Module 10

Cost Recovery DeductionsCost Recovery Deductions

Cost Recovery Topics

DepreciationDepreciation Accelerated Cost Recovery SystemAccelerated Cost Recovery System Modified Accelerated Cost Recovery SystemModified Accelerated Cost Recovery System

AmortizationAmortization DepletionDepletion

Economics of Cost Recovery

Expenditure benefits more than 1 tax yearExpenditure benefits more than 1 tax year §263 denies a current deduction §263 denies a current deduction Cost recovery allows deduction over timeCost recovery allows deduction over time Tax policy issues Tax policy issues

Marginal efficiency of capital affected by tax Marginal efficiency of capital affected by tax savings savings Recovery periodsRecovery periods Recovery methodsRecovery methods

Cost Recovery Tax Savings AssumptionsAssumptions

$10,000 asset $10,000 asset 35% marginal tax rate 35% marginal tax rate 10% interest rate10% interest rate

Cost Recovery Tax Savings AssumptionsAssumptions

$10,000 asset $10,000 asset 35% marginal tax rate 35% marginal tax rate 10% interest rate10% interest rate

Method ofCost Recovery

After-tax NPV ofDeduction

Expense $3,500

Accelerated(over 5 years)

$2,977

Straight line(over 5 Years)

$2,786

The Depreciation Allowance: Basic Requirements

Key Learning ObjectiveKey Learning Objective

Basic requirement Basic requirement Qualifying propertyQualifying property Placed in servicePlaced in service Depreciable basisDepreciable basis

Qualifying Property

Limited (Exhaustible) Useful LifeLimited (Exhaustible) Useful Life Qualifying Use of PropertyQualifying Use of Property

Trade or BusinessTrade or Business Income-Producing ActivityIncome-Producing Activity

Placed in Service (PLIS)

PLIS when taxpayer can demonstrate PLIS when taxpayer can demonstrate ReadinessReadiness AvailabilityAvailability Capacity to performCapacity to perform

Date PLIS can effect amount of cost Date PLIS can effect amount of cost recoveryrecovery Change in tax lawChange in tax law Affect modifying conventionAffect modifying convention

Cost Recovery Basis

Initial basis Initial basis Purchased propertyPurchased property Constructed propertyConstructed property Personal property converted to business usePersonal property converted to business use

Subsequent changes in basisSubsequent changes in basis Capital improvementsCapital improvements Depreciation “allowed or allowable”Depreciation “allowed or allowable” Return of capitalReturn of capital

Compliance Query: Conversion from Personal to Business Use Purchased home for $125,000Purchased home for $125,000 IF FMV = $112,000 at conversionIF FMV = $112,000 at conversion

What is basis for depreciation?What is basis for depreciation?

IF FMV = $150,000 at conversionIF FMV = $150,000 at conversion What is basis for depreciation?What is basis for depreciation?

Solution to Compliance Query: Conversion from Personal Use Get lower of basis or FMV Get lower of basis or FMV Basis if converted when FMV = $112,000Basis if converted when FMV = $112,000

$112,000--lose decline in value during personal $112,000--lose decline in value during personal useuse

Basis if converted when FMV = $150,000Basis if converted when FMV = $150,000 $125,000--no step up for unrealized $125,000--no step up for unrealized

appreciationappreciation

MACRS--The Basic Rules

Key Learning ObjectivesKey Learning Objectives

Class life Class life Depreciable basisDepreciable basis Recovery method Recovery method Modifying conventionModifying convention

Class Life = Recovery Period

EquipmentEquipment 5 & 7 year classes5 & 7 year classes

Most commonMost common Tangible equipmentTangible equipment

3 year class 3 year class Some animals & Some animals &

specialized equipmentspecialized equipment

10,15,20 10,15,20 Specialized usesSpecialized uses

Real EstateReal Estate Residential--27.5 yearResidential--27.5 year

Generally apartments Generally apartments & rental houses& rental houses

Non-residentialNon-residential 39 year 39 year

In service after 8-9-93In service after 8-9-93

31.5 year31.5 year In service before 8-8-93In service before 8-8-93

Class Life Rev. Procs. 87-56 & 88-22

IRS provides information as to class lifeIRS provides information as to class life Assets used in all businesses Assets used in all businesses

Classes 00.11 - 00.4Classes 00.11 - 00.4 Assets used in particular activitiesAssets used in particular activities

Classes 01.1 - 80.0Classes 01.1 - 80.0 Equipment with no class life given Equipment with no class life given

Use 7 yearsUse 7 years

Research Query: MACRS Recovery Periods

This year Sea DrillingThis year Sea Drilling Installed sidewalks around its office buildingInstalled sidewalks around its office building Purchased five floating drilling platforms for Purchased five floating drilling platforms for

at-sea exploration. at-sea exploration. See Rev. Proc. 87-56 in the OnPoint See Rev. Proc. 87-56 in the OnPoint

Service to determine recovery periods.Service to determine recovery periods.

