Concept Review The capital recovery concept allows a taxpayer to recover all invested capital before income is taxed – An asset’s basis is the maximum investment that qualifies as capital for recovery Legislative grace allows the capital to be recovered systematically over the life of the asset
Categories of Assets Realty includes land and buildings Personalty is any asset that is not realty and includes machinery and equipment Personal-use property is any property used for personal purposes
Capital Expenditures The cost of a business asset with a useful life extending beyond the current year may be – Deducted currently – Capitalized until disposal or – Capitalized with the cost allocated to the years the asset’s use benefits (cost recovery period)
Basis of Property Basis is the taxpayer’s unrecovered investment in an asset that can be recovered without tax cost As the asset’s basis is recovered (through depreciation, depletion or amortization deductions), basis is reduced and is called adjusted basis
Basis of Property The original basis of an asset includes – Cash plus fair market value of property given up by the purchaser – Money borrowed and used to pay for the property – Liabilities of the seller assumed by the purchaser – Expenses of the purchase such as attorney fees or brokerage commissions
After-Tax Cost Tax savings from depreciation deductions reduce the effective after- tax cost of an asset The annual tax saving equals the depreciation deduction multiplied by the marginal tax rate Recovering an asset’s basis over a shorter time period reduces the after- tax cost of the asset
Methods of Recovery Depreciation: used for tangible assets that – Are used for a business or production of income purpose – Have a determinable life Depletion: used for wasting assets Amortization: used for intangible assets
History of Depreciation Based on facts and circumstances related to asset life and taxpayer’s situation ACRS Based on method and life prescribed by law MACRS Based on method and life prescribed by law; less accelerated than ACRS Section 179 Election to Expense Assets
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
Section 179 Election A taxpayer may elect to expense rather than capitalize qualifying property placed in service during the year. Promotes administrative convenience Treated as a depreciation deduction
Section 179 Election Qualifying Property Tangible, personal property – Real estate does not qualify Used in a trade or business – Investment property does not qualify
Section 179 Deduction Limits The Sec. 179 limit of $500,000 for 2013 was not extended to New limit is $25,000 Until Congress Acts.
Section 179 Deduction Limits Limitations apply to each entity Cannot exceed $500,000 in 2013 Cannot exceed taxable income from the business – Excess may be carried forward
Section 179 Deduction Phase-Out Deduction decreased if total cost of qualifying property placed in service exceeds $2,000,000 – by $1 for every $1 of value over $2,000,000. What is maximum Section 179 write-off. – See next 2 slides
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.
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. 20
Section 179 Strategy Expensing the assets with the longest class life generally maximizes the value of the Section 179 deduction Section 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.
MACRS applies to – New and used tangible, depreciable property – Used in a trade or business or for the production of income Depreciable basis is: – The asset’s original basis for depreciation – Reduced by any § 179 deduction Adjusted basis: the remaining unrecovered capital of an asset = asset basis minus accumulated depreciation
MACRS Recovery Period Each asset is placed in a MACRS class according to its class life – Most personal property is in a 3, 5, or 7 year class – Most land improvements and specialized property are in a 10, 15, or 20 year class – Real estate is in a 27.5, 31.5, or 39 year class
MACRS Conventions Three assumptions are made about the time property was placed in service during the year – Mid-year convention applies to all property except real estate – Mid-month convention applies to real estate only – Mid-quarter convention applies to some personal property (when major acquisitions are made in final quarter)
Mid-Year Convention Assumes property is placed in service and will be disposed of at the mid-point of the year – One-half year depreciation allowed in the first year of service – One-half year depreciation allowed in the last year of service IRS tables reflect the mid-year adjustment only for the first year
Mid-Month Convention Assumes property is placed in service and will be disposed of at the mid- point of a month – One-half month allowed at the beginning – One-half month allowed at disposition IRS tables reflect the adjustment only for acquisition
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-year – Determine the 40% after taking §179 expense
Depreciation Method Alternatives Regular MACRS – with Section 179 Straight-line MACRS Straight-line Alternative Depreciation System (ADS)
Regular MACRS Method is double declining balance – IRS tables provide the depreciation rate Designed to permit full recovery of depreciable basis Incorporate the conventions Maximizes acquisition year deduction using the Section 179 election
Straight-Line MACRS Taxpayers may elect to use the slower straight-line method – Election is made each year – MACRS recovery periods are used – Mid-year convention applies
Alternative Depreciation System Taxpayers may elect to use ADS Use is mandatory for Alternative Minimum Taxable Income Uses a longer recovery period than MACRS Election is made on a class-by-class, year-by-year basis Table yr. Page S/L:20%, Mid year: 10%. 150% DB:15%
Limits on Listed Property Most mixed-use property is considered listed property and subject to special limitations – Examples: automobiles, computers, cellular phones, etc.
Limits on Listed Property Treatment depends on the percentage of business usage – if >50% business use, treated like other depreciable assets – if < 50% business use, deductions are limited to ADS without Section 179 – In either case, only the business portion of the asset’s basis is depreciable
Limit on Passenger Autos The total amount of depreciation and § 179 expense that can be deducted is limited – Annual maximum limit set and linked to the year the car was placed in service – Annual limit is further reduced by the business use %
Adequate Record Keeping Listed property is subject to strict record keeping requirements No deduction without proof of – Why? The business purpose of the use – What? The amount – When? The dates of use – Where? The reality of the use
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?
Vehicle Ceiling Limits When a vehicle is used less than 100% for business purposes, the ceiling limit allowed is reduced accordingly If 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 use – Special rules apply to cars used by a more-than-5% owner or someone related to the employer
Heavy SUVs Heavy SUVs (gross vehicle weight over 6,000 lbs.) are not subject to the vehicle depreciation ceiling limits But 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
Leased Automobiles Taxpayers who lease autos can deduct the business portion of lease payments, but must add a lease inclusion amount to income The inclusion amount is obtained from an IRS table, based on – the car's FMV and the tax year in which the lease commences, and – is prorated for the number of days the car is leased
Lease Inclusions Examples of inclusion amounts for a new auto leased in 2009 – If 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
Depletion The basis of natural resource assets subject to wasting away is recovered using depletion Basis used is generally fees paid to acquire a lease and the costs of the lease, exploration, and drilling Computed using two methods – Figure both each year and use the largest as deduction
Cost Depletion Method Allocates unrecovered basis over the number of estimated units of resource = Depletion per Unit Unrecovered Basis Estimated Recoverable Units Cost Depletion = Depletion per Unit X # of Units Sold
Percentage Depletion Method Depletion is the lesser of – 50% of taxable income before depletion, or – Gross income from the sale of the natural resource times a statutory depletion rate Different statutory % for each type of resource is given in IRS tables
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. a.What are Lawrence's cost depletion deduction for the current year and his adjusted basis for the mineral deposit after deducting depletion?
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 Year Total Estimated Units Remaining For Lawrence, this results in a deduction for cost depletion of $30,000. $240,000 x 100,000 = $30, ,000
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 ($240,000 - $35,000).
Intangibles Intangible assets are grouped into 3 categories 1)Intangibles with perpetual life that cannot be amortized 2)15-year intangibles (including goodwill) acquired as part of a business purchase (Section 197 assets) 3)Intangibles amortizable over a life other than 15 years
Amortization Basis of intangible assets is recovered using straight-line method over the life of the asset Intangible assets acquired through purchase generally use a 15 year life Created assets and assets specifically excluded from use of 15-year period are amortized over their legal life
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.
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.
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
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?
On the preceding slide, what is the balance in the deferred tax account at the end of year 2?