1. #6-1 Chapter 6 McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Property Acquisitions and Cost Recovery Deductions Chapter 6

2. #6-2ObjectivesObjectives 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 Section 179 expensing election. Understand role of depreciation in NPV of after-tax cash flows. Amortize intangibles, deplete resources.

3. #6-3 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

4. #6-4 Expense vs. Capitalize Repairs and maintenance? Source of IRS dispute due to facts.  Capitalize expenditures that increase the value or useful life of an asset.  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.

5. #6-5 Tax Subsidies Permit Expensing R&D expenses.  Allowing deduction for R&D is a tax subsidy. What is the GAAP rationale for requiring expense under SFAS 2? Various oil and gas: IDC, depletion Advertising.

6. #6-6 Tax Basis Tax basis = unrecovered cost (cost - depreciation). 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. Adjusted basis is like the tax equivalent of “net book value”

7. #6-7 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. Footnote describes the effect of borrowing rate versus internal discount rate.  Tax deductions made leveraged tax shelters in early 1980’s have positive NPV even when pre-tax flows were breakeven or negative. Chapters 9 and 15 discuss limits on tax shelter losses.

8. #6-8 Cost Recovery of Inventory = cost of goods sold Tangible assets = depreciation Intangible assets = amortization Natural resources = depletion

9. #6-9 Cost of Goods Sold Similar to GAAP 1) Beginning inventory 2) PLUS purchases and cost of manufacture 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 263A. AP4

10. #6-10 Cost of Goods Sold Uniform capitalization rules (IRC Section 263A)  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?

11. #6-11 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 decreases book and taxable income.

12. #6-12DepreciationDepreciation 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.

13. #6-13DepreciationDepreciation MACRS - Modified Accelerated Cost Recovery System  Personalty:  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)

14. #6-14 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 2002. Sell the property in 2004. What is 2002, 2003, 2004 depreciation?

15. #6-15 Depreciation Conventions – Personalty - Midquarter IF > 40% personalty is acquired during the last quarter of the year, THEN Compute depreciation separately for EACH quarter’s acquisition using mid-quarter tables. Adjust table amounts in year of disposition: multiply table amount by X.5 / 4, where X = # of full quarters held. Example – dispose in May, which is the second quarter. Multiply table amount by 1.5/4

16. #6-16 Depreciation Conventions – Personalty New law 2003 Tax Act Elect 50% extra first-year depreciation for assets purchased after 5/5/03 and before 1/1/05:  MACRS personalty <= 20 yr life  Software w/ 3yr amortization life  Certain leasehold improvements. Compute 50% extra depreciation AFTER expense election under Section 179. Apply regular MACRS depreciation to basis remaining after Sec. 179 expense and 50% extra depreciation.

17. #6-17 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 2003. Sell in March 2008. What is depreciation in 2001- 2008?

18. #6-18 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 held only for a portion of the year  2) Easier rules than computing actual days held.

19. #6-19AutomobilesAutomobiles Maximum annual depreciation limit per vehicle, indexed for inflation.  2003 $3,060 (1st yr) + $4,600 (extra under 2002 Tax Act).  2004 $4,900 (2nd yr)  2005 $2,950 (3rd yr)  2006+ $1,775 (4th +++ yrs). Compute depreciation per MACRS, then limit above.

20. #6-20 Expensing Election Applies to tangible personalty. May expense $100,000 of assets purchased in 2003, 2004, 2005. The amount will revert back to $25,000 in 2006. Expense cannot create a business loss. Expense reduced $ for $ by purchases > $400,000. AP9. Reduces recordkeeping, benefit for small businesses Planning - if buying a 3-year, 5-year and 7-year asset, which one should you expense?

21. #6-21 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%. Different depreciation methods apply for Alternative Minimum Tax purposes (Chapter 10, 14).

22. #6-22 Lease versus Buy Text compares purchasing for cash up-front to an operating lease. A capital lease is treated like a purchase by the lessee. A lessee who obtains assets through an operating lease has rent expense but no interest and depreciation deductions (because lessor still owns the asset), but  doesn’t have deemed debt on financial balance sheet.

23. #6-23 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.

24. #6-24 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.

25. #6-25 Purchased Intangibles Allocate lump-sum price to assets by relative FMVs. Residual = goodwill. Tax = 15 years SL GAAP = 40 years pre-2002. No GAAP amortization post-2001 - evaluate for impairment annually. Book-tax difference is permanent post-2001.

26. #6-26DepletionDepletion Cost depletion = unrecovered basis * units sold / estimated beginning units. Percentage depletion  statutory % of gross income. See Q18. Deduct the greater of cost or percentage depletion.