Individual Income Taxes Copyright ©2010 Cengage Learning Chapter 8 Depreciation, Cost Recovery, Amortization, and Depletion Individual Income Taxes Copyright ©2010 Cengage Learning

Cost Recovery Recovery of the cost of business or income-producing assets is through: Cost recovery or depreciation: tangible assets Amortization: intangible assets Depletion: natural resources

Nature of Property Property includes both realty (real property) and personalty (personal property) Realty generally includes land and buildings permanently affixed to the land Personalty is defined as any asset that is not realty Personalty includes furniture, machinery, equipment, and many other types of assets Personalty (or personal property) should not be confused with personal use property Personal use property is any property (realty or personalty) that is held for personal use rather than for use in a trade or business or an income-producing activity Write-offs are not allowed for personal use assets

General Considerations (slide 1 of 3) Basis in an asset is reduced by the amount of cost recovery that is allowed and by not less than the allowable amount Allowed cost recovery is cost recovery actually taken Allowable cost recovery is amount that could have been taken under the applicable cost recovery method If no cost recovery is claimed on property The basis of the property must still be reduced by the amount that should have been deducted i.e., The allowable cost recovery

General Considerations (slide 2 of 3) If personal use assets are converted to business or income-producing use Basis for cost recovery and for loss is lower of Adjusted basis or Fair market value at time property was converted Losses that occurred prior to conversion can not be recognized for tax purposes through cost recovery

General Considerations (slide 3 of 3) MACRS applies to: Assets used in a trade or business or for the production of income Assets subject to wear and tear, obsolescence, etc. Assets that have a determinable useful life or decline in value on a predictable basis Assets that are tangible personalty or realty

MACRS-Personalty MACRS characteristics: MACRS Personalty . Statutory lives: 3, 5, 7, 10 yrs 15, 20 yrs Method: 200% DB 150% DB Convention: Half Yr or Mid-Quarter DB = declining balance with switch to straight-line Straight-line depreciation may be elected

Half-Year Convention General rule for personalty Assets treated as if placed in service (or disposed of) in the middle of taxable year regardless of when actually placed in service (or disposed of)

Example: Half-Year Convention Purchased and placed an asset in service on March 15 (Tax year end is December 31) Treated as placed in service June 30 Six months cost recovery in year 1 (and year disposed of, if within recovery period)

Additional First-Year Depreciation The Economic Stimulus Act of 2008 provided for additional first-year depreciation on qualified property Applied to property acquired after 12/31/07 and before 01/01/09 and placed in service before 01/01/09 ARRTA of 2009 extends additional first-year depreciation for an additional year (qualified property acquired and placed in service before January 1, 2010) Allows an additional 50% cost recovery in year asset is placed in service Qualified property includes most types of new property other than buildings Property that is used but new to the taxpayer does not qualify

Example: Additional First-Year Depreciation Maple Company acquires a 5-year class asset on March 20, 2009, for $20,000. Maple’s cost recovery deduction for 2009 is computed as follows: 50% additional first-year depreciation ($20,000 X .50) $10,000 MACRS cost recovery [($20,000 - $10,000) X .20 (Table 8–1)] 2,000 Total cost recovery $12,000

Mid-Quarter Convention Applies when more than 40% of personalty is placed in service during last quarter of year Assets treated as if placed into service (or disposed of) in the middle of the quarter in which they were actually placed in service (or disposed of)

Example: Mid-Quarter Convention Business with 12/31 year end purchased and placed in service the following used 5-year class assets: Asset 1: on 3/28 for $50,000, and Asset 2: on 12/28 for $100,000 More than 40% placed in service in last quarter; therefore, mid-quarter convention used: Asset 1: $50,000 × .20 × 200% × 10.5/12 = $17,500 Asset 2: $100,000 × .20 × 200% × 1.5/12 = $5,000 Table 8-2 provides the relevant percentages to be used when applying the mid-quarter convention

MACRS-Realty (slide 1 of 2) MACRS characteristics: MACRS Realty Residential Rental Nonresid. Realty Statutory lives: 27.5 yrs 31.5 yrs or 39 yrs Method: Straight-line Convention: Mid-month Residential rental real estate Includes property where 80% or more of gross rental revenues are from nontransient dwelling units e.g., Apartment building

MACRS-Realty (slide 2 of 2) Mid-month Convention Property placed in service at any time during a month is treated as if it was placed in service in the middle of the month Example: Business building placed in service April 25 is treated as placed in service April 15

