1. Chapter 8 Depreciation, Cost Recovery, Amortization, and Depletion Copyright ©2006 South-Western/Thomson Learning Individual Income Taxes

2. C8 - 2 Individual Income Taxes 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. C8 - 3 Individual Income Taxes General Considerations (slide 1 of 2) Basis in an asset is reduced by the amount of cost recovery that is allowed or allowable

4. C8 - 4 Individual Income Taxes General Considerations (slide 2 of 2) 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

5. C8 - 5 Individual Income Taxes 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

6. C8 - 6 Individual Income Taxes Additional 50% Cost Recovery Allowance For qualified property acquired after 5/05/03 and before 1/01/05, an additional 50% cost recovery allowance is available –Qualified property includes most types of new property other than buildings –Additional 50% cost recovery taken reduces adjusted basis of property –May elect to not take the additional first-year cost recovery For qualified property acquired after 5/05/03 and before 1/01/05, an additional 50% cost recovery allowance is available –Qualified property includes most types of new property other than buildings –Additional 50% cost recovery taken reduces adjusted basis of property –May elect to not take the additional first-year cost recovery

7. C8 - 7 Individual Income Taxes Example—Additional 50% Cost Recovery Allowance Corporation acquires new five-year property for $10,000 on 01/15/04 –Cost recovery allowance for 2004: 50% additional first-year depreciation ($10,000×.50)$ 5,000 MACRS calculation ($10,000-$5,000)×.20 1,000 Total Cost Recovery$ 6,000 Corporation acquires new five-year property for $10,000 on 01/15/04 –Cost recovery allowance for 2004: 50% additional first-year depreciation ($10,000×.50)$ 5,000 MACRS calculation ($10,000-$5,000)×.20 1,000 Total Cost Recovery$ 6,000

8. C8 - 8 Individual Income Taxes Additional 30% Cost Recovery Allowance For qualified property acquired after 9/10/01 and before 9/11/04, an additional 30% cost recovery allowance is available (instead of the 50% additional depreciation) –Qualified property must meet same general requirements as for 50% additional depreciation –Taxpayer may elect to: Take 30% additional depreciation instead of the 50% additional depreciation Not take the additional first-year cost recovery For qualified property acquired after 9/10/01 and before 9/11/04, an additional 30% cost recovery allowance is available (instead of the 50% additional depreciation) –Qualified property must meet same general requirements as for 50% additional depreciation –Taxpayer may elect to: Take 30% additional depreciation instead of the 50% additional depreciation Not take the additional first-year cost recovery

9. C8 - 9 Individual Income Taxes 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)

10. C8 - 10 Individual Income Taxes 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)

11. C8 - 11 Individual Income Taxes 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)

12. C8 - 12 Individual Income Taxes Example: Mid-Quarter Convention Business with 12/31 year end purchased and placed in service the following 5-year class assets (Assume election is made to not take additional 50% or 30% depreciation): 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 Business with 12/31 year end purchased and placed in service the following 5-year class assets (Assume election is made to not take additional 50% or 30% depreciation): 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

13. C8 - 13 Individual Income Taxes 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 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

14. C8 - 14 Individual Income Taxes MACRS-Realty (slide 2 of 2) Mid-month Convention –Property placed in service at any time during a month is treated as if it were 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 were 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

15. C8 - 15 Individual Income Taxes 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

16. C8 - 16 Individual Income Taxes Election to Expense Assets -Section 179 (slide 1 of 5) General rules –Can elect to immediately expense up to $105,000 (for 2005) 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 $105,000 (for 2005) of business tangible personalty placed in service during the year –Cannot use § 179 for realty or production of income property

17. C8 - 17 Individual Income Taxes Election to Expense Assets -Section 179 (slide 2 of 5) Section 179 general rules –Amount expensed is taken before the 50% or 30% additional depreciation is computed –Amount expensed reduces depreciable basis –Cost recovery available on remaining basis Section 179 general rules –Amount expensed is taken before the 50% or 30% additional depreciation is computed –Amount expensed reduces depreciable basis –Cost recovery available on remaining basis

