1. Chapter 7 Property Acquisitions and Cost Recovery Deductions 7-1
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2. Objectives Decide if an expenditure should be deducted or capitalized
Define tax basis and adjusted basis
Explain why leverage can reduce the after-tax cost of assets
Compute cost of goods sold for tax purposes
Understand the MACRS framework
Apply the Section 179 expensing election
Compute amortization of purchased intangibles
Distinguish between cost and percentage depletion

3. Expense or Capitalize?
Deduction allowed for all ordinary and necessary business expenses
Deduction prohibited for permanent improvements to increase the value of property
Cost of improvement is capitalized

4. Capitalized Costs
Similar to GAAP, if an expenditure creates or enhances an identifiable asset with a useful life substantially beyond the current year, the expenditure must be capitalized
Some capitalized costs can be recovered through depreciation, amortization, or depletion deductions
A capitalized cost that is not depreciable, amortizable, or depletable is recovered only on disposition of the asset

5. Expense or Capitalize? Repairs and maintenance
Expenditures that are regular and recurring in nature and do not materially add to either the value or the useful life of an asset are deductible
Repair and maintenance expense
The distinction between a repair and a capital improvement is frequently a matter of dispute between taxpayers and the IRS

6. Tax Subsidies Permit Expensing
The tax law permits immediate expensing of certain capital expenditures
Indirect federal subsidy for taxpayers who make these tax-preferred expenditures
One example is research and development (R&D) expenditures
Indirect federal subsidy to encourage business to engage in basic research

7. Tax Subsidies Permit Expensing
Other examples include:
Advertising
Industry specific deductions:
Farmers can deduct soil and water conservation expenditures as well as the cost of fertilizers
Oil and gas producers can deduct intangible drilling and development costs (IDC) of wells

8. Tax Basis
Basis is key to calculating cash flows because taxpayers recover basis at no tax cost
Tax basis = unrecovered dollars represented by an asset
Every asset has a tax basis
In most cases, the initial basis of an asset is cost
Cost is the FMV of cash, property, or services expended to acquire an asset
Includes sales tax and incidental costs relating to placing the asset in service

9. Adjusted Tax Basis
Adjusted basis equals initial basis reduced by depreciation, amortization, or depletion deductions
An asset’s adjusted tax basis may be different than the asset’s adjusted book basis
Initial book and tax basis may be different
Book and tax recovery deductions may be different ≠

10. Tax Basis and Leverage
Leverage is the use of borrowed funds to purchase assets
Cost basis includes the amount of borrowed funds
Firm A used $10 of its own cash and $80 of borrowed cash to buy an asset
Firm A’s cost basis is $90
Interest paid on borrowed funds is deductible

11. Cost Recovery Methods Inventory = cost of goods sold
Tangible assets = depreciation
Intangible assets = amortization
Natural resources = depletion

12. Cost of Goods Sold Calculating cost of goods sold
Beginning inventory
Capitalized costs
Inventory available for sale
(Ending inventory)
Cost of goods sold
Capitalized costs may be greater for tax than book
Unicap rules for capitalization of indirect costs (overhead)
Temporary unfavorable book/tax difference
Reverses through cost of goods sold

13. Inventory Valuation Methods
Taxpayers may value ending inventory and cost of goods sold by using:
Specific identification method
First-In, first-out convention (FIFO)
Last-in, first-out convention (LIFO)
Must be consistent with financial reporting

14. Depreciation Depreciation applies to tangible assets that:
Lose value over time due to wear and tear, obsolescence
Buildings are depreciable but land is not
Have a reasonably ascertainable useful life
Artwork is not depreciable

15. Depreciation
Before 1981, tax depreciation was based on an asset’s estimated useful life. Under MACRS, estimated useful life is irrelevant
The MACRS recovery period is usually shorter than an asset’s estimated useful life. What affect does this have on the purchasing behavior of firms?
The shorter lives reduce the after-tax cost of the assets and acts as an incentive for firms to make capital acquisitions

16. MACRS Recovery Periods and Methods
Depreciation for 3, 5, 7, and 10-year recovery property is computed under the 200% declining balance method
Depreciation for 15 and 20-year recovery property is computed under the 150% declining balance method
Depreciation for 25, 27.5, 39, and 50-year recovery property is computed under the straight-line method

17. Depreciation Conventions for Personalty
Depreciation for 3, 5, 7, 10, 15, and 20-year recovery property (personalty) is generally based on a half-year convention
One-half year of depreciation is allowed for the year in which property is placed in service
Convention built in to IRS Tables
One-half year of depreciation is allowed for the year in which property is disposed of
Not built into IRS Tables
Midquarter convention applies if more than 40% of personalty acquired in a year is placed in service in the 4th quarter

