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6 - 1 ©2006 Prentice Hall, Inc. Property Acquisitions and Cost Recovery Deductions Chapter 6
6 - 2 ©2006 Prentice Hall, Inc. Capital Expenditures The cost of a business asset with a useful life extending beyond the current year may be 1)Deducted currently 2)Capitalized until disposal or 3)Capitalized with the cost allocated to the years the asset’s use benefits the taxpayer (cost recovery period)
6 - 3 ©2006 Prentice Hall, Inc. 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
6 - 4 ©2006 Prentice Hall, Inc. Basis of Property The original basis of an asset includes: 1)Cash plus fair market value of property given up by the purchaser 2)Money borrowed and used to pay for the property acquired 3)Liabilities of the seller assumed by the purchaser 4)Expenses of making the purchase, such as attorney fees or brokerage commissions
6 - 5 ©2006 Prentice Hall, Inc. Multiple Asset Purchase If more than one asset is acquired in a single transaction, the cost is apportioned to each using their relative fair market values (FMV) Original basis of specific asset = Total purchase price x (FMV of specific asset / FMV of all assets) If the purchase price exceeds the value of the assets, the excess is goodwill Alternatively, buyer and seller can agree to a written allocation of the purchase price to individual assets
6 - 6 ©2006 Prentice Hall, Inc. Adjusted Basis The original basis of an asset is Increased for nondeductible capital expenditures that prolong its useful life or enhance its usefulness Decreased by cost recoveries (depreciation, depletion, or amortization) Decreased by other recoveries (casualty losses)
6 - 7 ©2006 Prentice Hall, Inc. Basis of Converted Property If the property is converted from personal use to business use, the basis for depreciation is the lesser of the property’s fair market value (FMV) or adjusted basis at the date of conversion This prevents taxpayers from depreciating the portion used for personal purposes
6 - 8 ©2006 Prentice Hall, Inc. Acquisition in a Taxable Exchange Basis of acquired asset equals the FMV of the property given up or the services performed Gain or loss is recognized as if cash had been exchanged for the property surrendered
6 - 9 ©2006 Prentice Hall, Inc. Acquisition by Gift Donee’s basis = donor’s basis + portion of gift taxes due to appreciation (but total cannot exceed FMV at date of gift) This addition is gift tax paid multiplied by FMV at gift date – Donor’s Basis FMV at gift date
6 - 10 ©2006 Prentice Hall, Inc. If FMV at gift date is less than donor’s basis: FMV used as basis for loss determination Donor’s basis used for gain determination No gain or loss if sold for price between FMV at gift date and donor’s basis Acquisition by Gift
6 - 11 ©2006 Prentice Hall, Inc. Acquisition by Inheritance Use date-of-death fair market value as basis for inherited property (or alternate valuation date, if elected) Will
6 - 12 ©2006 Prentice Hall, Inc. After-Tax Cost Tax savings from depreciation deductions reduce the effective after-tax cost of an asset The annual tax savings 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
6 - 13 ©2006 Prentice Hall, Inc. 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
6 - 14 ©2006 Prentice Hall, Inc. MACRS Modified Accelerated Cost Recovery System assigns assets to a class with a pre- determined recovery period (ignores salvage value) Recovery periods for personalty are 5 years (autos and computers) or 7 years (machinery and furniture) Recovery periods for realty are 27½ years (residential rental property) or 39 years (commercial and industrial buildings)
6 - 15 ©2006 Prentice Hall, Inc. MACRS Depreciation for personalty uses 200% declining-balance method (with a switch to straight-line to maximize deductions) or Straight-line method Realty must use the straight-line method IRS provides tables with annual allowable depreciation expressed as a percentage Annual deduction equals the asset’s original basis multiplied by % from table
6 - 16 ©2006 Prentice Hall, Inc. MACRS Tables Year5-Year7-Year 120.00%14.29% 232.00%24.49% 319.20%17.49% 411.52%12.49% 511.52%8.93% 65.76%8.92% 78.93% 84.46%
6 - 17 ©2006 Prentice Hall, Inc. Averaging Conventions Under the half-year convention a depreciation deduction is taken for half of a full year’s depreciation in the year of acquisition, regardless of when the asset was actually acquired This averaging convention is built into the MACRS tables for personalty If a taxpayer elects straight-line, the half-year convention still applies
6 - 18 ©2006 Prentice Hall, Inc. Averaging Conventions Mid-quarter convention is required if more than 40% of the personalty (not buildings) is placed in service during the last quarter of the tax year This usually results in smaller deductions than the half-year convention and is intended to discourage taxpayers from waiting until the end of the year to make their purchases
6 - 19 ©2006 Prentice Hall, Inc. Averaging Conventions Realty is depreciated using a mid-month convention Depreciation is calculated from the midpoint of the month in which the property is placed in service Table amount for all years determined by the month of acquisition
6 - 20 ©2006 Prentice Hall, Inc. Dispositions When an asset is disposed of before it is fully depreciated, the same averaging convention applies in the year of disposition An asset that was depreciated under the half- year convention will be allowed one-half year’s depreciation in the year of disposal Taxpayer must adjust the deduction determined by the table to reflect this half-year
6 - 21 ©2006 Prentice Hall, Inc. Dispositions For mid-quarter convention property, depreciation is allowed from the beginning of the year to the mid-point of the quarter in which the asset is disposed of First quarter dispositions, 1.5 /12 months Second quarter dispositions, 4.5/12months Third quarter dispositions, 7.5/12 months Fourth quarter dispositions, 10.5 /12 months