Solution--Research Query

Sidewalks -- Sidewalks -- MACRS life of 15 yearsMACRS life of 15 years used in all business activitiesused in all business activities listed in Class 00.3 listed in Class 00.3

Drilling platforms -- Drilling platforms -- MACRS life of 5 yearsMACRS life of 5 years used in specific activities used in specific activities listed in Class 13.0 listed in Class 13.0

TaxPoint: Class 57.0-- 7 Gets You 5

Class 57.0 reads as follows:Class 57.0 reads as follows: Distributive Trades and Services: Includes Distributive Trades and Services: Includes

assets used in wholesale and retail trade, and assets used in wholesale and retail trade, and personal and professional services. Includes personal and professional services. Includes section 1245 assets used in marketing section 1245 assets used in marketing petroleum and petroleum productspetroleum and petroleum products

If used in a “distributive trade or service,” an If used in a “distributive trade or service,” an asset normally classified as 7-year property asset normally classified as 7-year property would get 5-year class life.would get 5-year class life.

Depreciable (Recovery) Basis

Salvage value always ignoredSalvage value always ignored Equipment (equipment)Equipment (equipment)

Reduction for §179 ElectionReduction for §179 Election Reduction for 50% of certain business creditsReduction for 50% of certain business credits

RealtyRealty Exclusion of any land costsExclusion of any land costs Reduction for rehabilitation creditsReduction for rehabilitation credits

MACRS Recovery Methods

200% declining balance 200% declining balance 3,5,7,10 year classes of equipment 3,5,7,10 year classes of equipment

150% declining balance150% declining balance 15 and 20 year classes of equipment 15 and 20 year classes of equipment

Conversion to straight-line allowed Conversion to straight-line allowed Straight-lineStraight-line

All realtyAll realty

Modifying ConventionYear of Acquisition

EquipmentEquipment General rule--half-year conventionGeneral rule--half-year convention Exception--mid-quarter convention Exception--mid-quarter convention IFIF

More than 40%More than 40% In service in last quarterIn service in last quarter

RealtyRealty Mid-month conventionMid-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 propertyYear Midyear First

quarterSecondquarter

Thirdquarter

Fourthquarter

1 20.00% 35.00% 25.00% 15.00% 5.00%2 32.00 26.00 30.00 34.00 38.003 19.20 15.60 18.00 20.40 22.804 11.52 11.01 11.37 12.24 13.685 11.52 11.01 11.37 11.30 10.946 5.76 1.38 4.26 7.06 9.58

Compliance Query: Modifying Convention

A calendar year taxpayer places in service:

Date Asset Type Cost

March Machine (No class life)

$ 250,000

October Warehouse $100,000

December Computer (Class life = 5) $ 10,000

Solution to Compliance Query: Modifying Convention

First test for mid-quarterFirst test for mid-quarter The warehouse is ignored for the 40% testThe warehouse is ignored for the 40% test 4th quarter divided by all Equipment acquisitions4th quarter divided by all Equipment acquisitions

10,000 ÷ 260,000 = 3.8%10,000 ÷ 260,000 = 3.8% This is less than 40%This is less than 40%

The half-year convention appliesThe half-year convention applies

Solution--Compliance Query Appropriate MACRS Deduction

Machine ($250,000 x .1429) . . . . . $35,725Machine ($250,000 x .1429) . . . . . $35,725

Computer ($10,000 x .20) . . . . . . 2,000Computer ($10,000 x .20) . . . . . . 2,000

Warehouse ($100,000 x .00535) . . 535Warehouse ($100,000 x .00535) . . 535 The mid-month convention applies to buildings.The mid-month convention applies to buildings.

Note that the tables other than five -year are on the Note that the tables other than five -year are on the TaxPoint disk.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 Asset Type Cost

December Machine (No class life)

$ 250,000

October Warehouse $100,000

March Computer (Class life = 5) $ 10,000

Solution to Compliance Query: Modifying Convention

First test for mid-quarterFirst test for mid-quarter The warehouse is ignored for the 40% testThe warehouse is ignored for the 40% test 4th quarter divided by all equipment acquisitions4th quarter divided by all equipment acquisitions

250,000 ÷ 260,000 = 96.2%250,000 ÷ 260,000 = 96.2% This is more than 40%This is more than 40%

The mid-quarter convention appliesThe mid-quarter convention applies

The Four Quarters of Mid-Quarter

The computer was placed in service in March, so it is first The computer was placed in service in March, so it is first quarter mid quarter 5-year property--35%.quarter mid quarter 5-year property--35%.

