1. Individual Income Taxes C8-1 Chapter 8 Depreciation, Cost Recovery, Amortization, and Depletion Copyright ©2009 Cengage Learning Individual Income Taxes

2. C8-2 Cost Recovery Recovery of the cost of business or income- producing assets is through: –Cost recovery or depreciation: tangible assets –Amortization: intangible assets –Depletion: natural resources Recovery of the cost of business or income- producing assets is through: –Cost recovery or depreciation: tangible assets –Amortization: intangible assets –Depletion: natural resources

3. Individual Income Taxes C8-3 Nature of Property Property includes both realty (real property) and personalty (personal property) –Realty generally includes land and buildings permanently affixed to the land –Personalty is defined as any asset that is not realty Personalty includes furniture, machinery, equipment, and many other types of assets Personalty (or personal property) should not be confused with personal use property –Personal use property is any property (realty or personalty) that is held for personal use rather than for use in a trade or business or an income-producing activity Write-offs are not allowed for personal use assets Property includes both realty (real property) and personalty (personal property) –Realty generally includes land and buildings permanently affixed to the land –Personalty is defined as any asset that is not realty Personalty includes furniture, machinery, equipment, and many other types of assets Personalty (or personal property) should not be confused with personal use property –Personal use property is any property (realty or personalty) that is held for personal use rather than for use in a trade or business or an income-producing activity Write-offs are not allowed for personal use assets

4. Individual Income Taxes C8-4 General Considerations (slide 1 of 3) Basis in an asset is reduced by the amount of cost recovery that is allowed and by not less than the allowable amount –Allowed cost recovery is cost recovery actually taken –Allowable cost recovery is amount that could have been taken under the applicable cost recovery method If no cost recovery is claimed on property –The basis of the property must still be reduced by the amount that should have been deducted i.e., The allowable cost recovery Basis in an asset is reduced by the amount of cost recovery that is allowed and by not less than the allowable amount –Allowed cost recovery is cost recovery actually taken –Allowable cost recovery is amount that could have been taken under the applicable cost recovery method If no cost recovery is claimed on property –The basis of the property must still be reduced by the amount that should have been deducted i.e., The allowable cost recovery

5. Individual Income Taxes C8-5 General Considerations (slide 2 of 3) If personal use assets are converted to business or income-producing use –Basis for cost recovery and for loss is lower of Adjusted basis or Fair market value at time property was converted –Losses that occurred prior to conversion can not be recognized for tax purposes through cost recovery If personal use assets are converted to business or income-producing use –Basis for cost recovery and for loss is lower of Adjusted basis or Fair market value at time property was converted –Losses that occurred prior to conversion can not be recognized for tax purposes through cost recovery

6. Individual Income Taxes C8-6 General Considerations (slide 3 of 3) MACRS applies to: –Assets used in a trade or business or for the production of income –Assets subject to wear and tear, obsolescence, etc. –Assets must have a determinable useful life –Assets that are tangible personalty or realty MACRS applies to: –Assets used in a trade or business or for the production of income –Assets subject to wear and tear, obsolescence, etc. –Assets must have a determinable useful life –Assets that are tangible personalty or realty

7. Individual Income Taxes C8-7 MACRS-Personalty MACRS characteristics: MACRS Personalty. Statutory lives: 3, 5, 7, 10 yrs 15, 20 yrs Method: 200% DB 150% DB Convention: Half Yr or Mid-Quarter DB = declining balance with switch to straight-line Straight-line depreciation may be elected MACRS characteristics: MACRS Personalty. Statutory lives: 3, 5, 7, 10 yrs 15, 20 yrs Method: 200% DB 150% DB Convention: Half Yr or Mid-Quarter DB = declining balance with switch to straight-line Straight-line depreciation may be elected

8. Individual Income Taxes C8-8 Half-Year Convention General rule for personalty Assets treated as if placed in service (or disposed of) in the middle of taxable year regardless of when actually placed in service (or disposed of) General rule for personalty Assets treated as if placed in service (or disposed of) in the middle of taxable year regardless of when actually placed in service (or disposed of)