6 - 22 ©2006 Prentice Hall, Inc. Dispositions For Realty Depreciation is taken from the beginning of the year until the midpoint of the month in which the disposition takes place Table amount must be adjusted for the month of disposition: 3 rd month disposition = 2.5/12
6 - 23 ©2006 Prentice Hall, Inc. Alternative Depreciation System (ADS) Under ADS, depreciation is computed using the straight-line method and the appropriate averaging convention Under ADS, recovery periods for some assets are longer than MACRS ADS must be used For certain listed property To compute earnings and profits To compute AMT adjustment
6 - 24 ©2006 Prentice Hall, Inc. Section 179 Election Taxpayers may elect to expense a portion of the cost of depreciable personalty in the year of acquisition Applies to both new and used property Annual limit is $105,000 per taxpayer for 2005
6 - 25 ©2006 Prentice Hall, Inc. Section 179 Limits When the total cost of eligible property placed in service for the year exceeds a dollar limit, the maximum annual expensing limit is reduced dollar-for-dollar Limit is $420,000 for 2005 If more than $525,000 ($420,000 + $105,000) of eligible assets placed in service, then no Sec. 179 expensing allowed
6 - 26 ©2006 Prentice Hall, Inc. Section 179 Limits The expense deduction cannot exceed taxable income from the business using the asset The unused cost (due to this income limitation only) is carried forward to the next year and added to the amounts eligible for the expense deduction in that year
6 - 27 ©2006 Prentice Hall, Inc. 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
6 - 28 ©2006 Prentice Hall, Inc. Mixed-Use Assets If an asset is used for both business and personal purposes, depreciation is only permitted for the business-use portion If asset not used more than 50% for business, ADS must be used and Sec. 179 may not be elected Business use does not include investment use
6 - 29 ©2006 Prentice Hall, Inc. Mixed-Use Assets Once ADS is required, it must be used for all future years for that asset If business use is more than 50% in the first year, but business use declines in a future year, a change to ADS must be made Any excess depreciation claimed in earlier years must be recaptured as income in the year of change to ADS
6 - 30 ©2006 Prentice Hall, Inc. Employee-Owned Property Two additional tests must be met to depreciate employee-owned property 1)The use of the property must be for the convenience of the employer and 2)The use of the property must be required as a condition of employment
6 - 31 ©2006 Prentice Hall, Inc. Limits for Passenger Vehicles Depreciation is limited to the lesser of: Regular MACRS deductions (including any Section 179 expensing) or Ceiling limit
6 - 32 ©2006 Prentice Hall, Inc. Revised 2005 Auto Limits Rev. Proc. 2005-13 revised the 2005 ceiling limits for autos by reducing the 2 nd year limit by $100 New limits for autos placed in service in 2005 $2,960 for first year $4,700 in the second year (reduced from $4,800 in 2004) $2,850 in the third year $1,675 per year thereafter
6 - 33 ©2006 Prentice Hall, Inc. Truck and Van Limits Revised 2005 limits for trucks and vans $3,260 for first year $5,200 in the second year (reduced from $5,300 in 2004) $3,150 in the third year $1,875 per year thereafter
6 - 34 ©2006 Prentice Hall, Inc. 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
6 - 35 ©2006 Prentice Hall, Inc. 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
6 - 36 ©2006 Prentice Hall, Inc. 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
6 - 37 ©2006 Prentice Hall, Inc. Revised Lease Inclusions Rev. Proc 2005-13 also revised the 2005 lease inclusion amounts Examples of the increased inclusion amounts for a new auto leased in 2005 If FMV = $40,000 then $113 for year 1, $249 for year 2, $370 for year 3, $443 for year 4, and $512 for year 5 and later years If FMV = $50,000 then $159 for year 1, $350 for year 2, $518 for year 3, $623 for year 4, and $719 for year 5 and later years
6 - 38 ©2006 Prentice Hall, Inc. Depletion The cost of minerals, other natural resources, and timber are recovered through depletion Taxpayers can elect to claim the greater of the two depletion deductions 1)Cost depletion – depletion per unit calculated by dividing adjusted basis by estimated recoverable units 2)Percentage depletion – calculated as a percentage of gross income
6 - 39 ©2006 Prentice Hall, Inc. 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
6 - 40 ©2006 Prentice Hall, Inc. Research and Experimentation Three alternatives for research and experimentation expenditures 1)Expense them in full in the year paid or incurred 2)Amortize them over 60 months or more 3)Capitalize them
6 - 41 ©2006 Prentice Hall, Inc. Software Off-the-shelf software can be deducted on a straight-line basis over 36 months beginning with the month placed in service It is eligible for Section 179 expensing
6 - 42 ©2006 Prentice Hall, Inc. Bonus Depreciation Permitted additional first-year depreciation for new personalty (used personalty and all realty ineligible) For assets acquired between 5/6/03 and 12/31/04, 50% bonus depreciation allowed For new assets acquired after 9/11/01 (but before 5/6/03), 30% bonus depreciation allowed Section 179 expensing claimed before bonus depreciation
6 - 43 ©2006 Prentice Hall, Inc. Bonus Depreciation Basis is first reduced for Section 179 expensing, and then reduced for bonus depreciation, before claiming regular MACRS depreciation on balance Higher first year ceiling limit of $10,610 allowed in 2004 for autos eligible for bonus depreciation
6 - 44 ©2006 Prentice Hall, Inc. The End
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