property acquisitions and cost recovery deductions

6 - 1©2004 Prentice Hall, Inc.

Property Acquisitionsand

Cost Recovery Deductions

Chapter 6


Capital Expenditures

The cost of a business asset with a useful life extending beyond the current year is: Deducted currently or 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 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


Basis of Property

If more than one asset is acquired in a single transaction, the cost is apportioned to each using their relative fair market values (FMV) If the purchase price exceeds the value of

the assets, the excess is goodwill Alternatively, the buyer and seller can agree

to a written allocation of the purchase price to individual assets


Adjusted Basis

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)


Basis of 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 of the property’s decline in value while it was used for personal purposes


Acquisition in aTaxable 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 and the basis of the property acquired is its FMV


Acquisition by Gift

Donee’s basis is the donor’s basis + portion of gift taxes due to appreciation (but total cannot exceed FMV at date of gift) FMV at gift date – Donor’s Basis

FMV at gift date If FMV at gift date is less than donor’s

basis and property is sold for a loss, donee uses lower FMV as basis


Acquisition by Inheritance

Use Fair Market Value as basis for inherited property

WillWill


After-Tax Cost

Tax savings from depreciation deductions reduces the effective after-tax cost of an asset

The annual tax savings equals the 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


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


MACRS

Modified Accelerated Cost Recovery System assigns assets to a class with a predetermined recovery period (and 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)


MACRS

Depreciation for personalty can use: 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 Original basis is multiplied by % from table


MACRS Tables

Year 5-Year 7-Year

1 20.00% 14.29%

2 32.00% 24.49%

3 19.20% 17.49%

4 11.52% 12.49%

5 11.52% 8.93%

6 5.76% 8.92%

7 8.93%

8 4.46%


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



Mid-quarter convention is required if more than 40% of the personalty (not buildings) was placed in service during the last quarter of the 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



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


Mixed-Use Assets

If an asset is used for both business and personal purposes, depreciation is only permitted for the business-use portion No depreciation is allowed for the

personal-use portion


Dispositions

When an asset is disposed of before it is fully depreciated, the same averaging convention will apply An asset that was depreciated under the

half-year convention will be allowed one-half year’s depreciation in the year of disposal


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, 1½ /12 months Fourth quarter dispositions, 10½ /12 months

For realty, depreciation is taken from the beginning of the year until the midpoint of the month in which the disposition takes place


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


Section 179 Election

Taxpayers may elect to expense a portion of the cost of depreciable personalty in the year of acquisition Pre-2003 Tax Act annual limit was

$25,000 per taxpayer 2003 Tax Act raises limit to $100,000 for

2003, 2004, and 2005 Excess cost is subject to regular MACRS

depreciation


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 Pre-2003 Tax Act limit was $200,000 2003 Tax Act increased limit to

$400,000 for 2003, 2004, and 2005


Section 179 Limits

The expense deduction cannot exceed taxable income from the trade or business using the asset The unused cost (due to this income

limitation only) is carried forward to the next year and added to the qualifying amounts for the expense deduction in that year


Section 179 Strategy

Expensing the assets with the longest class life will generally maximizes the value of the Section 179 deduction

The use of 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


Additional First-Year Depreciation

Permits additional first-year depreciation for new personalty Before 2003 Tax Act, 30% was allowed

for assets acquired 9/11/01 - 9/10/04 2003 Tax Act increases this to 50% for

assets acquired 5/6/03 – 12/31/04 Basis is reduced for this additional

depreciation before taking regular MACRS depreciation


Additional First-Year Depreciation

When Section 179 has been elected, the amount expensed is deducted before the additional first-year depreciation is computed

Then the regular MACRS depreciation is taken on the balance


Listed Property

Properties that can be used for both business and personal use (automobiles, computers, cell phones) are subject to limits unless: Owned or leased by the business and Used exclusively at the business

If 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


Listed Property

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


Employee-Owned Property

Two additional tests must be met to depreciate employee-owned property: The use of the property must be for the

convenience of the employer and The use of the property must be required

as a condition of employment


Ceiling Limits for Automobiles

Depreciation is limited to the lesser of regular MACRS deductions (including any Section 179 expensing) or the ceiling limit $3,060 in the year the auto is placed in

service (if additional first-year depreciation not claimed)

$4,900 in the second year $2,950 in the third year $1,775 per year thereafter


Ceiling Limits for Automobiles

When a car 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


Additional First-Year Depreciation for Autos

The first-year ceiling limit for new business-use autos is increased Before 2003 Tax Act, an additional $4,600

($3,060 + $4,600 = $7,660 total first year) 2003 Tax Act increases additional amount

to $7,650 for cars acquired 5/6/03 – 12/31/04

Additional first-year amount only available if car used more than 50% for business


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


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: Cost depletion – depletion per unit

calculated by dividing adjusted basis by estimated recoverable units

Percentage depletion – calculated as a percentage of gross income


Intangibles

Intangible assets are grouped into 3 categories Intangibles with perpetual life that cannot

be amortized 15-year intangibles (including goodwill)

acquired as part of a business purchase (Section 197 assets)

Intangibles amortizable over a life other than 15 years


The End

property acquisitions and cost recovery deductions

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