4 Concept ReviewThe capital recovery concept allows a taxpayer to recover all invested capital before income is taxedAn asset’s basis is the maximum investment that qualifies as capital for recoveryLegislative grace allows the capital to be recovered systematically over the life of the asset
5 Categories of AssetsRealty includes land and buildingsPersonalty is any asset that is not realty and includes machinery and equipmentPersonal-use property is any property used for personal purposes
6 Capitalized until disposal or Capital ExpendituresThe cost of a business asset with a useful life extending beyond the current year may beDeducted currentlyCapitalized until disposal orCapitalized with the cost allocated to the years the asset’s use benefits (cost recovery period)
7 Basis of PropertyBasis is the taxpayer’s unrecovered investment in an asset that can be recovered without tax costAs the asset’s basis is recovered (through depreciation, depletion or amortization deductions), basis is reduced and is called adjusted basis
8 The original basis of an asset includes Basis of PropertyThe original basis of an asset includesCash plus fair market value of property given up by the purchaserMoney borrowed and used to pay for the propertyLiabilities of the seller assumed by the purchaserExpenses of the purchase such as attorney fees or brokerage commissions
9 After-Tax CostTax savings from depreciation deductions reduce the effective after-tax cost of an assetThe annual tax saving equals the depreciation deduction multiplied by the marginal tax rateRecovering an asset’s basis over a shorter time period reduces the after-tax cost of the asset
10 Methods of Recovery Depreciation: used for tangible assets that Are used for a business or production of income purposeHave a determinable lifeDepletion: used for wasting assetsAmortization: used for intangible assets
11 History of Depreciation Section 179 Electionto Expense Assets19811987MACRSBased on method and lifeprescribed by law;less accelerated than ACRSACRSBased on method and lifeprescribed by lawBased on facts and circumstancesrelated to asset life and taxpayer’ssituation
12 Congress simplified depreciation Asset lives used for depreciation are specified in the tax law.Do not subtract estimated salvage value when computing depreciation.Standard Conventions: Mid-Month, Mid-Year, Mid-Quarter
13 Section 179 ElectionA taxpayer may elect to expense rather than capitalize qualifying property placed in service during the year.Promotes administrative convenienceTreated as a depreciation deduction
14 Section 179 Election Qualifying Property Tangible, personal propertyReal estate does not qualifyUsed in a trade or businessInvestment property does not qualify
15 Section 179 Deduction Limits The Sec. 179 limit of $500,000 for 2013 was not extended to 2014.New limit is $25,000 Until Congress Acts.
16 Section 179 Deduction Limits Limitations apply to each entityCannot exceed $500,000 in 2013Cannot exceed taxable income from the businessExcess may be carried forward
17 Section 179 Deduction Phase-Out Deduction decreased if total cost of qualifying property placed in service exceeds $2,000,000by $1 for every $1 of value over $2,000,000.What is maximum Section 179 write-off.See next 2 slides
18 Firefly, Inc., (1) acquires equipment in July 2013 for $2,100,000. a. What is Firefly's maximum Sec. 179 deduction for 2013?b. What happens to any part of the annual limit not deducted in 2013? c. What is the depreciable basis of the equipment? Explain.
20 The bonus depreciation allowance of 50% of the cost of equipment, etc The bonus depreciation allowance of 50% of the cost of equipment, etc. (after subtracting Sec. 179 write-off) has not been extended. There is no bonus depreciation for Just Sec. 179 write-off and regular depreciation.
22 Section 179 StrategyExpensing the assets with the longest class life generally maximizes the value of the Section 179 deductionSection 179 expensing can also alter the application of the mid-quarter convention because property expensed under Section 179 is not counted in calculating the 40% test for the mid-quarter convention.The 100% bonus depreciation (until end of 2011) makes Sec. 179 pretty irrelevant.