9. Individual Income Taxes C8-9 Example: Half-Year Convention Bought and placed an asset in service on March 15 (Tax year end is December 31) –Treated as placed in service June 30 –Six months cost recovery in year 1 (and year disposed of, if within recovery period) Bought and placed an asset in service on March 15 (Tax year end is December 31) –Treated as placed in service June 30 –Six months cost recovery in year 1 (and year disposed of, if within recovery period)

10. Individual Income Taxes C8-10 Additional First-Year Depreciation The Economic Stimulus Act of 2008 provides for additional first-year depreciation on qualified property –Applies to property acquired after 12/31/07 and before 01/01/09 and placed in service before 01/01/09 Allows an additional 50% cost recovery in year asset is placed in service Qualified property includes most types of new property other than buildings –Property that is used but new to the taxpayer does not qualify The Economic Stimulus Act of 2008 provides for additional first-year depreciation on qualified property –Applies to property acquired after 12/31/07 and before 01/01/09 and placed in service before 01/01/09 Allows an additional 50% cost recovery in year asset is placed in service Qualified property includes most types of new property other than buildings –Property that is used but new to the taxpayer does not qualify

11. Individual Income Taxes C8-11 Example: Additional First-Year Depreciation Maple Company acquires a 5-year class asset on March 20, 2008, for $20,000. Maple’s cost recovery deduction for 2008 is computed as follows: 50% additional first-year depreciation ($20,000 X.50) $10,000 MACRS cost recovery [($20,000 - $10,000) X.20 (Table 8–1)] 2,000 Total cost recovery $12,000 Maple Company acquires a 5-year class asset on March 20, 2008, for $20,000. Maple’s cost recovery deduction for 2008 is computed as follows: 50% additional first-year depreciation ($20,000 X.50) $10,000 MACRS cost recovery [($20,000 - $10,000) X.20 (Table 8–1)] 2,000 Total cost recovery $12,000

12. Individual Income Taxes C8-12 Mid-Quarter convention Applies when more than 40% of personalty is placed in service during last quarter of year Assets treated as if placed into service (or disposed of) in the middle of the quarter in which they were actually placed in service (or disposed of) Applies when more than 40% of personalty is placed in service during last quarter of year Assets treated as if placed into service (or disposed of) in the middle of the quarter in which they were actually placed in service (or disposed of)

13. Individual Income Taxes C8-13 Example: Mid-Quarter Convention Business with 12/31 year end purchased and placed in service the following 5-year class assets: Asset 1: on 3/28 for $50,000, and Asset 2: on 12/28 for $100,000 More than 40% placed in service in last quarter; therefore, mid-quarter convention used: Asset 1: $50,000 ×.20 × 200% × 10.5/12 = $17,500 Asset 2: $100,000 ×.20 × 200% × 1.5/12 = $5,000 Table 8-2 provides the relevant percentages to be used when applying the mid-quarter convention Business with 12/31 year end purchased and placed in service the following 5-year class assets: Asset 1: on 3/28 for $50,000, and Asset 2: on 12/28 for $100,000 More than 40% placed in service in last quarter; therefore, mid-quarter convention used: Asset 1: $50,000 ×.20 × 200% × 10.5/12 = $17,500 Asset 2: $100,000 ×.20 × 200% × 1.5/12 = $5,000 Table 8-2 provides the relevant percentages to be used when applying the mid-quarter convention

14. Individual Income Taxes C8-14 MACRS-Realty (slide 1 of 2) MACRS characteristics: MACRS Realty Residential Rental Nonresid. Realty Statutory lives: 27.5 yrs 31.5 yrs or 39 yrs Method: Straight-line Convention: Mid-month Residential rental real estate –Includes property where 80% or more of gross rental revenues are from nontransient dwelling units –e.g., Apartment building MACRS characteristics: MACRS Realty Residential Rental Nonresid. Realty Statutory lives: 27.5 yrs 31.5 yrs or 39 yrs Method: Straight-line Convention: Mid-month Residential rental real estate –Includes property where 80% or more of gross rental revenues are from nontransient dwelling units –e.g., Apartment building

