© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Chapter 10 Cost Recovery on Property: Depreciation, Depletion, and Amortization Murphy & Higgins, Concepts in Federal Taxation, 2010 edition

10-2 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Concept Review 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

10-3 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. 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

10-4 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. 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

10-5 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Section 179 Election Taxpayer may elect to expense rather than capitalize qualifying property placed in service during the year Promotes administrative convenience Treated as a depreciation deduction

10-6 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Section 179 Election Qualified Taxpayers In 2009, organizations may elect to deduct as an expense up to $133,000 in investment Elements required for an activity to qualify under Section 179 election: profit motivation regularity continuity of the taxpayer’s involvement

10-7 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Section 179 Election Qualified Taxpayers Elements not required for an activity to qualify under Section 179 election hobby amusement similar motivations

10-8 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Section 179 Election Qualifying Property Tangible, personal property Real estate does not qualify Used in a trade or business Investment property does not qualify

10-9 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Section 179 Election Deduction Limitations Limitations apply to each entity Cannot exceed $133,000 Cannot exceed taxable income from the business Excess may be carried forward

10-10 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Section 179 Election Deduction Phase-Out Deduction decreased if total cost of qualifying property placed in service exceeds $530,000 by $1 for every $1 of value over $530,000 thus, when total cost = $663,000, deduction = $133,000 – ($663,000 - $530,000) = $0

10-11 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. MACRS Qualifying Property MACRS applies to New and used tangible, depreciable property Used in a trade or business or for the production of income

10-12 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. MACRS Basis Depreciable basis is Asset’s original basis for depreciation (discussed in Chapter 9) Reduced by any § 179 deduction Adjusted basis is Remaining unrecovered capital of an asset = asset basis minus accumulated depreciation

10-13 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. MACRS Recovery Period Each asset must be 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

10-14 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. MACRS Conventions Administrative convenience, 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

10-15 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. 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

10-16 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. 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

10-17 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. 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

10-18 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Depreciation Method Alternatives Regular MACRS with Section 179 Straight-line MACRS Straight-line Alternative Depreciation System (ADS)

10-19 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. 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

10-20 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. 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

10-21 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Alternative Depreciation System (ADS) 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

10-22 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Limitations on Listed Property Most mixed-use property is considered listed property and subject to special limitations Examples: automobiles, computers, cellular phones, etc.

10-23 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Limitations 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

10-24 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Limitation on Passenger Autos 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 %

10-25 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Adequate Record Keeping Listed property is subject to strict record keeping requirements No deduction is allowed without proof of Why? The business purpose of the use What? The amount When? The dates of use Where? The reality of the use

10-26 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Depletion 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

10-27 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. 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

10-28 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Percentage Depletion Method Also called Statutory depletion 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

10-29 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Amortization Basis of intangible assets is recovered using the 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 the 15 year period are amortized over their legal life