The equipment is fourth quarter, mid quarter 7 year, so this The equipment is fourth quarter, mid quarter 7 year, so this

table doesn’t apply.table doesn’t apply. You will find 3.57% in the 7 year 4th You will find 3.57% in the 7 year 4th quarter mid-quarter table on the disk.quarter mid-quarter table on the disk.

Table 10-3-A. MACRS 5-Year propertyYear Midyear First

quarterSecondquarter

Thirdquarter

Fourthquarter

1 20.00% 35.00% 25.00% 15.00% 5.00%2 32.00 26.00 30.00 34.00 38.003 19.20 15.60 18.00 20.40 22.804 11.52 11.01 11.37 12.24 13.685 11.52 11.01 11.37 11.30 10.946 5.76 1.38 4.26 7.06 9.58

Solution--Compliance Query Appropriate MACRS Deduction

Machine ($250,000 x .0357) . . . . . $8,925Machine ($250,000 x .0357) . . . . . $8,925

Computer ($10,000 x .35) . . . . . . . . 3,500Computer ($10,000 x .35) . . . . . . . . 3,500

Warehouse ($100,000 x .00535) . . . . 535Warehouse ($100,000 x .00535) . . . . 535 The mid-month convention applies to buildings.The mid-month convention applies to buildings.

Note that the tables other than five -year are on the Note that the tables other than five -year are on the TaxPoint disk.TaxPoint disk.

Compliance Query: MACRS Deduction in Year 2, (no disposition)

Do not leave the column you started in!Do not leave the column you started in!

Machine ($250,000 x .2755) . . . . . $ 68,875Machine ($250,000 x .2755) . . . . . $ 68,875

Computer ($10,000 x .26) . . . . . . . .$ 2,600Computer ($10,000 x .26) . . . . . . . .$ 2,600

Warehouse ($100,000 x .02564) . . $ 2,564Warehouse ($100,000 x .02564) . . $ 2,564

Note that the tables other than five -year are on the Note that the tables other than five -year are on the TaxPoint disk.TaxPoint disk.

Modifying ConventionYear of Disposition

Applies to both equipment & realtyApplies to both equipment & realty Use same convention as in year acquiredUse same convention as in year acquired

If mid-month, count the months, subtract 1/2 month, If mid-month, count the months, subtract 1/2 month, divide by 12divide by 12

If mid-year, use 1/2 If mid-year, use 1/2 If mid-quarter, count the quarters, subtract 1/2 If mid-quarter, count the quarters, subtract 1/2

quarter, divide by 4quarter, divide by 4

Compliance Query MACRS Deduction in Year 3, (sell in July)

Do not leave the column you started in!Do not leave the column you started in!

MachineMachine

($250,000 x .1968 x ($250,000 x .1968 x 2.5 ÷ 42.5 ÷ 4) . . . . $30,750) . . . . $30,750

Computer Computer

($10,000 x .1560 x ($10,000 x .1560 x 2.5 ÷ 42.5 ÷ 4) . . . . . .$975) . . . . . .$975

Warehouse Warehouse

($100,000 x .02564 x ($100,000 x .02564 x 6.5÷126.5÷12) . . . . $1,389) . . . . $1,389

Compliance Query: Once More, on Your Own

Mac Co. a calendar-year corporationMac Co. a calendar-year corporation Placed in service in OctoberPlaced in service in October $250,000 of computers$250,000 of computers

only assets acquired that yearonly assets acquired that year What is the recovery deduction for Year 1?What is the recovery deduction for Year 1? If Mac sells the computer in June, of Year 3 If Mac sells the computer in June, of Year 3

what is the year 3 recovery deduction?what is the year 3 recovery deduction?

Solution--Compliance Query: Once More, on Your Own.

Solution Year 1: 5 year/ mid-quarter propertySolution Year 1: 5 year/ mid-quarter property

$250,000 x .05 = $12,500$250,000 x .05 = $12,500

Solution Year 3: still 5 year/mid-quarterSolution Year 3: still 5 year/mid-quarter

$250,000 x .2280 x (1.5/4) = $21,375$250,000 x .2280 x (1.5/4) = $21,375 Mid-quarter, count the quarters, subtract 1/2 quarter, divide by 4Mid-quarter, count the quarters, subtract 1/2 quarter, divide by 4

MACRS - Special Elections

Key Learning ObjectivesKey Learning Objectives

The requirements for the §179 election The requirements for the §179 election The two straight-line recovery methods The two straight-line recovery methods

available under MACRSavailable under MACRS

§179 Immediate Expensing Election

Qualifying personal propertyQualifying personal property

equipment used in an active trade or businessequipment used in an active trade or business

Year of acquisition onlyYear of acquisition only $20,000 maximum annual election -- 2000$20,000 maximum annual election -- 2000 $ for $ phaseout of $ 20,000 for acquisitions $ for $ phaseout of $ 20,000 for acquisitions

over $200,000over $200,000 Can’t create a loss with §179 deductionCan’t create a loss with §179 deduction

Tax Planning QueryMake a §179 Election?

