Depreciation, Cost Recovery, Amortization and Depletion Chapter 10 Depreciation, Cost Recovery, Amortization and Depletion 1

Learning Objectives Understand the general concepts of tax depreciation Classify property and calculate cost recovery under the MACRS rules 2

Learning Objectives Calculate amortization for intangible assets and understand the difference between amortizable and non-amortizable assets Apply cost and percentage methods and understand the treatment of intangible drilling costs 2

Introduction Allows taxpayers to deduct a reasonable allowance for the exhaustion, wear and tear, and obsolescence. Taxpayers must use specific depreciation methods depending on when an asset is placed into service.

Depreciation and Cost Recovery Property placed into service prior to 1981 Property placed into after December 30, 1980 and before January 1, 1987 Property placed into service after December 31, 1986 3

Common Rules of All Systems No depreciation may be claimed on land or other assets that have an indefinite life (works of art). Depreciation is permitted in the year the asset is placed into service Consistency is required, no matter which system is used

Types of Property Tangible Property Intangible Property Real Property Personal Property vs. Personal-Use Property

Depreciation Methods 1986 and later years MACRS Personal property Use 3, 5, 7, 10, 15, 20 year useful life 200% declining balance with a conversion to straight-line Half-year convention(no matter when asset is placed into service, the first year can only take a half years depreciation) Mid-Quarter convention is used when the aggregate basis of all personal property placed into service during the last three months of the year exceed 40% No salvage value 5

Depreciation Methods Real Property Residential rental property: 27.5 years Nonresidential rental property: 39 years Depreciation is calculated using the straight-line method Mid-month convention –year of acquisition and year of disposition Straight-line or Alternate Depreciation System(ADS)

Section 179 Expensing Election May elect to expense up to $100,000 in years 2003-2005 Placed into service during the year Not applicable to real estate, only applicable personal property. 9

Section 179 Expense 10

Bonus Depreciation Additional first year depreciation deduction for certain qualified property. Be acquired after September 10, 2001 and before September 11, 2004. Non real estate Recovery period of 20 years or less Computer software Qualified leasehold improvement property Depreciation deduction is 30% of the adjusted basis of the property. Increased to 50% for qualified property placed in service after May 5, 2003 and before January 1, 2005

MACRS Restrictions Portion of asset used for personal use is not depreciable Listed property rules Recapture of excess cost-recovery Luxury automobile limitation (see textbook for limits) 11

Amortization Intangible Assets Definition of Section 197 – Goodwill and going concern value, covenants not to compete, franchise fees, trademarks, and trade names etc. Classification and disposition of intangibles A Sec. 197 asset is treated as depreciable property so that Sec. 1231 treatment is accorded. Research and experimental expenditures Include experimental and laboratory costs incidental to the development of a product. Computer software 14

Depletion and Intangible Drilling and Development Costs Treatment of intangible drilling and development costs (IDCs) Capitalized or deducted currently Decision to expense or capitalize depends on taxpayer’s current position (profit or loss) 12

Depletion and Intangible Drilling and Development Costs Depletion methods Cost depletion method is calculated by dividing the adjusted basis of natural resource by expected quantity to be extracted Percentage depletion method is calculated by multiplying the statutory depletion percentage times the gross income generated 13

Tax Planning Considerations Alternative depreciation under MACRS IDCs: CAPITALIZATION VS. EXPENSING Units of Production Depreciation Structuring a business combination 15

Compliance And Procedural Considerations IDCs Election Form 4562 is used to report depreciation, depletion, and amortization deductions. Research and Experimental Expenditures 16