18. C8 - 18 Individual Income Taxes Election to Expense Assets -Section 179 (slide 3 of 5) Annual limitations: –Expense limitation ($105,000 for 2005) is reduced by amount of § 179 property placed in service during year that exceeds $420,000 –Example: In 2005, taxpayer placed in service $427,000 of § 179 property. The expense limit is reduced to $98,000 [$105,000 – ($427,000 – $420,000)] Annual limitations: –Expense limitation ($105,000 for 2005) is reduced by amount of § 179 property placed in service during year that exceeds $420,000 –Example: In 2005, taxpayer placed in service $427,000 of § 179 property. The expense limit is reduced to $98,000 [$105,000 – ($427,000 – $420,000)]

19. C8 - 19 Individual Income Taxes 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

20. C8 - 20 Individual Income Taxes Election to Expense Assets -Section 179 (slide 5 of 5) Example: Taxpayer buys equipment for $300,000 (7-year property) on August 15, 2005 and elects immediate expensing of the maximum amount Cost of equipment$300,000 § 179 deduction 105,000 Amount subject to MACRS$195,000 MACRS rate.1429 Cost recovery allowance$ 27,866 Total cost recovery allowed in 2005 is $132,866 ($105,000 + $27,866) Example: Taxpayer buys equipment for $300,000 (7-year property) on August 15, 2005 and elects immediate expensing of the maximum amount Cost of equipment$300,000 § 179 deduction 105,000 Amount subject to MACRS$195,000 MACRS rate.1429 Cost recovery allowance$ 27,866 Total cost recovery allowed in 2005 is $132,866 ($105,000 + $27,866)

21. C8 - 21 Individual Income Taxes 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 –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 –Property used for entertainment, recreation, or amusement –Computer or peripheral equipment –Cellular telephone

22. C8 - 22 Individual Income Taxes 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

23. C8 - 23 Individual Income Taxes 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 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 recovery with some limitations

24. C8 - 24 Individual Income Taxes 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 –30% or 50% additional first-year depreciation not available –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 –30% or 50% additional first-year depreciation not available –If business use falls to 50% or lower after year property is placed in service, must recapture excess cost recovery

25. C8 - 25 Individual Income Taxes Passenger Auto Cost Recovery Limits (slide 1 of 7) For autos placed in service in 2004, cost recovery limits are: Year Recovery Limitation 1 $2,960 2 4,800 3 2,850 Succeeding years until the cost is recovered 1,675 For autos placed in service in 2004, cost recovery limits are: Year Recovery Limitation 1 $2,960 2 4,800 3 2,850 Succeeding years until the cost is recovered 1,675

26. C8 - 26 Individual Income Taxes 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

27. C8 - 27 Individual Income Taxes Passenger Auto Cost Recovery Limits (slide 3 of 7) Example: Taxpayer acquired an auto in 2005 for $30,000 and used it 80% for business 2005 cost recovery allowance: $30,000 ×.20$6,000 Deduction is limited to $2,960 × Business use %.80 Cost recovery allowance$2,368 Example: Taxpayer acquired an auto in 2005 for $30,000 and used it 80% for business 2005 cost recovery allowance: $30,000 ×.20$6,000 Deduction is limited to $2,960 × Business use %.80 Cost recovery allowance$2,368

28. C8 - 28 Individual Income Taxes 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

29. C8 - 29 Individual Income Taxes 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 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 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

30. C8 - 30 Individual Income Taxes 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 deduction 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 deduction 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

