new
equipment (the only asset acquired that year).
Technoid may choose one of 8 different
methods of cost recovery for this
equipment.
Can you name them?
Solution - Compliance Query
Name That Method!
§179 election & normal MACRS
§179 election & straight-line MACRS
§179 election & ADS straight-line
§179 election & 150% ADS (AMT)
Normal MACRS recovery only
Straight-line MACRS recovery only
Straight-line ADS recovery only
150% ADS (AMT) recovery
Ace Co., a calendar-year taxpayer, Placed in
service in 2000 the following assets. What is
Ace’s maximum cost recovery deduction?
Date
June
June
June
July
Asset
Auto
Warehouse
Apartment
Equipment
Cost
$ 10,000
100,000
200,000
20,000
(10 year CL)
October
Punch Machine
38,000
(8 year CL)
November Drill Machine
(No Class Life)
December Cutting Machine
(12 year CL)
30,000
104,000
Solution to Concepts Review:
Step 1: Separate equipment and realty
Equipment--$202,000
Realty--$300,000
Step 2: Separate reality into
Residential
(27.5 year recovery) -- 200,000
Non-residential (39 year recovery) -- 100,000
Solution to Concepts Review:
Step 3: Calculate §179 deduction
20,000-2,000
= 18,000
Before selecting consider impact on midquarter test (none in this problem)
Generally best to take from property with
longest recovery period-- but no set rule
In
next slide you will see that mid-quarter applies.
Therefore largest deduction will come from
expensing some of the 4th quarter, mid-quarter stuff.
Solution to Concepts Review:
Step 4: Determine modifying convention for
equipment
Allocate
equipment by quarter
2th
Qtr -- $ 10,000
3th Qtr.-- $ 20,000
4th Qtr.--$172,000
MQ
convention applies to equipment
172,000÷
202,000 = 85.1%
Solution to Concepts Review:
Step 5: Stop to consider impact of listed
property and luxury auto rules.
None
in this problem.
Since cost of car is only $10,000, the first year
will not exceed 3,060.
Solution to Concepts Review:
Total Deduction
Warehouse
$200,000 x .0197) = 3,940
2nd qtr, MQ 5 year
$10,000 x .25
= 2,500
Equip
3rd qtr, MQ 7 year
($20,000 x .1071) = 2,142
Punch Machine
4th qtr, MQ 5 year
38,000 x .05)
= 1,900
Drill Machine
Auto
$100,000 x .0139 = 1,390
Rental Apartment
$34,013
4th qtr, MQ 7 year
30,000 x .0357 = 1,071
Cutting Machine
4th qtr, MQ 7 year
expense
depreciate 86,000
18,000
3,070
Cost Recovery of Intangibles
Key Learning Objectives
General tax rules for amortization of
intangibles
Special rules for §197 intangibles
Special provisions for research and
experimentation expenses
Amortization--Cost Recovery for
Intangible Assets
Need estimated useful or legal life
Straight-line recovery
Whole month convention used
Special 5-year recovery period
Organization
& start-up costs
§197 purchased intangibles
Research & experimentation expenditures
§197 Amortizing Goodwill
Post 8/10/93 Acquisitions
Acquisitions of a business if purchase price
includes intangibles
Goodwill
Going
concern value
Other purchased intangibles (covenants not to
compete, customer lists, workforce, etc...)
Amortize over 15 years
Amortization begins in month of acquisition
Compliance Query
§197 Intangibles
As part of the acquisition of Bee Company,
Ace Company paid $20,000 for Bee’s
contractual agreement not to enter into a
competing business for the next 10 years.
What is Ace’s recovery period for the
$20,000?
Solution--The agreement not to compete is a
§197 intangible and must be amortized over
15 years. The contract is irrelevant.
Research and Experimentation
Expenditures (R&E)
Definition--incident to product or process
Three tax options:
Expense
immediately
Amortize over a period of not less than 5 years
Capitalize
Any tangible property must be capitalized
and depreciated
Any R&E credit allowed reduces the
deduction
Compliance Query
Which of the following expenditures do not
qualify as R&E?
Depreciation
on research building
Wages of R&E employees
Consumer survey costs
Blueprints and drawings of product
Solution:
The
consumer surveys are development costs
and do not qualify.
Depletion Deductions
Key Learning Concept
Requirements for the depletion deduction
Computations under the
Cost
and
Percentage methods
Depletion--General Concepts
Cost recovery for natural resources
Allowed to anyone with an economic
interest in the minerals or natural resource
in place
Two methods of computing depletion:
Cost
method
Percentage (statutory) method
Taxpayer may deduct the larger of the two
methods
TaxPoint: Blood as a Mineral?
In the case of Margaret Green, 74 TC 1229, the
taxpayer attempted to deplete the mineral content
of her blood using statutory recovery.
She received commissions for donating her blood
(a rare AB-type), and argued that she should be
able to deplete her blood supply.
The Tax Court disagreed, stating that such
minerals were not “natural deposits,” and eventual
loss of ability to regenerate minerals was not
relevant.
Cost Method of Depletion
Determine a depletion rate per unit
Undepleted
cost/estimated remaining
recoverable units
Multiply the rate times the number of units
sold during the tax year
Total recovery may not exceed investment
cost
Percentage Method of Depletion
Determine statutory (code) rate for
particular resource
Multiply rate times the gross income from
the property
Statutory depletion is further limited to:
50%
of the taxable income from the property
(100% of taxable income for oil properties)
65% of the taxpayer’s taxable income
Percentage depletion may exceed cost
Compliance Query
Sierra Co. paid $600,000 to lease land for mining
uranium (22% rate).
Mine is estimated to contain 200,000 tons of ore.
This year, Sierra extracted 60,000 tons of ore and
sold 40,000 tons for $20 per ton.
Sierra’s gross income for the year was $700,000
($800,000 sales less a $100,000 royalty)
Expenses totaled $480,000.
What is Sierra’s depletion deduction ?
Solution--Compliance Query
Cost depletion:
$600,000/200,000
x 40,000 = $120,000
Percentage (statutory) depletion:
$700,000
x .22 = $154,000, limited to:
($700,000 - $480,000) x .50 = $110,000
Deduction is $120,000 (larger of the two)
Research Query
M Company discovered that Sleasy had drilled a
slant hole under their property and had stolen
50,000 barrels of oil.
M initiated a lawsuit to recover the value of the
stolen oil.
Early Win, an attorney, agreed to represent M
Company on a 1/3 contingency basis (receives 1/3
of the value if M wins, and nothing if M loses).
If Win wins the case, can he take a depletion
deduction on his 1/3 of the proceeds?
Solution--Research Query
No, Win will not qualify for depletion. In a
similar case, Parr v. Schofield (89 F Supp
98), the Court of Appeals for the 5th Circuit
stated that such recoveries were not
depletable gross income because the legal
contract did not cause a transfer of an
interest in the mineral property to the
attorney.
(Federal Tax Coordinator, Para.N-2113)
Appendix--Pre-1981
Depreciation
Useful life
Salvage value
Maximum depreciation recovery methods:
Equipment
Realty
Appendix--Pre-1987 ACRS
Equipment classes (3, 5, 10, and 15)
Realty classes (15, 18, and 19)
Acquisition year assumption
Maximum recovery rates:
Equipment
Realty
§179 expensing option
Straight-line options