Minor Co. a calendar-year corporationMinor Co. a calendar-year corporation PLIS a $15,000 computer in AprilPLIS a $15,000 computer in April

(the only asset acquired that year). (the only asset acquired that year). Taxable income for the current year is $500 before Taxable income for the current year is $500 before

considering MACRS recovery considering MACRS recovery Minor had profits of $120,000 in each of the Minor had profits of $120,000 in each of the

preceding five years. preceding five years. What factors should Minor consider in evaluating a What factors should Minor consider in evaluating a

§179 election?§179 election?

Solution--Tax Planning Query Make a §179 Election?

Key Factor--Expected profitability in future

Electing §179Electing §179

Expense $15,000Expense $15,000

Deduction limited to Deduction limited to $500 (limited to $500 (limited to taxable income)taxable income)

$14,500 may be carried $14,500 may be carried to the next yearto the next year

Not Electing §179Not Electing §179

MACRS deduction = MACRS deduction = $3,000 ($15,000 x .05) $3,000 ($15,000 x .05)

creating an NOLcreating an NOL

NOL may be carried back NOL may be carried back to the third prior tax yearto the third prior tax year

Refund = $975Refund = $975

($2,500 x .39) ($2,500 x .39)

Tax Planning Query:Place In Service This Year or Next?

Meta Co. a calendar-year corporationMeta Co. a calendar-year corporation Put in service in FebruaryPut in service in February

$120,000 equipment (only acquisition to date) $120,000 equipment (only acquisition to date) Meta wants to acquire $83,000 of furnitureMeta wants to acquire $83,000 of furniture Should Meta placed the furniture in service Should Meta placed the furniture in service

in December or January of the next tax year?in December or January of the next tax year? What factors should Meta consider in What factors should Meta consider in

deciding when to buy the furniture? deciding when to buy the furniture?

Solution--Tax Planning Query Place In Service This Year or Next?

If placed in service in DecemberIf placed in service in December Total acquisitions = $203,000Total acquisitions = $203,000

Maximum §179 = 17,000. (20,000Maximum §179 = 17,000. (20,000 - 3000)- 3000) Expensed property not used in test for mid-quarterExpensed property not used in test for mid-quarter

Could expense either equipment or furnitureCould expense either equipment or furniture If equipment, then mid-quarterIf equipment, then mid-quarter

83,000 ÷ (203,000-17,000) = 44.6%83,000 ÷ (203,000-17,000) = 44.6% If furniture, then half yearIf furniture, then half year

(83,000-17,000) ÷ (203,000-17,000) = 35.5%(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 yearIf placed in service in January of next year Then for the current year Then for the current year

Maximum §179 is $ 20,000 (assumes 2000)Maximum §179 is $ 20,000 (assumes 2000) The half-year convention will applyThe half-year convention will apply

no acquisitions in fourth quarterno acquisitions in fourth quarter

MACRS Straight-Line Options

Acquisition year conventions applyAcquisition year conventions apply Must make election by class by yearMust make election by class by year Straight-line over the MACRS life Straight-line over the MACRS life Straight-line over the class lifeStraight-line over the class life

Alternative depreciation system (ADS)Alternative depreciation system (ADS) Major exceptions to the class life rule:Major exceptions to the class life rule:

Autos and computers (5 years)Autos and computers (5 years) equipment with no class life (12 years)equipment with no class life (12 years) Realty (40 years)Realty (40 years)

Compliance Query:Which MACRS Elections?

Melon Corp. a calendar-year corporationMelon Corp. a calendar-year corporation PLIS a $29,000 machine in March 2000PLIS a $29,000 machine in March 2000

(the only asset acquired this year) (the only asset acquired this year) The machine does not have a class liveThe machine does not have a class live Melon elects §179Melon elects §179 What is the TOTAL cost recovery underWhat is the TOTAL cost recovery under

Regular MACRS recoveryRegular MACRS recovery Straight-line MACRS recoveryStraight-line MACRS recovery Alternative Depreciation System (ADS) Alternative Depreciation System (ADS)

Solution--Compliance Query Which MACRS Elections?