24 MACRS applies to New and used tangible, depreciable property Used in a trade or business or for the production of incomeDepreciable basis is:The asset’s original basis for depreciationReduced by any § 179 deductionAdjusted basis: the remaining unrecovered capital of an asset = asset basis minus accumulated depreciation
25 MACRS Recovery PeriodEach asset is placed in a MACRS class according to its class lifeMost personal property is in a 3, 5, or 7 year classMost land improvements and specialized property are in a 10, 15, or 20 year classReal estate is in a 27.5, 31.5, or 39 year class
26 MACRS ConventionsThree assumptions are made about the time property was placed in service during the yearMid-year convention applies to all property except real estateMid-month convention applies to real estate onlyMid-quarter convention applies to some personal property (when major acquisitions are made in final quarter)
27 Mid-Year ConventionAssumes property is placed in service and will be disposed of at the mid-point of the yearOne-half year depreciation allowed in the first year of serviceOne-half year depreciation allowed in the last year of serviceIRS tables reflect the mid-year adjustment only for the first year
32 Mid-Month ConventionAssumes property is placed in service and will be disposed of at the mid-point of a monthOne-half month allowed at the beginningOne-half month allowed at dispositionIRS tables reflect the adjustment only for acquisition
34 Mid-Quarter Convention If > 40% of the total depreciable basis of all personal property is placed in service during the 4th quarter of the year, mid-quarter:Assumes property is placed in service and will be disposed of at the mid-point of a quarter rather than at mid-yearDetermine the 40% after taking §179 expense
38 Depreciation Method Alternatives Regular MACRSwith Section 179Straight-line MACRSStraight-line Alternative Depreciation System (ADS)
39 Regular MACRS Method is double declining balance IRS tables provide the depreciation rateDesigned to permit full recovery of depreciable basisIncorporate the conventionsMaximizes acquisition year deduction using the Section 179 election
40 Straight-Line MACRSTaxpayers may elect to use the slower straight-line methodElection is made each yearMACRS recovery periods are usedMid-year convention applies
42 Alternative Depreciation System Taxpayers may elect to use ADSUse is mandatory for Alternative Minimum Taxable IncomeUses a longer recovery period than MACRSElection is made on a class-by-class, year-by-year basisTable yr. Page 10-22S/L:20%, Mid year: 10%. 150% DB:15%
43 Limits on Listed Property Most mixed-use property is considered listed property and subject to special limitationsExamples: automobiles, computers, cellular phones, etc.
44 Limits on Listed Property Treatment depends on the percentage of business usageif >50% business use, treated like other depreciable assetsif < 50% business use, deductions are limited to ADS without Section 179In either case, only the business portion of the asset’s basis is depreciable
45 Limit on Passenger Autos The total amount of depreciation and § 179 expense that can be deducted is limitedAnnual maximum limit set and linked to the year the car was placed in serviceAnnual limit is further reduced by the business use %
46 Adequate Record Keeping Listed property is subject to strict record keeping requirementsNo deduction without proof ofWhy? The business purpose of the useWhat? The amountWhen? The dates of useWhere? The reality of the use
48 56. On June 1, 2013, Kirsten buys an automobile for $60,000 56. On June 1, 2013, Kirsten buys an automobile for $60,000. Her mileage log for the year reveals the following: 20,000 miles for business purposes; 7,000 miles for personal reasons; and 3,000 miles commuting to and from work. What is Kirsten's maximum cost-recovery deduction for 2013?