31. C8 - 31 Individual Income Taxes 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

32. C8 - 32 Individual Income Taxes Alternative Depreciation System (ADS) (slide 1 of 2) ADS is an alternative depreciation system that is used in calculating depreciation for: –Alternative minimum tax (AMT) –Assets used predominantly outside the U.S. –Property owned by the taxpayer and leased to tax exempt entities –Earnings and profits ADS is an alternative depreciation system that is used in calculating depreciation for: –Alternative minimum tax (AMT) –Assets used predominantly outside the U.S. –Property owned by the taxpayer and leased to tax exempt entities –Earnings and profits

33. C8 - 33 Individual Income Taxes Alternative Depreciation System (ADS) (slide 2 of 2) Generally, use straight-line recovery without regard to salvage value –For AMT, 150% declining balance allowed –Half-year, mid-quarter, and mid-month conventions still apply Generally, use straight-line recovery without regard to salvage value –For AMT, 150% declining balance allowed –Half-year, mid-quarter, and mid-month conventions still apply

34. C8 - 34 Individual Income Taxes Amortization Can claim amortization deduction on § 197 intangibles –Use straight-line recovery over 15 years (180 months) beginning in month intangible is acquired Section 197 intangibles include acquired goodwill, going-concern value, trademarks, trade names, etc. Can claim amortization deduction on § 197 intangibles –Use straight-line recovery over 15 years (180 months) beginning in month intangible is acquired Section 197 intangibles include acquired goodwill, going-concern value, trademarks, trade names, etc.

35. C8 - 35 Individual Income Taxes Depletion (slide 1 of 4) Two methods of natural resource depletion –Cost: determined by using the adjusted basis of the resource and allocating over the recoverable units –Percentage: determined using percentage provided in Code and multiplying by gross income from resource sales Two methods of natural resource depletion –Cost: determined by using the adjusted basis of the resource and allocating over the recoverable units –Percentage: determined using percentage provided in Code and multiplying by gross income from resource sales

36. C8 - 36 Individual Income Taxes Depletion (slide 2 of 4) Cost depletion –Depletion is computed on a per unit basis –Per unit amount is determined by dividing the basis of the resource by the estimated recoverable units of resource Number of units sold in year × per unit depletion = depletion for year –Total depletion can not exceed total cost of the property Cost depletion –Depletion is computed on a per unit basis –Per unit amount is determined by dividing the basis of the resource by the estimated recoverable units of resource Number of units sold in year × per unit depletion = depletion for year –Total depletion can not exceed total cost of the property

37. C8 - 37 Individual Income Taxes Depletion (slide 3 of 4) Percentage depletion –Depletion is computed by using the statutory percentage rate for the type of resource –Rate is applied to the gross income from the property Percentage depletion –Depletion is computed by using the statutory percentage rate for the type of resource –Rate is applied to the gross income from the property

38. C8 - 38 Individual Income Taxes Depletion (slide 4 of 4) Percentage depletion –Percentage depletion cannot exceed 50% of the taxable income (before depletion) from the property –Percentage depletion reduces basis in property –However, total percentage depletion may exceed the total cost of the property Example: Property with zero basis but still generating income Percentage depletion –Percentage depletion cannot exceed 50% of the taxable income (before depletion) from the property –Percentage depletion reduces basis in property –However, total percentage depletion may exceed the total cost of the property Example: Property with zero basis but still generating income

39. C8 - 39 Individual Income Taxes Intangible Drilling Costs (IDC) Intangible drilling costs include –Costs for making the property ready for drilling –Costs of drilling the hole Treatment of IDC –Expense in the year incurred, or –Capitalize and write off through depletion It is generally advantageous to write off IDC immediately Intangible drilling costs include –Costs for making the property ready for drilling –Costs of drilling the hole Treatment of IDC –Expense in the year incurred, or –Capitalize and write off through depletion It is generally advantageous to write off IDC immediately

40. C8 - 40 Individual Income Taxes If you have any comments or suggestions concerning this PowerPoint Presentation for West Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA TRIPPEDR@oneonta.edu SUNY Oneonta If you have any comments or suggestions concerning this PowerPoint Presentation for West Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA TRIPPEDR@oneonta.edu SUNY Oneonta