§179 deduction = $20,000§179 deduction = $20,000

Remaining basis = $ 9,000 Remaining basis = $ 9,000

No class live so MACRS = 7 and ADS = 12No class live so MACRS = 7 and ADS = 12

MACRS = $1,286 ($9,000 x .1429) MACRS = $1,286 ($9,000 x .1429)

MACRS SL = $ 643 ($9,000 x 1/7 x .5)MACRS SL = $ 643 ($9,000 x 1/7 x .5)

ADS SL = $ 375 ($9,000 x 1/12 x .5)ADS SL = $ 375 ($9,000 x 1/12 x .5)

TOTAL deduction increased by $ 20,000 in each TOTAL deduction increased by $ 20,000 in each casecase

MACRS--Special Restrictions

Key Learning ObjectivesKey Learning Objectives The anti-churning rulesThe anti-churning rules Restrictions applicable to listed properties Restrictions applicable to listed properties

Including special limits on automobilesIncluding special limits on automobiles MACRS computations for alternative MACRS computations for alternative

minimum tax (AMT) purposesminimum tax (AMT) purposes

Anti-churning RulesPrevent Perceived Abuse

Prevents using sales between related parties Prevents using sales between related parties to change depreciation methods when tax to change depreciation methods when tax law changeslaw changes

If related party sale occurs, the transaction If related party sale occurs, the transaction is ignored, old recovery method continuesis ignored, old recovery method continues

Listed Property Rules: Personal Use Can Limit Recovery

Applies only to equipment Applies only to equipment Subject to restriction if Subject to restriction if Qualified Business Qualified Business

UseUse (QBU) < 50% (QBU) < 50% QBU generally limited to non-employee QBU generally limited to non-employee

trade/business usetrade/business use

Listed Property Rules: Personal Use Can Limit Recovery

Straight line over Straight line over CLASS LIFECLASS LIFE used in used in any year QBU < 50%any year QBU < 50%

Test must be applied each yearTest must be applied each year Recapture applies if MACRS used prior to Recapture applies if MACRS used prior to

failing the business usage testfailing the business usage test

Compliance Query:Change in QBU

Sue Adams , a calendar-year taxpayerSue Adams , a calendar-year taxpayer Placed in service in MarchPlaced in service in March $10,000 computer$10,000 computer

the only asset acquired this yearthe only asset acquired this year §179 NOT elected§179 NOT elected For Year 1 QBU = 90%.For Year 1 QBU = 90%. For Year 2 QBU = 40%.For Year 2 QBU = 40%.

What are Sue’s recovery deductions?What are Sue’s recovery deductions?

Solution--Compliance Query Change in QBU

Year 1Year 1

MACRS recovery = MACRS recovery = $1,800 $1,800

($10,000 x .2 x .9)($10,000 x .2 x .9)

($10000 ($10000 ÷ 5 x 2 x .9)x .9)

Note ADS would have Note ADS would have been $900been $900

($10,000 ($10,000 ÷ 5 x .9)x .9)

Year 2Year 2

ADS straight-line ADS straight-line recovery = $800 recovery = $800 ($10,000 x 1/5 x .40).($10,000 x 1/5 x .40).

$900 recaptured as $900 recaptured as additional incomeadditional income

This is the difference This is the difference between MACRS Yr 1 between MACRS Yr 1 (1800)(1800) & ADS Yr 1 & ADS Yr 1 (900)(900)

Luxury Auto Rules--Everyone Bought a $15,300 Car in 1999

Limits for autos placed into service in 2000Limits for autos placed into service in 2000 First year $3,060First year $3,060 (15,300 x .20) (15,300 x .20) Second year $5,000 Second year $5,000 (15,300 x .32) (15,300 x .32) Third year $2,950Third year $2,950 Remaining years $1,775Remaining years $1,775

Luxury Auto Rules IBM follows them too!

Indexed annually for inflation Indexed annually for inflation Limit is reduced by personal useLimit is reduced by personal use Limit applies to recovery and §179 electionLimit applies to recovery and §179 election Special rules for leased autosSpecial rules for leased autos

Compliance Query: Recovering the Cost of Autos

Deck’s Realty, a calendar-year taxpayerDeck’s Realty, a calendar-year taxpayer Placed in service in May, 1999Placed in service in May, 1999 $40,000 auto $40,000 auto (the only asset acquired that (the only asset acquired that

year) year) QBU = 80% QBU = 80% What is the 1999 cost recovery deduction?What is the 1999 cost recovery deduction?