15. Individual Income Taxes C8-15 MACRS-Realty (slide 2 of 2) Mid-month Convention –Property placed in service at any time during a month is treated as if it was placed in service in the middle of the month –Example: Business building placed in service April 25 is treated as placed in service April 15 Mid-month Convention –Property placed in service at any time during a month is treated as if it was placed in service in the middle of the month –Example: Business building placed in service April 25 is treated as placed in service April 15

16. Individual Income Taxes C8-16 Optional Straight-line Election May elect straight-line rather than accelerated depreciation on personalty placed in service during year –Use the class life of the asset for the recovery period –Use half-year or mid-quarter convention as applicable –Election is made annually by class of property May elect straight-line rather than accelerated depreciation on personalty placed in service during year –Use the class life of the asset for the recovery period –Use half-year or mid-quarter convention as applicable –Election is made annually by class of property

17. Individual Income Taxes C8-17 Leasehold Improvement Property (slide 1 of 2) If lessor is owner of leasehold improvement property, depreciation is calculated as follows: –Real Property – Use straight-line method over 27.5 or 39 year statutory recovery periods –Tangible personal property – Use the shorter MACRS lives and accelerated methods When these improvements are disposed of or abandoned by the lessor due to lease termination –Property is treated as disposed of by the lessor –A loss can be taken for the unrecovered basis If lessor is owner of leasehold improvement property, depreciation is calculated as follows: –Real Property – Use straight-line method over 27.5 or 39 year statutory recovery periods –Tangible personal property – Use the shorter MACRS lives and accelerated methods When these improvements are disposed of or abandoned by the lessor due to lease termination –Property is treated as disposed of by the lessor –A loss can be taken for the unrecovered basis

18. Individual Income Taxes C8-18 Leasehold Improvement Property (slide 2 of 2) If lessee is owner of leasehold improvement property –Costs of leasehold improvements are recovered in accordance with the general cost recovery rules Cost recovery period is determined without regard to the lease term –Any unrecovered basis in the leasehold improvement property not retained by the lessee is deducted in the year the lease is terminated If lessee is owner of leasehold improvement property –Costs of leasehold improvements are recovered in accordance with the general cost recovery rules Cost recovery period is determined without regard to the lease term –Any unrecovered basis in the leasehold improvement property not retained by the lessee is deducted in the year the lease is terminated

19. Individual Income Taxes C8-19 Election to Expense Assets -Section 179 (slide 1 of 5) General rules –Can elect to immediately expense up to $250,000 (for 2008) of business tangible personalty placed in service during the year –Cannot use § 179 for realty or production of income property General rules –Can elect to immediately expense up to $250,000 (for 2008) of business tangible personalty placed in service during the year –Cannot use § 179 for realty or production of income property

20. Individual Income Taxes C8-20 Election to Expense Assets -Section 179 (slide 2 of 5) Section 179 general rules –Amount expensed reduces depreciable basis –Any elected § 179 expense is taken before the 50% additional first-year depreciation is computed –The base for calculating the standard MACRS deduction is net of the § 179 expense and the 50% additional first-year depreciation Section 179 general rules –Amount expensed reduces depreciable basis –Any elected § 179 expense is taken before the 50% additional first-year depreciation is computed –The base for calculating the standard MACRS deduction is net of the § 179 expense and the 50% additional first-year depreciation

21. Individual Income Taxes C8-21 Election to Expense Assets -Section 179 (slide 3 of 5) Annual limitations: –Expense limitation ($250,000 for 2008) is reduced by amount of § 179 property placed in service during year that exceeds $800,000 Example: In 2008, taxpayer placed in service $815,000 of § 179 property. –The § 179 expense limit is reduced to $235,000 [$250,000 – ($815,000 – $800,000)] Annual limitations: –Expense limitation ($250,000 for 2008) is reduced by amount of § 179 property placed in service during year that exceeds $800,000 Example: In 2008, taxpayer placed in service $815,000 of § 179 property. –The § 179 expense limit is reduced to $235,000 [$250,000 – ($815,000 – $800,000)]

