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Chapter 10

Chapter 10 . Cost Recovery on Property: Depreciation, Depletion, and Amortization. Murphy & Higgins, Concepts in Federal Taxation, 2012 edition. Concept Review. Capital recovery concept allows a taxpayer to recover all invested capital before income is taxed

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Chapter 10

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  1. Chapter 10 Cost Recovery on Property: Depreciation, Depletion, and Amortization Murphy & Higgins, Concepts in Federal Taxation, 2012 edition © 20121 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  2. Concept Review • Capital recovery concept allows a taxpayer to recover all invested capital before income is taxed • An asset’s basis is the maximum investment that qualifies as capital for recovery • Legislative grace allows the capital to be recovered systematically over the life of the asset © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  3. Methods of Recovery • Depreciation: used for tangible assets that • Are used for a business or production of income purpose • Have a determinable life • Depletion: used for wasting assets • Amortization: used for intangible assets © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  4. History of Depreciation Section 179 Election to Expense Assets 1981 1987 MACRSBased on method and life prescribed by law; less accelerated than ACRS ACRSBased on method and life prescribed by law Based on facts and circumstances related to asset life and taxpayer’s situation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  5. Section 179 Election • Taxpayer may elect to expense rather than capitalize qualifying property placed in service during the year • Promotes administrative convenience • Treated as a depreciation deduction © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  6. Section 179 ElectionQualified Taxpayers • In 2011, organizations may elect to deduct as an expense up to $500,000 in investment • Elements required for an activity to qualify under Section 179 election: • profit motivation • regularity • continuity of the taxpayer’s involvement © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  7. Section 179 ElectionQualified Taxpayers • Activities that will not qualify for Section 179 election • hobby • amusement • similar motivations © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  8. Section 179 ElectionQualifying Property • Tangible, personal property • Real estate does not qualify • Used in a trade or business • Investment property does not qualify © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  9. Section 179 ElectionDeduction Limitations • Limitations apply to each entity • Maximum deduction = $500,000 • Deduction cannot exceed taxable income from the business • Excess may be carried forward © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  10. Section 179 ElectionDeduction Phase-Out • Deduction decreased if total cost of qualifying property placed in service exceeds $2,000,000 • by $1 for every $1 of value over $2,000,000 • thus, when total cost = $2,500,000, • deduction = $500,000 – ($2,500,000 - $2,000,000) = $0 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  11. Bonus Depreciation • 100% for property acquired after 9/8/10 and before 1/1/12 • 50% for property acquired after 12/31/11 and before 1/1/13 • No purchase limit • No annual income restriction © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  12. Bonus Depreciation Qualified Property • New MACRS property with life ≤ 20 years • MACRS water utility property • Computer software not acquired in the acquisition of all assets of a business • Qualified leasehold improvement property © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  13. Bonus DepreciationNon-Qualifying Property • Property that must be depreciated using ADS • Property whose original use did not begin with the taxpayer © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  14. Bonus DepreciationOther Rules • Mandatory unless election not to claim is made • Election not to claim must be made for each class of property acquired during the year • Section 179 must be claimed before calculation of bonus depreciation • Bonus depreciation reduces depreciable basis © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  15. MACRSQualifying Property • MACRS applies to • New and used tangible, depreciable property • Used in a trade or business or for the production of income © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  16. MACRS Basis • Depreciable basis is • Asset’s original basis for depreciation (discussed in Chapter 9) • Reduced by any § 179 deduction • Reduced by any Bonus Depreciation • Adjusted basis is • Remaining unrecovered capital of an asset = asset basis minus accumulated depreciation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  17. MACRSRecovery Period • Each asset must be placed in a MACRS class according to its class life • Most personal property is in a 3, 5, or 7 year class • Most land improvements and specialized property are in a 10, 15, or 20 year class • Real estate is in a 27.5, 31.5, or 39 year class © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  18. MACRSConventions • Administrative convenience, three assumptions are made about the time property was placed in service during the year • Mid-year convention applies to all property except real estate • Mid-month convention applies to real estate only • Mid-quarter convention applies to some personal property © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  19. MACRSMid-Year Convention • Assumes property is placed in service and will be disposed of at the mid-point of the year • One-half year depreciation allowed in the first year of service • One-half year depreciation allowed in the last year of service • IRS tables reflect the mid-year adjustment only for the first year © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  20. MACRSMid-Month Convention • Assumes property is placed in service and will be disposed of at the mid-point of a month • One-half month allowed at the beginning • One-half month allowed at disposition • IRS tables reflect the adjustment only for acquisition © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  21. MACRSMid-Quarter Convention • If > 40% of the total depreciable basis of all personal property is placed in service during the 4th quarter of the year, mid-quarter: • Assumes property is placed in service and will be disposed of at the mid-point of a quarter rather than at mid-year • Determine the 40% after taking §179 expense © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  22. Depreciation Method Alternatives • Regular MACRS • with Section 179 • Straight-line MACRS • Straight-line Alternative Depreciation System (ADS) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  23. Regular MACRS • Method is double declining balance • IRS tables provide the depreciation rate • Designed to permit full recovery of depreciable basis • Incorporate the conventions • Maximizes acquisition year deduction using the Section 179 election © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  24. Straight-Line MACRS • Taxpayers may elect to use the slower straight-line method • Election is made each year • MACRS recovery periods are used • Mid-year convention applies © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  25. Alternative Depreciation System (ADS) • Taxpayers may elect to use ADS • Use is mandatory for Alternative Minimum Taxable Income • Uses a longer recovery period than MACRS • Election is made on a class-by-class, year-by-year basis © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  26. Limitations on Listed Property • Most mixed-use property is considered listed property and subject to special limitations • Examples: automobiles, computers, etc. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  27. Limitations on Listed Property • Treatment depends on the percentage of business usage • if >50% business use, treated like other depreciable assets • if < 50% business use, deductions are limited to ADS without Section 179 • In either case, only the business portion of the asset’s basis is depreciable © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  28. Limitations on Passenger Autos • Total amount of depreciation and § 179 expense that can be deducted is limited • Annual maximum limit set and linked to the year the car was placed in service • Annual limit is further reduced by the business use % © 2012Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  29. Adequate Record Keeping • Listed property is subject to strict record keeping requirements • No deduction is allowed without proof of • Why? The business purpose of the use • What? The amount • When? The dates of use • Where? The reality of the use © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  30. Depletion • Basis of natural resource assets subject to wasting away is recovered using depletion • Basis used is generally fees paid to acquire a lease and the costs of the lease, exploration, and drilling • Computed using two methods • Figure both each year and use the largest as deduction © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  31. Cost Depletion Method • Allocates unrecovered basis over the number of estimated units of resource Unrecovered Basis Estimated Recoverable Units = Depletion per Unit Cost Depletion= Depletion per Unit x # of Units Sold © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  32. Percentage Depletion Method • Also called Statutory depletion • Depletion is the lesser of • 50% of taxable income before depletion, or • Gross income from the sale of the natural resource times a statutory depletion rate • Different statutory % for each type of resource is given in IRS tables © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

  33. Amortization • Basis of intangible assets is recovered using the straight-line method over the life of the asset • Intangible assets acquired through purchase generally use a 15 year life • Created assets and assets specifically excluded from use of the 15 year period are amortized over their legal life © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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