1. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 7 Property Acquisitions and Cost Recovery Deductions McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 7-2Objectives  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. 7-3 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. 7-4 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. 7-5 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. 7-6 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. 7-7 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. 7-8 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. 7-9 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. 7-10 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. 7-11 Cost Recovery Methods  Inventory = cost of goods sold  Tangible assets = depreciation  Intangible assets = amortization  Natural resources = depletion

12. 7-12 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. 7-13 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. 7-14Depreciation  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. 7-15Depreciation  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. 7-16 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. 7-17 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 4 th quarter

18. 7-18 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. 7-19 Limited Depreciation for Passenger Automobiles  Maximum annual depreciation per vehicle placed in service in 2012  2012 $3,160  2013 $5,100 (2 nd year)  2014 $3,050 (3 rd year)  2015 $1,875 (4 th year and beyond)  Compute depreciation per MACRS, then apply the limit

20. 7-20 Section 179 Expensing Election  Taxpayer may expense a limited amount of cost of qualifying property placed in service in a year  Limited amount is $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 $2,000,000 in 2013

21. 7-21 Section 179 Example  Mayer Inc. purchased $609,200 of qualifying property in 2013  Mayer may expense $500,000 of the cost and capitalize $109,200 as the depreciable basis of the property  Lowe Inc. purchased $2,070,000 of qualifying property in 2013  Lowe must reduce its limited amount by $70,000 ($2,070,000 - $2,000,000 threshold)  Lowe may expense $430,000 of the cost ($500,000 – $70,000) and capitalize $1,640,000 as the depreciable basis of the property

22. 7-22 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 2013, Boyd Inc. elected to expense $112,000 of the cost of qualifying property  Boyd’s taxable income before any Section 179 deduction was $91,800  Boyd’s Section 179 deduction is limited to $91,800  Boyd has a $20,200 expense carryforward to 2014

23. 7-23 Bonus Depreciation  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. 7-24 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

25. 7-25 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. 7-26 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. 7-27 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. 7-28 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. 7-29 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. 7-30Depletion  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

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