18. Depreciation Convention for Realty
Depreciation for 25, 27.5, 39, and 50-year recovery property (realty) is based on a midmonth convention
One-half month of depreciation is allowed for the month in which property is placed in service
Convention built into IRS Tables
One-half month of depreciation is allowed for the month in which property is disposed of
Not built into IRS Tables

19. Limited Depreciation for Passenger Automobiles
Maximum annual depreciation per vehicle placed in service in 2013
$3,160
$5,100 (2nd year)
$3,050 (3rd year)
$1,875 (4th year and beyond)
Compute depreciation per MACRS, then apply the limit

20. Section 179 Expensing Election
Taxpayer may expense a limited amount of cost of qualifying property placed in service in a year
Limited amount is $25,000 in 2014 ($500,000 in 2013)
Qualifying property is depreciable personalty and off-the-shelf software
Capitalized cost (unexpensed) is recovered through MACRS
Limited amount is reduced by the aggregate cost of qualifying property in excess of a threshold
Threshold is $200,000 in 2014 ($2,000,000 in 2013)

21. Section 179 Example
Mayer Inc. purchased $69,200 of qualifying property in 2014
Mayer may expense $25,000 of the cost and capitalize $44,200 as the depreciable basis of the property
Lowe Inc. purchased $207,000 of qualifying property in 2014
Lowe must reduce its limited amount by $7,000 ($207,000 - $200,000 threshold)
Lowe may expense $18,000 of the cost ($25,000 – $7,000) and capitalize $51,200 as the depreciable basis of the property

22. Taxable Income Limitation
The deduction for a Section 179 expense is limited to taxable business income before the deduction
Any nondeductible expense carries forward to future years
In 2014, Boyd Inc. elected to expense $12,000 of the cost of qualifying property
Boyd’s taxable income before any Section 179 deduction was $9,800
Boyd’s Section 179 deduction is limited to $9,800
Boyd has a $2,200 expense carryforward to 2015

23. Bonus Depreciation
Bonus depreciation not available for 2014 acquisitions
100% bonus depreciation permits immediate expensing of 100% of the cost of qualifying property placed in service after September 8, 2010 and before January 1, 2012
Qualifying property is new depreciable personalty, computer software and certain leasehold improvements
50% bonus applies to acquisitions after December 31, 2012 and before January 1, 2014

24. Bonus Depreciation Example
Evans Inc. acquired new depreciable personalty costing $4 million on January 3, 2013
Evans could deduction $2 million ($4 million × 50%) in 2013 using bonus depreciation
The remaining $2 million depreciable basis would be recovered under MACRS, beginning in 2013
If the property were acquired on January 3, 2011
Evans may deduct the entire $4 million cost in 2011 using bonus depreciation
If the property were acquired on January 3, 2014
Bonus depreciation not permitted; MACRS would apply

25. Intangible Assets Intangible assets have no physical substance
Examples include leases, patents, and other contractual rights
The basis of an intangible asset is amortized on a straight-line method over the determinable life
Intangible assets with no determinable life are not amortizable
Examples include securities and partnership interests

26. Organizational and Start-Up Costs
Organizational costs of a corporation or partnership include legal, accounting, and filing fees attributable to the formation of the entity
Start-up costs include the cost of investigating a new business and expenses incurred before the new business is operational
Both costs are subject to the same cost recovery rule
First $5,000 is deductible
Deduction reduced by any amount of cost in excess of $50,000
Nondeductible costs are capitalized and amortized over 15 years

27. Leasehold Costs and Improvements
The cost of acquiring a lease is amortized over the term of the lease
Physical improvements to leased property are capitalized and depreciated over the appropriate MACRS recovery period
This cost recovery rule applies even if the term of the lease is shorter than the MACRS recovery period

28. Acquisition Intangibles
A firm that purchases an entire business for a lump-sum price must allocated the cost to both tangible and intangible assets
Cost allocation based on FMV of identifiable assets
Any residual cost is allocable to purchased goodwill
Capitalized cost of most acquisition intangibles (including goodwill) is amortized over 15 years

29. Amortization of Purchased Goodwill
For tax purposes, the cost of purchased goodwill is amortized over 15 years
For book purposes, goodwill is not amortized
Amortization deduction results in a favorable book/tax difference
Firms must test purchased goodwill annually for any impairment to its value
Any write-down of goodwill is a nondeductible expense resulting in an unfavorable book/tax difference

30. Depletion
Taxpayers recover the capitalized cost of productive mines and wells through depletion
Depletion deduction equals the greater of cost depletion or percentage depletion
Cost depletion = unrecovered basis × units of production sold/estimated total units in the ground
Percentage depletion = statutory % of gross income from the mine or well
Allowable even after basis
has been reduced to zero