22. Individual Income Taxes C8-22 Election to Expense Assets -Section 179 (slide 4 of 5) Annual limitations: –Election to expense cannot exceed taxable income (before § 179) of taxpayer’s trades or businesses Any amount expensed under § 179 over taxable income limitation may be carried over to subsequent year(s) Amount carried over still reduces basis currently Annual limitations: –Election to expense cannot exceed taxable income (before § 179) of taxpayer’s trades or businesses Any amount expensed under § 179 over taxable income limitation may be carried over to subsequent year(s) Amount carried over still reduces basis currently

23. Individual Income Taxes C8-23 Election to Expense Assets -Section 179 (slide 5 of 5) Example: Taxpayer buys 5-year property for $275,000 on August 15, 2008 and elects immediate expensing of the maximum amount. The total deduction for the year is calculated as follows: § 179 expense $250,000 50% additional first-year depreciation [($275,000 - $250,000) X.50] 12,500 Standard MACRS calculation [($275,000 - $250,000 - $12,500) X.20] 2,500 Total cost recovery allowed in 2008$265,000 Example: Taxpayer buys 5-year property for $275,000 on August 15, 2008 and elects immediate expensing of the maximum amount. The total deduction for the year is calculated as follows: § 179 expense $250,000 50% additional first-year depreciation [($275,000 - $250,000) X.50] 12,500 Standard MACRS calculation [($275,000 - $250,000 - $12,500) X.20] 2,500 Total cost recovery allowed in 2008$265,000

24. Individual Income Taxes C8-24 Listed Property (slide 1 of 4) There can be substantial limits on cost recovery of assets considered listed property Listed property includes the following: –Passenger automobile –Other property used as a means of transportation –Property used for entertainment, recreation, or amusement –Computer or peripheral equipment –Cellular telephone There can be substantial limits on cost recovery of assets considered listed property Listed property includes the following: –Passenger automobile –Other property used as a means of transportation –Property used for entertainment, recreation, or amusement –Computer or peripheral equipment –Cellular telephone

25. Individual Income Taxes C8-25 Listed Property (slide 2 of 4) To be considered as predominantly used for business, business use must exceed 50% Use of asset for production of income is not considered in this 50% test However, both business and production of income use percentages are used to compute cost recovery To be considered as predominantly used for business, business use must exceed 50% Use of asset for production of income is not considered in this 50% test However, both business and production of income use percentages are used to compute cost recovery

26. Individual Income Taxes C8-26 Listed Property (slide 3 of 4) To be considered as predominantly used for business (cont’d) If 50% test is met, then allowed to use statutory percentage method of cost recovery with some limitations To be considered as predominantly used for business (cont’d) If 50% test is met, then allowed to use statutory percentage method of cost recovery with some limitations

27. Individual Income Taxes C8-27 Listed Property (slide 4 of 4) If asset is not used predominantly for business i.e., business use does not exceed 50% –Must use straight-line method –If business use falls to 50% or lower after year property is placed in service, must recapture excess cost recovery If asset is not used predominantly for business i.e., business use does not exceed 50% –Must use straight-line method –If business use falls to 50% or lower after year property is placed in service, must recapture excess cost recovery

28. Individual Income Taxes C8-28 Passenger Auto Cost Recovery Limits (slide 1 of 7) For autos placed in service in 2007, cost recovery limits are: Year Recovery Limitation 1 $3,060 2 4,900 3 2,850 Succeeding years until the cost is recovered 1,775 If passenger automobile qualifies for 50% additional first- year depreciation (i.e., new property), the 2008 recovery limitation is increased by $8,000 –The initial-year cost recovery limitation increases from $3,060 to $11,060 ($3,060 + $8,000) For autos placed in service in 2007, cost recovery limits are: Year Recovery Limitation 1 $3,060 2 4,900 3 2,850 Succeeding years until the cost is recovered 1,775 If passenger automobile qualifies for 50% additional first- year depreciation (i.e., new property), the 2008 recovery limitation is increased by $8,000 –The initial-year cost recovery limitation increases from $3,060 to $11,060 ($3,060 + $8,000)