Optional Straight-line Election May elect straight-line rather than accelerated depreciation on personalty placed in service during year Use the class life of the asset for the recovery period Use half-year or mid-quarter convention as applicable Election is made annually by class of property

Farm Property (slide 1 of 2) Generally, for farm assets use: MACRS 150% declining-balance method for personalty MACRS straight-line method is required for any tree or vine bearing fruits or nuts Straightline method over the normal periods (27.5 years and 39 years) for real property If the election is made to not have the uniform capitalization rules apply, alternative depreciation system (ADS) straight-line method must be used

Farm Property (slide 2 of 2) Under the Emergency Economic Stabilization Act of 2008 New machinery or equipment placed in service in a farming business in 2009 has a recovery period of 5 years under MACRS Does not include a grain bin, cotton ginning asset, fence, or land improvement

Leasehold Improvement Property (slide 1 of 3) If lessor is owner of leasehold improvement property, depreciation is calculated as follows: Real Property – Use straight-line method over 27.5 or 39 year statutory recovery periods Tangible personal property – Use the shorter MACRS lives and accelerated methods When these improvements are disposed of or abandoned by the lessor due to lease termination Property is treated as disposed of by the lessor A loss can be taken for the unrecovered basis

Leasehold Improvement Property (slide 2 of 3) If lessee is owner of leasehold improvement property Costs of leasehold improvements are recovered in accordance with the general cost recovery rules Cost recovery period is determined without regard to the lease term Any unrecovered basis in the leasehold improvement property not retained by the lessee is deducted in the year the lease is terminated

Leasehold Improvement Property (slide 3 of 3) Under the Emergency Economic Stabilization Act of 2008, qualified leasehold improvement property placed in service before 01/01/10 is allowed 15-year recovery period Includes any improvement to an interior portion of nonresidential real property if: The improvement is § 1250 property The lease is not between related persons Interior portion of building is to be occupied exclusively by the lessee or any sublessee of that interior portion Improvement is placed in service > 3 years after date building was first placed in service by any person

Election to Expense Assets -Section 179 (slide 1 of 5) General rules Can elect to immediately expense up to $250,000 (for 2009) of business tangible personalty placed in service during the year Cannot use § 179 for realty or production of income property

Election to Expense Assets -Section 179 (slide 2 of 5) Section 179 general rules Amount expensed reduces depreciable basis Any elected § 179 expense is taken before the 50% additional first-year depreciation is computed The base for calculating the standard MACRS deduction is net of the § 179 expense and the 50% additional first-year depreciation

Election to Expense Assets -Section 179 (slide 3 of 5) Annual limitations: Expense limitation ($250,000 for 2009) is reduced by amount of § 179 property placed in service during year that exceeds $800,000 Example: In 2009, taxpayer placed in service $815,000 of § 179 property. The § 179 expense limit is reduced to $235,000 [$250,000 – ($815,000 – $800,000)]

Election to Expense Assets -Section 179 (slide 4 of 5) Annual limitations: Election to expense cannot exceed taxable income (before § 179) of taxpayer’s trades or businesses Any amount expensed under § 179 over taxable income limitation may be carried over to subsequent year(s) Amount carried over still reduces basis currently

Election to Expense Assets -Section 179 (slide 5 of 5) Example: Taxpayer buys 5-year property for $275,000 on August 15, 2009 and elects immediate expensing of the maximum amount. The total deduction for the year is calculated as follows: § 179 expense $250,000 50% additional first-year depreciation [($275,000 - $250,000) X .50] 12,500 Standard MACRS calculation [($275,000 - $250,000 - $12,500) X .20] 2,500 Total cost recovery allowed in 2009 $265,000

Listed Property (slide 1 of 4) There can be substantial limits on cost recovery of assets considered listed property Listed property includes the following: Passenger automobile Other property used as a means of transportation Property used for entertainment, recreation, or amusement Computer or peripheral equipment Cellular telephone

Listed Property (slide 2 of 4) To be considered as predominantly used for business, business use must exceed 50% Use of asset for production of income is not considered in this 50% test However, both business and production of income use percentages are used to compute cost recovery

Listed Property (slide 3 of 4) To be considered as predominantly used for business (cont’d) If 50% test is met, then allowed to use statutory percentage method of cost recovery with some limitations

Listed Property (slide 4 of 4) If asset is not used predominantly for business i.e., business use does not exceed 50% Must use straight-line method If business use falls to 50% or lower after year property is placed in service, must recapture excess cost recovery