Solution to Compliance Query: Recovering the Cost of Autos

Car is half year, five year propertyCar is half year, five year property MACRS and §179 are availableMACRS and §179 are available If this was not a car, without §179, the If this was not a car, without §179, the

deduction would bededuction would be 40,000 x .2 x .8 = 6,40040,000 x .2 x .8 = 6,400

But auto rules limit deduction toBut auto rules limit deduction to $2,448 (3,060 x .80)$2,448 (3,060 x .80)

Alternative Minimum Tax Cost Recovery

Alternative Depreciation System (ADS)Alternative Depreciation System (ADS) Equipment--150% DB over class lifeEquipment--150% DB over class life Realty--Straight-line over 40 yearsRealty--Straight-line over 40 years ADS--150% & SL OK for regular tax ADS--150% & SL OK for regular tax

To slow down deductionTo slow down deduction To reduce record keepingTo reduce record keeping

Election on class by class, Election on class by class,

year-by-year basisyear-by-year basis

TaxPoint: Possible Taxpayer Depreciation Records

Regular federal income taxRegular federal income tax Alternative minimum taxAlternative minimum tax Earnings and profits determinationEarnings and profits determination Adjusted current earnings determinationAdjusted current earnings determination State income taxState income tax Financial accounting recordsFinancial accounting records Regulatory agency mandated methodsRegulatory agency mandated methods

Compliance QueryName That Method!

Technoid Corporation, 12/31 year end.Technoid Corporation, 12/31 year end. Put in service in May $20,000 of new Put in service in May $20,000 of new

equipment equipment (the only asset acquired that year).(the only asset acquired that year).

Technoid may choose one of 8 different Technoid may choose one of 8 different methods of cost recovery for this methods of cost recovery for this equipment. equipment.

Can you name them?Can you name them?

Solution - Compliance Query Name That Method!

§179 election & normal MACRS §179 election & normal MACRS §179 election & straight-line MACRS §179 election & straight-line MACRS §179 election & ADS straight-line§179 election & ADS straight-line §179 election & 150% ADS (AMT)§179 election & 150% ADS (AMT) Normal MACRS recovery onlyNormal MACRS recovery only Straight-line MACRS recovery onlyStraight-line MACRS recovery only Straight-line ADS recovery onlyStraight-line ADS recovery only 150% ADS (AMT) recovery150% 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 Asset Cost June Auto $ 10,000June Warehouse 100,000June Apartment 200,000July Equipment

(10 year CL) 20,000

October Punch Machine (8 year CL)

38,000

November Drill Machine (No Class Life)

30,000

December Cutting Machine (12 year CL)

104,000

Solution to Concepts Review:

Step 1: Separate equipment and realtyStep 1: Separate equipment and realty Equipment--$202,000Equipment--$202,000 Realty--$300,000Realty--$300,000

Step 2: Separate reality into Step 2: Separate reality into Residential (27.5 year recovery) -- 200,000Residential (27.5 year recovery) -- 200,000 Non-residential (39 year recovery) -- 100,000Non-residential (39 year recovery) -- 100,000

Solution to Concepts Review:

Step 3: Calculate §179 deduction Step 3: Calculate §179 deduction 20,000-2,000 = 18,00020,000-2,000 = 18,000 Before selecting consider impact on mid-quarter Before selecting consider impact on mid-quarter

test (none in this problem)test (none in this problem) Generally best to take from property with Generally best to take from property with

longest recovery period-- but no set rulelongest recovery period-- but no set rule In next slide you will see that mid-quarter applies. In next slide you will see that mid-quarter applies.

Therefore largest deduction will come from Therefore largest deduction will come from expensing some of the 4th quarter, mid-quarter stuff. expensing some of the 4th quarter, mid-quarter stuff.

Solution to Concepts Review:

Step 4: Determine modifying convention Step 4: Determine modifying convention for equipmentfor equipment Allocate equipment by quarterAllocate equipment by quarter

2th Qtr -- $ 10,000 2th Qtr -- $ 10,000 3th Qtr.-- $ 20,000 3th Qtr.-- $ 20,000 4th Qtr.--$172,000 4th Qtr.--$172,000

MQ convention applies to equipmentMQ convention applies to equipment 172,000÷ 202,000 = 85.1% 172,000÷ 202,000 = 85.1%

Solution to Concepts Review:

Step 5: Stop to consider impact of listed Step 5: Stop to consider impact of listed property and luxury auto rules.property and luxury auto rules. None in this problem.None in this problem. Since cost of car is only $10,000, the first year Since cost of car is only $10,000, the first year

will not exceed 3,060.will not exceed 3,060.

