Chapter 10 Cost Recovery on Property: Depreciation, Depletion, and Amortization ©2006 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

Transparency 10-2 © 2006 South-Western Concept Review vThe capital recovery concept allows a taxpayer to recover all invested capital before income is taxed FAn asset’s basis is the maximum investment that qualifies as capital for recovery vLegislative grace allows the capital to be recovered systematically over the life of the asset

Transparency 10-3 © 2006 South-Western Methods of Recovery vDepreciation: used for tangible assets that FAre used for a business or production of income purpose FHave a determinable life vDepletion: used for wasting assets vAmortization: used for intangible assets

Transparency 10-4 © 2006 South-Western History of Depreciation Based on facts and circumstances related to asset life and taxpayer’s situation ACRS Based on method and life prescribed by law MACRS Based on method and life prescribed by law; less accelerated than ACRS Section 179 Election to Expense Assets

Transparency 10-5 © 2006 South-Western Section 179 Election vPromotes administrative convenience vTreated as a depreciation deduction A taxpayer may elect to expense rather than capitalize qualifying property placed in service during the year.

Transparency 10-6 © 2006 South-Western Section 179 Election Qualifying Property vTangible, personal property FReal estate does not qualify vUsed in a trade or business FInvestment property does not qualify

Transparency 10-7 © 2006 South-Western Section 179 Election Deduction Limitations vLimitations apply to each entity vCannot exceed $105,000 vCannot exceed taxable income from the business FExcess may be carried forward

Transparency 10-8 © 2006 South-Western Section 179 Election Deduction Phase-Out vDeduction decreased if total cost of qualifying property placed in service exceeds $420,000 Fby $1 for every $1 of value over $420,000 Fthus, when total cost = $525,000, deduction = $0

Transparency 10-9 © 2006 South-Western MACRS Qualifying Property vMACRS applies to FNew and used tangible, depreciable property FUsed in a trade or business or for the production of income

Transparency © 2006 South-Western MACRS Basis vDepreciable basis is FThe asset’s original basis for depreciation (discussed in Chapter 9) FReduced by any § 179 deduction vAdjusted basis is FThe remaining unrecovered capital of an asset = asset basis minus accumulated depreciation

Transparency © 2006 South-Western MACRS Recovery Period vEach asset must be placed in a MACRS class according to its class life FMost personal property is in a 3, 5, or 7 year class FMost land improvements and specialized property are in a 10, 15, or 20 year class FReal estate is in a 27.5, 31.5, or 39 year class

Transparency © 2006 South-Western MACRS Conventions vFor administrative convenience, three assumptions are made about the time property was placed in service during the year FMid-year convention applies to all property except real estate FMid-month convention applies to real estate only FMid-quarter convention applies to some personal property

Transparency © 2006 South-Western Mid-Year Convention vAssumes property is placed in service and will be disposed of at the mid-point of the year FOne-half year depreciation allowed in the first year of service FOne-half year depreciation allowed in the last year of service vIRS tables reflect the mid-year adjustment only for the first year

Transparency © 2006 South-Western Mid-Month Convention vAssumes property is placed in service and will be disposed of at the mid-point of a month FOne-half month allowed at the beginning FOne-half month allowed at disposition vIRS tables reflect the adjustment only for acquisition

Transparency © 2006 South-Western Mid-Quarter Convention vIf > 40% of the total depreciable basis of all personal property is placed in service during the 4th quarter of the year, mid- quarter: FAssumes property is placed in service and will be disposed of at the mid-point of a quarter rather than at mid-year FDetermine the 40% after taking §179 expense

Transparency © 2006 South-Western Depreciation Method Alternatives vRegular MACRS Fwith Section 179 vStraight-line MACRS vStraight-line Alternative Depreciation System (ADS)

Transparency © 2006 South-Western Regular MACRS vMethod is double declining balance FIRS tables provide the depreciation rate VDesigned to permit full recovery of depreciable basis VIncorporate the conventions vMaximizes acquisition year deduction using the Section 179 election

Transparency © 2006 South-Western Straight-Line MACRS vTaxpayers may elect to use the slower straight-line method FElection is made each year FMACRS recovery periods are used FMid-year convention applies

Transparency © 2006 South-Western Alternative Depreciation System vTaxpayers may elect to use ADS vUse is mandatory for Alternative Minimum Taxable Income vUses a longer recovery period than MACRS vElection is made on a class-by-class, year-by-year basis

Transparency © 2006 South-Western Limitations on Listed Property vMost mixed-use property is considered listed property and subject to special limitations FExamples: automobiles, computers, cellular phones, etc.

Transparency © 2006 South-Western Limitations on Listed Property vTreatment depends on the percentage of business usage Fif >50% business use, treated like other depreciable assets Fif < 50% business use, deductions are limited to ADS without Section 179 FIn either case, only the business portion of the asset’s basis is depreciable

Transparency © 2006 South-Western Limitation on Passenger Autos vThe total amount of depreciation and Section 179 expense that can be deducted is limited FAnnual maximum limit set and linked to the year the car was placed in service FAnnual limit is further reduced by the business use %

Transparency © 2006 South-Western Adequate Record Keeping vListed property is subject to strict record keeping requirements vNo deduction is allowed without proof of FWhy? The business purpose of the use FWhat? The amount FWhen? The dates of use FWhere? The reality of the use

Transparency © 2006 South-Western Depletion vThe basis of natural resource assets subject to wasting away is recovered using depletion vBasis used is generally fees paid to acquire a lease and the costs of the lease, exploration, and drilling vComputed using two methods FFigure both each year and use the largest as deduction

Transparency © 2006 South-Western Cost Depletion Method vAllocates unrecovered basis over the number of estimated units of resource = Depletion per Unit Unrecovered Basis Estimated Recoverable Units Cost Depletion = Depletion per Unit X # of Units Sold

Transparency © 2006 South-Western Percentage Depletion Method vDepletion is the lesser of F50% of taxable income before depletion, or FGross income from the sale of the natural resource times a statutory depletion rate VDifferent statutory % for each type of resource is given in IRS tables

Transparency © 2006 South-Western Amortization vThe basis of intangible assets is recovered using the straight-line method over the life of the asset vIntangible assets acquired through purchase generally use a 15 year life vCreated assets and assets specifically excluded from use of the 15 year period are amortized over their legal life

Transparency © 2006 South-Western End of Chapter 10