Passenger Auto Cost Recovery Limits (slide 1 of 7) For autos placed in service in 2008, cost recovery limits are: Year Recovery Limitation 1 $2,960 2 4,800 3 2,850 Succeeding years until the cost is recovered 1,775 If passenger automobile qualifies for 50% additional first-year depreciation (i.e., new property), the 2009 recovery limitation is increased by $8,000 The initial-year cost recovery limitation increases from $2,960 to $10,960 ($2,960 + $8,000)

Passenger Auto Cost Recovery Limits (slide 2 of 7) Limits are for 100% business use Must reduce limits by percentage of personal use Limit in the first year includes any amount the taxpayer elects to expense under § 179

Passenger Auto Cost Recovery Limits (slide 3 of 7) Example: Taxpayer acquired an auto in 2009 for $30,000 and used it 80% for business 2009 cost recovery allowance: {[($30,000 X 50%) + ($15,000 X 20%)] X 80%} $14,400 But deduction is limited to $10,960 × Business use % .80 Cost recovery allowance $8,768

Passenger Auto Cost Recovery Limits (slide 4 of 7) Limit on § 179 deduction For certain vehicles not subject to the statutory dollar limits imposed on passenger automobiles the § 179 deduction is limited to $25,000 The limit applies to sport utility vehicles with an unloaded GVW rating of more than 6,000 pounds and not more than 14,000 pounds

Passenger Auto Cost Recovery Limits (slide 5 of 7) Listed property that fails the >50% business usage test in year property is placed in service must be recovered using the straight-line method Such property does not qualify for the 50% additional first-year depreciation If the >50% business usage test is failed in a year after the property is placed in service, straight-line method must be used for remainder of property’s life Cost recovery of passenger auto under straight-line listed property rule still subject to annual limits

Passenger Auto Cost Recovery Limits (slide 6 of 7) Change from predominantly business use If the business use percentage falls to 50% or lower after the year the property is placed in service, the property is subject to cost recovery recapture The amount recaptured as ordinary income is the excess cost recovery Excess cost recovery is the excess of the cost recovery deductions taken in prior years using the statutory percentage method over the amount that would have been allowed if the straight-line method had been used

Passenger Auto Cost Recovery Limits (slide 7 of 7) Leased autos subject to “inclusion amount” rule Using IRS tables, taxpayer has gross income equal to each lease year’s inclusion amount Purpose is to prevent avoidance of cost recovery dollar limits applicable to purchased autos by leasing autos

Alternative Depreciation System (ADS) (slide 1 of 2) ADS is an alternative depreciation system that is used in calculating depreciation for: Alternative minimum tax (AMT) Assets used predominantly outside the U.S. Property owned by the taxpayer and leased to tax exempt entities Earnings and profits

Alternative Depreciation System (ADS) (slide 2 of 2) Generally, use straight-line recovery without regard to salvage value For AMT, 150% declining balance is allowed for personalty Half-year, mid-quarter, and mid-month conventions still apply

Amortization (slide 1 of 2) Can claim amortization deduction on § 197 intangibles Use straight-line recovery over 15 years (180 months) beginning in month intangible is acquired Section 197 intangibles include acquired goodwill, going-concern value, trademarks, trade names, etc.

Amortization (slide 2 of 2) Startup expenditures are also partially amortizable under § 195 Treatment is available only by election Allows the taxpayer to deduct the lesser of: The amount of startup expenditures, or $5,000, reduced by the amount startup expenditures exceed $50,000 Any amounts not deducted may be amortized ratably over 180-months beginning in month trade or business begins

Depletion (slide 1 of 4) Two methods of natural resource depletion Cost: determined by using the adjusted basis of the resource and allocating over the recoverable units Percentage: determined using percentage provided in Code and multiplying by gross income from resource sales

Depletion (slide 2 of 4) Cost depletion Depletion is computed on a per unit basis Per unit amount is determined by dividing the basis of the resource by the estimated recoverable units of resource Number of units sold in year × per unit depletion = depletion for year Total depletion can not exceed total cost of the property

Depletion (slide 3 of 4) Percentage depletion Depletion is computed by using the statutory percentage rate for the type of resource Rate is applied to the gross income from the property

Depletion (slide 4 of 4) Percentage depletion Percentage depletion cannot exceed 50% of the taxable income (before depletion) from the property Percentage depletion reduces basis in property However, total percentage depletion may exceed the total cost of the property Example: Property with zero basis but still generating income

Intangible Drilling Costs (IDC) Intangible drilling costs include Costs for making the property ready for drilling Costs of drilling the hole Treatment of IDC Expense in the year incurred, or Capitalize and write off through depletion It is generally advantageous to write off IDC immediately

Dr. Donald R. Trippeer, CPA If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta