1. Contemporary Engineering Economics, 4 th edition, © 2007 Tax Depreciation Lecture No. 34 Chapter 9 Contemporary Engineering Economics Copyright © 2006

2. Contemporary Engineering Economics, 4 th edition, © 2007 Brief History on Tax Depreciation Purpose: Used to report income taxes for the IRS  Assets placed in service prior to 1981  Use the book depreciation methods (SL, DB, SOYD)  Assets placed in service from 1981 to 1986  Use the ACRS (Accelerated Cost Recovery System) Table  Assets placed in service after 1986  Use the MACRS (Modified ACRS) Table

3. Contemporary Engineering Economics, 4 th edition, © 2007 Modified Accelerated Cost Recovery Systems (MACRS)  Personal Property Depreciation method based on DB method switching to SL Half-year convention Zero salvage value  Real Property SL Method Mid-month convention Zero salvage value

4. Contemporary Engineering Economics, 4 th edition, © 2007 MACRS Property Classifications (IRS Publication 534) Recovery PeriodADR Midpoint ClassApplicable Property 3-yearSpecial tools for manufacture of plastic products, fabricated metal products, and motor vehicles. 5-yearAutomobiles, light trucks, high-tech equipment, equipment used for R&D, computerized telephone switching systems 7-yearManufacturing equipment, office furniture, fixtures 10-yearVessels, barges, tugs, railroad cars 15-yearWaste-water plants, telephone- distribution plants, or similar utility property. 20-yearMunicipal sewers, electrical power plant. 27.5-yearResidential rental property 39-yearNonresidential real property including elevators and escalators ADR: Asset Depreciation Range

5. Contemporary Engineering Economics, 4 th edition, © 2007 MACRS Depreciation Schedules for Personal Property with Half-Year Convention

6. Contemporary Engineering Economics, 4 th edition, © 2007 MACRS Rate Calculation  Asset cost = $10,000  Property class = 5-year MACRS  DB method = Half-year convention, zero salvage value, 200% DB switching to SL 20% $2000 32% $3200 Full 19.20% $1920 Full 11.52% $1152 Full 11.52% $1152 Full 5.76% $576 123 4 5 6 Half-year Convention

7. Contemporary Engineering Economics, 4 th edition, © 2007 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%)17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%)13.71% (0.4)(100%-71.20%)Switch to SL11.52% SL = (1/2.5)(29.80%)11.52% SL = (1/1.5)(17.28%)11.52% SL = (0.5)(11.52%)5.76% MACRS (%) DDB SL Sample Calculation – 5-Year MACRS

8. Contemporary Engineering Economics, 4 th edition, © 2007 Comparison between DDB with Switching to SL and MACRS Method

9. Contemporary Engineering Economics, 4 th edition, © 2007 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: Placed a residential property in service in March. Find the depreciation allowance in year 1. D 1 = (9.5/12)(100%/27.5) = 2.879% Types of Real Property

10. Contemporary Engineering Economics, 4 th edition, © 2007 Depreciation Allowances for a 10-year Ownership of the Property Year (n)CalculationAllowed Depreciation (%) 1(9.5/12)(100%/27.5)2.8788% 2100%/27.53.6364% 3100%/27.53.6364% 4100%/27.53.6364% 5100%/27.53.6364% 6100%/27.53.6364% 7100%/27.53.6364% 8100%/27.53.6364% 9100%/27.53.6364% 10(11.5/12)(100%/27.5)3.4848% Assume that the property will be sold in December of the10th year.

11. Contemporary Engineering Economics, 4 th edition, © 2007 Depletion Unlike depreciation and amortization, which mainly describe the deduction of expenses due to the aging of equipment and property, depletion is the physical reduction of natural resources. Two types of depletion:  Cost depletion  Percentage depletion

12. Contemporary Engineering Economics, 4 th edition, © 2007 Cost Depletion Concept: Units-of-production method Cost depletion formula: Example 9.10: Cost basis = $120,000, total recoverable volume = 1.5MBF, amount sold this year = 0.5 MBF

13. Contemporary Engineering Economics, 4 th edition, © 2007 Percentage Depletion Concept: Based on a prescribed percentage of the gross income from the property during the tax year Example 9.11:  Given: Basis = $30 million, total recoverable volume = 300,000 ounces of gold, amount sold this year = 45,000 ounces, gross income = $16,425,000, and this year’s expenses before depletion = $12,250,000  Find: Maximum depletion allowance Gross income from sale of 45,000 ounces$16,425,000 Depletion percentage x 15% Computed percentage depletion$ 2,463,750 Gross income from sale of 45,000 ounces$16,425,000 Less mining expenses 12,250,000 Taxable income from mine $ 4,175,000 Deduction limitation x 50% Maximum depletion deduction $2,088,000 Allowable percentage deduction

14. Contemporary Engineering Economics, 4 th edition, © 2007 Calculating the Allowable Depletion Deduction for Federal Tax $2,463,750 $2,088,000 $4,500,000

15. Contemporary Engineering Economics, 4 th edition, © 2007 Summary 1 Because it employs accelerated methods of depreciation and shorter-than-actual depreciable lives, the MACRS (Modified Accelerated Cost Recovery System) gives taxpayers a break: It allows them to take earlier and faster advantage of the tax-deferring benefits of depreciation. The total amount of taxes to pay remains unchanged regardless of depreciation methods adopted. It only changes the timing of the payment.

16. Contemporary Engineering Economics, 4 th edition, © 2007 Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation. Given the frequently changing nature of depreciation and tax law, we must use whatever percentages, depreciable lives, and salvage values mandated at the time an asset is acquired. Summary 2