Solution to Concepts Review: Total Deduction $34,013

WarehouseWarehouse $100,000 x .0139 = 1,390$100,000 x .0139 = 1,390

Rental ApartmentRental Apartment $200,000 x .0197) = 3,940 $200,000 x .0197) = 3,940

Auto Auto 2nd qtr, MQ 5 year2nd qtr, MQ 5 year $10,000 x .25$10,000 x .25 = 2,500 = 2,500

Equip Equip 3rd qtr, MQ 7 year3rd qtr, MQ 7 year ($20,000 x .1071) = 2,142($20,000 x .1071) = 2,142

Punch MachinePunch Machine 4th qtr, MQ 5 year4th qtr, MQ 5 year 38,000 x .05) = 1,900 38,000 x .05) = 1,900

Drill MachineDrill Machine 4th qtr, MQ 7 year 4th qtr, MQ 7 year 30,000 x .0357 = 1,071 30,000 x .0357 = 1,071

Cutting MachineCutting Machine 4th qtr, MQ 7 year 4th qtr, MQ 7 year expense 18,000expense 18,000 depreciate 86,000 3,070depreciate 86,000 3,070

Cost Recovery of Intangibles

Key Learning ObjectivesKey Learning Objectives

General tax rules for amortization of General tax rules for amortization of intangiblesintangibles

Special rules for §197 intangiblesSpecial rules for §197 intangibles Special provisions for research and Special provisions for research and

experimentation expenses experimentation expenses

Amortization--Cost Recovery for Intangible Assets

Need estimated useful or legal lifeNeed estimated useful or legal life Straight-line recoveryStraight-line recovery Whole month convention usedWhole month convention used Special 5-year recovery periodSpecial 5-year recovery period

Organization & start-up costsOrganization & start-up costs §197 purchased intangibles§197 purchased intangibles Research & experimentation expendituresResearch & experimentation expenditures

§197 Amortizing Goodwill Post 8/10/93 Acquisitions

Acquisitions of a business if purchase price Acquisitions of a business if purchase price includes intangiblesincludes intangibles GoodwillGoodwill Going concern valueGoing concern value Other purchased intangibles (covenants not to Other purchased intangibles (covenants not to

compete, customer lists, workforce, etc...)compete, customer lists, workforce, etc...) Amortize over 15 yearsAmortize over 15 years Amortization begins in month of acquisitionAmortization begins in month of acquisition

Compliance Query§197 Intangibles

As part of the acquisition of Bee Company, As part of the acquisition of Bee Company, Ace Company paid $20,000 for Bee’s Ace Company paid $20,000 for Bee’s contractual agreement not to enter into a contractual agreement not to enter into a competing business for the next 10 years. competing business for the next 10 years. What is Ace’s recovery period for the $20,000?What is Ace’s recovery period for the $20,000?

Solution--The agreement not to compete is a Solution--The agreement not to compete is a §197 intangible and must be amortized over 15 §197 intangible and must be amortized over 15 years. The contract is irrelevant.years. The contract is irrelevant.

Research and Experimentation Expenditures (R&E)

Definition--incident to product or processDefinition--incident to product or process Three tax options:Three tax options:

Expense immediatelyExpense immediately Amortize over a period of not less than 5 yearsAmortize over a period of not less than 5 years CapitalizeCapitalize

Any tangible property must be capitalized and Any tangible property must be capitalized and depreciateddepreciated

Any R&E credit allowed reduces the deductionAny R&E credit allowed reduces the deduction

Compliance Query

Which of the following expenditures do not Which of the following expenditures do not qualify as R&E?qualify as R&E? Depreciation on research buildingDepreciation on research building Wages of R&E employeesWages of R&E employees Consumer survey costsConsumer survey costs Blueprints and drawings of productBlueprints and drawings of product

Solution:Solution: The consumer surveys are development costs and do The consumer surveys are development costs and do

not qualify.not qualify.

Depletion Deductions

Key Learning ConceptKey Learning Concept

Requirements for the depletion deductionRequirements for the depletion deduction Computations under the Computations under the

Cost andCost and Percentage methodsPercentage methods

Depletion--General Concepts

Cost recovery for natural resourcesCost recovery for natural resources Allowed to anyone with an economic interest Allowed to anyone with an economic interest

in the minerals or natural resource in placein the minerals or natural resource in place Two methods of computing depletion:Two methods of computing depletion:

Cost methodCost method Percentage (statutory) methodPercentage (statutory) method

Taxpayer may deduct the larger of the two Taxpayer may deduct the larger of the two methodsmethods

TaxPoint: Blood as a Mineral?

In the case of Margaret Green, 74 TC 1229, the In the case of Margaret Green, 74 TC 1229, the taxpayer attempted to deplete the mineral content taxpayer attempted to deplete the mineral content of her blood using statutory recovery. of her blood using statutory recovery.