29. Individual Income Taxes C8-29 Passenger Auto Cost Recovery Limits (slide 2 of 7) Limits are for 100% business use –Must reduce limits by percentage of personal use Limit in the first year includes any amount the taxpayer elects to expense under § 179 Limits are for 100% business use –Must reduce limits by percentage of personal use Limit in the first year includes any amount the taxpayer elects to expense under § 179

30. Individual Income Taxes C8-30 Passenger Auto Cost Recovery Limits (slide 3 of 7) Example: Taxpayer acquired an auto in 2008 for $30,000 and used it 80% for business 2008 cost recovery allowance: {[($30,000 X 50%) + ($15,000 X 20%)] X 80%}$14,400 But deduction is limited to $11,060 × Business use %.80 Cost recovery allowance$8,848 Example: Taxpayer acquired an auto in 2008 for $30,000 and used it 80% for business 2008 cost recovery allowance: {[($30,000 X 50%) + ($15,000 X 20%)] X 80%}$14,400 But deduction is limited to $11,060 × Business use %.80 Cost recovery allowance$8,848

31. Individual Income Taxes C8-31 Passenger Auto Cost Recovery Limits (slide 4 of 7) Limit on § 179 deduction –For certain vehicles not subject to the statutory dollar limits imposed on passenger automobiles the § 179 deduction is limited to $25,000 The limit applies to sport utility vehicles with an unloaded GVW rating of more than 6,000 pounds and not more than 14,000 pounds Limit on § 179 deduction –For certain vehicles not subject to the statutory dollar limits imposed on passenger automobiles the § 179 deduction is limited to $25,000 The limit applies to sport utility vehicles with an unloaded GVW rating of more than 6,000 pounds and not more than 14,000 pounds

32. Individual Income Taxes C8-32 Passenger Auto Cost Recovery Limits (slide 5 of 7) Listed property that fails the >50% business usage test in year property is placed in service must be recovered using the straight-line method –Such property does not qualify for the 50% additional first-year depreciation If the >50% business usage test is failed in a year after the property is placed in service, straight-line method must be used for remainder of property’s life –Cost recovery of passenger auto under straight-line listed property rule still subject to annual limits Listed property that fails the >50% business usage test in year property is placed in service must be recovered using the straight-line method –Such property does not qualify for the 50% additional first-year depreciation If the >50% business usage test is failed in a year after the property is placed in service, straight-line method must be used for remainder of property’s life –Cost recovery of passenger auto under straight-line listed property rule still subject to annual limits

33. Individual Income Taxes C8-33 Passenger Auto Cost Recovery Limits (slide 6 of 7) Change from predominantly business use –If the business use percentage falls to 50% or lower after the year the property is placed in service, the property is subject to cost recovery recapture –The amount recaptured as ordinary income is the excess cost recovery Excess cost recovery is the excess of the cost recovery deductions taken in prior years using the statutory percentage method over the amount that would have been allowed if the straight-line method had been used Change from predominantly business use –If the business use percentage falls to 50% or lower after the year the property is placed in service, the property is subject to cost recovery recapture –The amount recaptured as ordinary income is the excess cost recovery Excess cost recovery is the excess of the cost recovery deductions taken in prior years using the statutory percentage method over the amount that would have been allowed if the straight-line method had been used

34. Individual Income Taxes C8-34 Passenger Auto Cost Recovery Limits (slide 7 of 7) Leased autos subject to “inclusion amount” rule –Using IRS tables, taxpayer has gross income equal to each lease year’s inclusion amount –Purpose is to prevent avoidance of cost recovery dollar limits applicable to purchased autos by leasing autos Leased autos subject to “inclusion amount” rule –Using IRS tables, taxpayer has gross income equal to each lease year’s inclusion amount –Purpose is to prevent avoidance of cost recovery dollar limits applicable to purchased autos by leasing autos