Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Taxation Chapter 6 Property Acquisitions and Cost Recovery Deductions

Slide 6-2 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Objectives  Expense versus capitalize  Define tax basis and adjusted basis.  Show how leverage reduces the after-tax cost of assets.  Compute cost of goods sold.  Use recovery period, method and convention to compute MACRS depreciation.  Explain the limited expensing election.  Understand role of depreciation in NPV of after-tax cash flows.  Amortize intangibles, deplete resources.

Slide 6-3 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Expense vs. Capitalize  Deduction permitted for all “ORDINARY AND NECESSARY” business expenses  Deduction prohibited for “PERMANENT improvements to increase the value of property”  Some types of capitalized costs can be recovered through amortization or depreciation.

Slide 6-4 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Expense vs. Capitalize  Repairs and maintenance? Source of IRS dispute due to facts.  Environment cleanup and prevention costs: TRA1997 has a provision allowing firms to elect to deduct rather than capitalize expenditures to abate or control hazardous substances at contaminated areas.  Capitalize expenditures that increase the value or useful life of an asset.

Slide 6-5 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Tax Subsidies Permit Expensing  R&D expenses (this is BIG).  Allowing deduction for R&D is a tax subsidy. What is the GAAP rationale for requiring expense under SFAS 2?  Y2K costs - IRS has ruled these can be expensed.  Various oil and gas: IDC, depletion  Advertising.

Slide 6-6 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Tax Basis  Tax basis = unrecovered cost  Starting basis generally equals COST basis:  original purchase price, or  FMV of asset if cost more difficult to measure.  When do you recover the cost? Depreciation or sale. Example: For depreciable equipment, adjusted basis is the original basis reduced by depreciation. You can think of adjusted basis as being the tax equivalent of “net book value” of the asset, but with tax depreciation instead of book depreciation.

Slide 6-7 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Tax Basis and Leverage  Cost basis is the entire cost, even if asset purchased with debt.  Deductions for interest and cost recovery (depreciation) can improve NPV of after-tax cash flows. AP1, 2  Study example in text regarding After-Tax Cost of Leveraged Purchase. Note especially the footnote describing the effect of borrowing rate versus internal discount rate.  Tax deductions made some leveraged tax shelters in early 1980’s had positive NPV even when pre-tax flows were breakeven or negative. Chapters 9 and 15 will discuss limits on such tax shelter losses.

Slide 6-8 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Cost Recovery  Cost of goods sold  depreciation  amortization  depletion

Slide 6-9 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Cost of goods sold  Similar to GAAP 1) Beginning inventory 2) PLUS purchases 3) = inventory available for sale 4) MINUS ending inventory 5) = CGS  Tax versus GAAP differences may occur in capitalization of indirect costs. Tax requires “uniform capitalization” under Section 263. AP4

Slide 6-10 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Cost of goods sold  Uniform capitalization rules (IRC Section 263)  Indirect costs that “benefit or are incurred by reason of the performance of production or resale activities”  Examples? Officers’ comp (VP Mfg.), employee benefits, building rent, insurance, depreciation. Why might there be book-tax differences in indirect costs being capitalized?

Slide 6-11 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Cost of goods sold  What are permissible Inventory methods? Which one requires book-tax conformity?  1) FIFO  2) specific ID  3) LIFO - If use LIFO for tax, must also use LIFO for books.  In times of inflation, LIFO reduces book and taxable income.

Slide 6-12 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Depreciation  Depreciation applies to tangible assets (things you can touch, versus intangibles like patents, goodwill) that:  Lose value over time due to wear and tear, obsolescence  Buildings depreciate even though real estate often increases in value.  Have a reasonably ascertainable useful life  Artwork is not generally depreciable.

Slide 6-13 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Depreciation  MACRS - Modified Accelerated Cost Recovery System  Fixed recovery methods and periods  Personalty and other short-lived property:  DDB: 3, 5, 7, 10  150% DB:15, 20  Realty: SL method: 27.5 years residential, 39 years non-residential (specialty realty 20, 25, 50)

Slide 6-14 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Depreciation Conventions - Personalty  Table 6-2 incorporates a half-year convention - provides only 1/2 of the regular rate in the year the property is put in service.  When dispose of asset, multiply table amount by 1/2 in the year of sale.  Buy $10,000 of 7-year property in Sell the property in What is 1997, 1998 and 1999 depreciation?

Slide 6-15 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Depreciation Conventions - Personalty  Exception to mid-year convention:  IF > 40% personalty is acquired during the last quarter of the year, THEN  Compute depreciation separately for EACH quarter’s acquisition.  See the MID-QUARTER tables. (Instructor hand out in class.) ONLY adjust table amounts in year of disposition.  AP6, TPC 1.

Slide 6-16 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Depreciation Conventions - Realty  Mid-month convention. Get 1/2 of a month in month acquired. Built into Table 6-3. Choose column for month put in service. Use this same column throughout the asset life. AP10.  Like personalty, you have to adjust table amount in year of disposition. Get 1/2 of a month for the month of disposition.  Buy apartment building for $1,000,000 in August Sell in March What is depreciation in ?

Slide 6-17 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Depreciation Conventions  What is the purpose of the half-year, midquarter and midmonth conventions?  Balance 1) prevent taxpayer from claiming a full year of depreciation if hold only for a portion of the year against  2) Easier rules than computing actual days held.

Slide 6-18 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Expensing Election  Applies to tangible personalty  1998 $18,500. See AP8.  Limits:  Expense cannot create a business loss.  Expense reduced $ for $ if purchases > $200,000. AP9.  Reduces recordkeeping, benefit for small businesses

Slide 6-19 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Other depreciation details not in text.  Combination business and personal use property - “listed property” - such as computers, phones, cars. Only use accelerated depreciation if business use > 50%.  Cars have additional depreciation limits per year.  Different depreciation methods apply for Alternative Minimum Tax purposes (Chapter 10, 14).

Slide 6-20 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Lease versus Buy  Example in text compares purchasing for cash up-front to an operating lease.  Tax rules are similar to financial rules for determining whether a lease is capital or ordinary. A capital lease is treated like a purchase by the lessee.  A lessee who obtains assets through an operating lease:  gives up interest and depreciation deductions (because lessor still owns the asset), but  doesn’t have deemed debt on financial balance sheet.

Slide 6-21 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Amortization of Intangibles  Generally requires a determinable useful life.  Organizational costs are amortizable straight line method over 60 months.  Start-up costs are also amortizable straight line method over 60 months - some exceptions.  Expansion costs may be currently deductible.

Slide 6-22 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Leasehold costs and improvements  Cost of acquiring lease is amortized over the period of lease.  Improvements to leased property are capitalized and depreciated according to type of property.

Slide 6-23 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Purchased intangibles  Allocate lump-sum price to assets by relative FMVs.  Residual = goodwill.  Tax = 15 years SL, GAAP = 40 years SL. Book-tax difference is temporary under current tax laws.

Slide 6-24 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Depletion  Cost depletion = unrecovered basis * units sold / estimated beginnning units.  Percentage depletion  statutory % of gross income. See Q18.  Deduct the greater of cost or percentage depletion.

Slide 6-25 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Review - book-tax differences  Temporary differences due to: depreciation, inventory methods, goodwill amortization (this used to be permanent before 1992 when goodwill was not amortizable for tax).  AP11.  Permanent differences due to % depletion (in excess of cost).