She received commissions for donating her blood She received commissions for donating her blood (a rare AB-type), and argued that she should be (a rare AB-type), and argued that she should be able to deplete her blood supply. able to deplete her blood supply.

The Tax Court disagreed, stating that such minerals The Tax Court disagreed, stating that such minerals were not “natural deposits,” and eventual loss of were not “natural deposits,” and eventual loss of

ability to regenerate minerals was not relevantability to regenerate minerals was not relevant. .

Cost Method of Depletion

Determine a depletion rate per unitDetermine a depletion rate per unit Undepleted cost/estimated remaining Undepleted cost/estimated remaining

recoverable unitsrecoverable units Multiply the rate times the number of units Multiply the rate times the number of units

sold during the tax yearsold during the tax year Total recovery may not exceed investment Total recovery may not exceed investment

costcost

Percentage Method of Depletion

Determine statutory (code) rate for particular Determine statutory (code) rate for particular resourceresource

Multiply rate times the gross income from the Multiply rate times the gross income from the propertyproperty

Statutory depletion is further limited to:Statutory depletion is further limited to: 50% of the taxable income from the property (100% 50% of the taxable income from the property (100%

of taxable income for oil properties)of taxable income for oil properties) 65% of the taxpayer’s taxable income65% of the taxpayer’s taxable income

Percentage depletion may exceed costPercentage depletion may exceed cost

Compliance Query

Sierra Co. paid $600,000 to lease land for mining Sierra Co. paid $600,000 to lease land for mining uranium (22% rate). uranium (22% rate).

Mine is estimated to contain 200,000 tons of ore. Mine is estimated to contain 200,000 tons of ore. This year, Sierra extracted 60,000 tons of ore and This year, Sierra extracted 60,000 tons of ore and

sold 40,000 tons for $20 per ton. sold 40,000 tons for $20 per ton. Sierra’s gross income for the year was $700,000Sierra’s gross income for the year was $700,000

($800,000 sales less a $100,000 royalty) ($800,000 sales less a $100,000 royalty) Expenses totaled $480,000. Expenses totaled $480,000. What is Sierra’s depletion deduction ?What is Sierra’s depletion deduction ?

Solution--Compliance Query

Cost depletion:Cost depletion: $600,000/200,000 x 40,000 = $120,000$600,000/200,000 x 40,000 = $120,000

Percentage (statutory) depletion:Percentage (statutory) depletion: $700,000 x .22 = $154,000, limited to:$700,000 x .22 = $154,000, limited to: ($700,000 - $480,000) x .50 = $110,000($700,000 - $480,000) x .50 = $110,000

Deduction is $120,000 (larger of the two)Deduction is $120,000 (larger of the two)

Research Query

M Company discovered that Sleasy had drilled a slant M Company discovered that Sleasy had drilled a slant hole under their property and had stolen 50,000 barrels hole under their property and had stolen 50,000 barrels of oil.of oil.

M initiated a lawsuit to recover the value of the stolen M initiated a lawsuit to recover the value of the stolen oil. oil.

Early Win, an attorney, agreed to represent M Company Early Win, an attorney, agreed to represent M Company on a 1/3 contingency basis (receives 1/3 of the value if on a 1/3 contingency basis (receives 1/3 of the value if M wins, and nothing if M loses). M wins, and nothing if M loses).

If Win wins the case, can he take a depletion deduction If Win wins the case, can he take a depletion deduction

on his 1/3 of the proceeds?on his 1/3 of the proceeds?

Solution--Research Query

No, Win will not qualify for depletion. In a No, Win will not qualify for depletion. In a similar case, Parr v. Schofield (89 F Supp similar case, Parr v. Schofield (89 F Supp 98), the Court of Appeals for the 5th Circuit 98), the Court of Appeals for the 5th Circuit stated that such recoveries were not stated that such recoveries were not depletable gross income because the legal depletable gross income because the legal contract did not cause a transfer of an interest contract did not cause a transfer of an interest in the mineral property to the attorney. in the mineral property to the attorney.

(Federal Tax Coordinator, Para.N-2113)(Federal Tax Coordinator, Para.N-2113)

Appendix--Pre-1981 Depreciation

Useful lifeUseful life Salvage valueSalvage value Maximum depreciation recovery methods:Maximum depreciation recovery methods:

Equipment Equipment RealtyRealty

Appendix--Pre-1987 ACRS

Equipment classes (3, 5, 10, and 15)Equipment classes (3, 5, 10, and 15) Realty classes (15, 18, and 19)Realty classes (15, 18, and 19) Acquisition year assumptionAcquisition year assumption Maximum recovery rates:Maximum recovery rates:

EquipmentEquipment RealtyRealty

§179 expensing option§179 expensing option Straight-line optionsStraight-line options