50 Vehicle Ceiling Limits When a vehicle is used less than 100% for business purposes, the ceiling limit allowed is reduced accordinglyIf an employee uses an employer’s car for personal use but is taxed on that use, the employer calculates depreciation as if all use is business useSpecial rules apply to cars used by a more-than-5% owner or someone related to the employer
51 Heavy SUVsHeavy SUVs (gross vehicle weight over 6,000 lbs.) are not subject to the vehicle depreciation ceiling limitsBut the 2004 Jobs Creation Act reduced to $25,000 the cost of heavy SUVs (acquired after 10/22/04) that can be expensed under Section 179
52 Leased AutomobilesTaxpayers who lease autos can deduct the business portion of lease payments, but must add a lease inclusion amount to incomeThe inclusion amount is obtained from an IRS table, based onthe car's FMV and the tax year in which the lease commences, andis prorated for the number of days the car is leased
53 Lease InclusionsExamples of inclusion amounts for a new auto leased in 2009If FMV = $40,000 then$58 for year 1,$127 for year 2,$188 for year 3, $225 for year 4, and$259 for year 5 and later years
55 DepletionThe basis of natural resource assets subject to wasting away is recovered using depletionBasis used is generally fees paid to acquire a lease and the costs of the lease, exploration, and drillingComputed using two methodsFigure both each year and use the largest as deduction
56 Cost Depletion MethodAllocates unrecovered basis over the number of estimated units of resourceUnrecovered BasisEstimated Recoverable Units= Depletion per UnitCost Depletion = Depletion per Unit X # of Units Sold
57 Percentage Depletion Method Depletion is the lesser of50% of taxable income before depletion, orGross income from the sale of the natural resource times a statutory depletion rateDifferent statutory % for each type of resource is given in IRS tables
58 On July 4 of the current year, Lawrence invests $240,000 in a mineral property. He estimates that he will recover 800,000 units of the mineral from the deposit. During the current year, Lawrence recovers and sells 100,000 units of the mineral for $3.50 per unit.What are Lawrence's cost depletion deduction for the current year and his adjusted basis for the mineral deposit after deducting depletion?
59 On July 4 of the current year, Lawrence invests $240,000 in a mineral property. Cost depletion is calculated using the units of production method. Each year the remaining depreciable basis is allocated based on the formula:Units Recovered During the YearTotal Estimated Units RemainingFor Lawrence, this results in a deduction for cost depletion of $30,000.$240,000 x 100, = $30,000800,000
60 Lawrence invests $240,000 in mineral property. b. If the percentage depletion rate for the mineral is 10%, what are his depletion deduction for the current year and his adjusted basis for the mineral deposit?Percentage depletion is calculated by multiplying the selling price of the mineral by the statutory rate for the mineral. Sales are $350,000 (100,000 x $3.50) and percentage depletion is $35,000 ($350,000 x 10%).Property basis after deducting percentage depletion is $205,000 ($240, $35,000).
61 Intangibles Intangible assets are grouped into 3 categories Intangibles with perpetual life that cannot be amortized15-year intangibles (including goodwill) acquired as part of a business purchase (Section 197 assets)Intangibles amortizable over a life other than 15 years
62 AmortizationBasis of intangible assets is recovered using straight-line method over the life of the assetIntangible assets acquired through purchase generally use a 15 year lifeCreated assets and assets specifically excluded from use of 15-year period are amortized over their legal life
63 On June 2, 2013, Lokar Corporation purchases a patent for $68,000 from the inventor of a new extrusion process. The patent has 12 years remaining on its legal life. Determine the maximum 2013 cost-recovery deductions for the asset purchased.The patent acquired separately (from the inventor) is amortized over the remaining useful life.
65 Next few slides show financial accounting with full year of depreciation in year of acquisition. This is done to simplify the illustration.That is not allowed by the tax law.
66 Double Declining Balance – Slide 1 of 2 On January 1, Year 1, office equipment was purchased and placed into service. The equipment cost $400,000, has an estimated useful life of 10 years, and an expected salvage value of $48,000. The depreciation expense under the double-declining balance method for Year 2 is: a. $64,000 b. $80,000 c. $72,000 d. $70,400
68 Depreciation Methods for Tax Purposes Depreciation Methods for Tax Purposes. Refer to next slide for Turtle Co. which uses straight-line method for financial reporting and accelerated method for tax returns. Asset cost $50,000 and has 5 year life. How much depreciation is shown on each report in year one? (For this illustration, use full year of depreciation with both methods.) If Turtle has a 30% tax rate, what is the tax savings for using the accelerated method? How much taxes will be saved in year 2?