OUTLINE Questions? News? Depreciation Taxes

DEPRECIATION METHODS DEPRECIATION IS CALCULATED TWO WAYS, EACH WITH ITS OWN PURPOSES BOOK DEPRECIATION FINANCIAL REPORTS INCOME STATEMENTS REFLECTS ACTUAL LOSS IN VALUE STATE TAXES AND FEDERAL TAXES BEFORE 1981 TAX DEPRECIATION TO CALCULATE TAXES FOR THE IRS TAKES ADVANTAGE OF TAX RULES USUALLY LEADS TO BETTER CASH POSITION IN EARLIER YEARS

BOOK DEPRECIATION METHODS STRAIGHT LINE (SL) ACCELERATED DECLINING BALANCE (DB) DECLINING BALANCE WITH CONVERSION TO SL UNIT OF PRODUCTION DEPLETION

DECLINING BALANCE METHOD USES A FIXED FRACTION (alpha) OF THE BEGINNING BOOK BALANCE EACH YEAR: MULTIPLIERS: 1.5 OR 150% DB 2.0 OR 200% OR DOUBLE DECLINING METHOD (DDB)

DECLINING BALANCE WITH CONVERSION TO STRAIGHT LINE WHAT DO WE DO IF THE DB METHOD DOES NOT RESULT IN THE ESTIMATED SALVAGE VALUE? 1. IF BN > S WE HAVE NOT DEPRECIATED THE ASSET FULLY SWITCH TO STRAIGHT LINE THE FIRST YEAR THAT THE STRAIGHT LINE DEPRECIATION IS GREATER THAN THE DB METHOD 2. BN < S STOP DEPRECIATING WHEN YOU GET TO S EXAMPLES 9.3 AND 9.4

Example 9.3 Cost basis of the asset I = $10,000 Useful life N = 5 years Estimated salvage value S = $2,000

Example 9.4 –Declining Balance Cost basis of the asset I = $10,000 Useful life N = 5 years Estimated salvage value, S = $778 D1 =

Changing to straight line WE DID NOT DEPRECIATE THE ASSET FULLY AND MUST SWITCH TO STRAIGHT LINE

UNITS - OF - PRODUCTION METHOD ALLOCATES THE DEPRECIATION IN PROPORTION TO THE UNITS PRODUCED AS A FRACTION OF THE TOTAL UNITS EXAMPLE 9.7

HISTORY OF DEPRECIATION METHODS UNTIL 1954 - STRAIGHT LINE ONLY 1954 - 1981 --ADDED ACCELERATED METHODS: DECLINING BALANCE (DB) DOUBLE DECLINING METHOD (DDB) SUM OF THE YEARS’ DIGITS (SOYD) (WE DO NOT COVER) 1981 REPLACED BY ACCELERATED COST RECOVERY SYSTEM (ACRS) 1986 MODIFIED ACRS = MACRS 2017 SOME MODIFICATIONS

2017-2018 MODIFICATIONS $1000 TO $2500 Bonus in year of acquisition $1M per item, $2.M max (sometimes quoted half that – we will us the larger amount Survey only, not tax advice – always use a tax specialist if you are in business Also extra 50% in first year for eligible equipment We will assume all equipment is eligible We will assume all buildings as 39 year life Modifications to buildings are eligible

MODIFIED ACCELERATED RECOVERY SYSTEM (MACRS) SALVAGE VALUE ALWAYS ZERO RECOVERY PERIOD -- ARBITRARY LIFE FOR THE INVESTMENT, NOT NECESSARILY EQUAL TO ACTUAL LIFE EIGHT CATEGORIES: 3, 5, 7, 10, 15, 20, 27.5, 39 YEARS 3, 5, 7 AND 10 YEARS - USE 200%DDB, SWITCH TO SL 15 AND 20 YEARS -- USE 150%DDB AND SWITCH TO SL 27.5 YEARS RESIDENTIAL RENTAL -- SL 39 YEARS COMMERCIAL BUILDINGS -- SL USE TABLE 9.3 ON PAGE 448

MACRS TABLE

HALF YEAR CONVENTION FOR EQUIPMENT PLACED IN SERVICE USING MACRS: ALL ASSETS ARE ASSUMED TO BE PLACED IN SERVICE IN THE MIDDLE OF THE YEAR (some change here that we will ignore) ALL SALVAGE VALUE IS ZERO ONLY A HALF YEARS’ DEPRECIATION IS ALLOWED THE FIRST YEAR THE REMAINING HALF YEAR IS ALLOWED FOLLOWING THE END OF THE RECOVERY PERIOD FOR REAL PROPERTY, USE MID - MONTH INSTEAD OF HALF YEAR

EXAMPLE 9.8 ASSET = $10,000 MACRS CLASS 5 YEARS

DEPLETION APPLIES TO NATURAL RESOURCES OBJECTIVE IS THE SAME AS DEPRECIATION COST DEPLETION WORKS JUST LIKE UNITS OF PRODUCTION - EQUATION 9.9: COST DEPLETION =(ADJUSTED BASIS OF MINERAL PROPERTY)x(NUMBER OF UNITS SOLD) / (TOTAL NUMBER OF RECOVERABLE UNITS) EXAMPLE 9.10 PERCENTAGE DEPLETION - PORTION OF GROSS INCOME, LIMITED BY 50% OF THE TAXABLE INCOME WITHOUT THE DEPLETION ALLOWABLE PERCENTAGES ARE GIVEN IN TABLE 9.5. THESE RANGE FROM 5% TO 22% EXAMPLE 9.11

Cost depletion vs. percentage depletion

REPAIRS OR IMPROVEMENTS For tax depreciation purposes, repairs or improvements made to any property are treated as separate property items. The recovery period for a repair or improvement to the initial property normally begins on the date the repaired or improved property is placed in service. The recovery class of the repair or improvement is the recovery class that would apply to the property if it were placed in service at the same time as the repair or improvement. Example 9.12 (modified)

EXAMPLE 9.12 In January 2004, Kendall Manufacturing Company purchased a new numerical control machine at a cost of $60,000. The machine had an expected life of 10 years at the time of purchase and a zero expected salvage value at the end of the 10 years. For book depreciation purposes, no major overhauls had been planned over the 10-year period, and the machine was being depreciated toward a zero salvage value, or $6,000 per year, with the straight-line method. • For tax purposes, the machine was classified as a 7-year MACRS property.

EXAMPLE 9.12 CONTINUED

EXAMPLE 9.12 CONTINUED In December 2006, however, the machine was thoroughly overhauled and rebuilt at a cost of $15,000. It was estimated that the overhaul would extend the machine’s useful life by 5 years.

EXAMPLE 9.12 CONTINUED