Depreciation

1. Depreciation Chapter 6 pp. 150-159

2. Economic Depreciation The decline over time in the potential usefulness (or value) of capital assets having limited life, which decline results from ordinary wear and tear, natural deterioration from exposure to the elements, and technical obsolescence.

3. Accounting Depreciation An allocation over time of the historical cost (or original cost), less salvage value, of a capital asset having a limited useful life by a non-cash expense periodically charged against income over the service, or useful, life of that asset in a rational and systematic manner.

4. Depreciation • Two functions • Prepare income statements • Compute income tax liability

5. Depreciation • Prepare income statements • Depreciation is one expense that is deducted from revenue to determine net income • Alternative procedures • Use tax depreciation records (already done for tax purposes) • Compute book depreciation (requires two sets of depreciation records)

6. Depreciation • Compute income tax liability • Depreciation is one farm expense that is deducted from gross income to compute net farm profit on Schedule F • Must apply rules that are described in IRS documents

7. Book vs. Tax Depreciation • Large potential deductions in first year can cause tax depreciation to deviate significantly from true or economic depreciation • The FFSC encourages producers to adopt book depreciation methods with appropriate useful lives and salvage values for the most accurate allocation of the purchase price of a depreciable asset over its useful life.

8. Book Depreciation • Required values • Original cost • May reflect purchase or other type of acquisition • Should reflect increase in cost-basis value of assets • Estimated useful life • Salvage value

9. Book Depreciation • Methods • Straight-line • Declining balance • Sum-of-years-digits

10. Book Depreciation • Straight-line Expense = (original cost - salvage value) ÷ life Expense for 2013 is included on 2013 income statement

11. Book Depreciation • Straight-line Compute book value (original cost less accumulated deprecation) at the end of each year Book value is recorded on balance sheet

12. Book Depreciation • Declining balance Expense = Book value x (1÷ life) x declining balance rate Double declining balance (DDB) rate = 200% or 2 Expense for 2013 is included on 2013 income statement

13. Book Depreciation • Declining balance Stop depreciation when book value = salvage value

14. Book Depreciation • Declining balance Compute book value (original cost less accumulated deprecation) at the end of each year Book value is recorded on balance sheet

15. Book Depreciation • Tractor depreciation • Assumes 300 hours per year • 10 year life • Salvage value = 36 percent of tractors list price http://www.farmdoc.illinois.edu/manage/machinery/tractors%202012.pdf

16. Book Depreciation • Tractor depreciation • 360 PTO HP tractor, 4WD • List price $257,000 • Purchase price = $218, 450 See p. 55 in packet

17. Tax Depreciation • Tax deductible expense (Chap. 7 Farmer’s Tax Guide (FTG); IRS forms & publications web site) • Tax forms • Form 4562 • Schedule F • Source of data: Depreciation records maintained on or off the farm

18. Tax Depreciation • Depreciable asset • Owned by taxpayer • Used in business or income producing activity

19. Farm Business You are in the business of farming if you cultivate, operate, or manage a farm for profit, either as owner or tenant. A farm includes livestock, dairy, poultry, fish, fruit, and truck farms. It also includes plantations, ranches, ranges, and orchards.

20. Tax Depreciation • Depreciable asset • Determinable useful life > 1 yr. • Wears out, decays, gets used up, etc. • Land?

21. Land You can never depreciate the cost of land because land does not wear out, become obsolete, or get used up (Farmer’s Tax Guide)

22. Land • Land preparation costs for center pivot irrigation systems are not depreciable • In general, you cannot depreciate earthen dams, ponds, and terraces unless the structures have a determinable useful life (Farmer’s Tax Guide)

23. Tax Basis Terminology • Three categories • Original • Unadjusted • Adjusted

24. Tax Basis Terminology Original basis: the property's cost or other basis

25. Tax Basis Terminology Unadjusted basis: original basis decreased by • Any amortization taken on the property • Any section 179 deduction claimed • Any special depreciation allowance taken on the property

26. Tax Basis Terminology Adjusted basis: Unadjusted basis less accumulated depreciation expense allowed

27. Tax Basis Terminology Unadjusted Less accumulated depreciation allowed equals adjusted Adjusted basis is similar to book value

28. Tax Basis Terminology Under MACRS, salvage value is assumed to be zero Entire original basis may be deducted as expense

29. Modified ACRS • MACRS (tables) • Straight-line (SL) • Declining Balance (DB SL) • Farm property after 1988 200% DB (DDB) not allowed

30. MACRS Deduction • Depreciation allowed = unadjusted basis x MACRS percentage • Percentages can be found in FTG or complete tables in Publ. 946 (IRS forms & publications web site)

31. Required Information • Unadjusted basis • Type of asset • GDS (default) vs ADS recovery • DB (default) vs SL • Date placed in service

32. Conventions • Half-year (tables 8 & 14 in Publ. 946) • Mid-quarter (tables 15-18) • > 40% of total basis placed in service in last 3 months of year • Placed in service at midpoint of quarter • Use mid-quarter tables (all assets placed in service during tax year)

33. Conventions • Mid-month • Nonresidential real property • Residential rental property

34. Other Factors • Section 179 deduction • Bonus depreciation • Single-purpose structures • Listed property • Partial business use

35. Section 179 Deduction • Limited to year placed in service • Multiple assets • Maximum dollar limit • 2009 $250,000 • 2010 $500,000 • 2011 $500,000 • 2012 $500,000 • 2013 $500,000 http://www.section179.org/

36. Section 179 Deduction • Investment limit • $800,000 in 2009 • $2,000,000 in 2010 • $2,000,000 in 2011 • $2,000,000 in 2012 • $2,000,000 in 2013 http://www.section179.org/

37. Section 179 Deduction • Property must be new to you (new or used). • Property acquired by gift or inheritance or purchased from a related person (spouse, ancestor, lineal descendent) does not qualify.

38. Section 179 Deduction • Traded property limit – cash paid • Section 179 deduction cannot exceed taxable income. • Real property (land and improvements) does not qualify, but single-purpose structures, grain bins, agricultural fence, and drainage tile do qualify.

39. Section 179 Deduction After the Section 179 benefits are exhausted, Bonus Depreciation of 50% can be taken on the remaining basis of eligible property placed into service

40. Other Factors • Special special depreciation allowance • Bonus depreciation is an additional deduction you can take after any section 179 deduction • 100% special depreciation for eligible assets placed in service after Sept 8, 2010 but before Jan 1, 2013; certain property with a long production period or certain aircraft • 50% special depreciation for certain qualified property acquired after Dec. 31, 2007 and before Jan. 1, 2014

41. Basis of Assets • Chap. 6 FTG • Basis of purchased property • Total cost to buyer • Includes sales tax, freight, installation and setup costs, etc.

42. Basis of Assets • Basis of property acquired through trade (nontaxable exchange) • Original basis of acquired asset equals total of: • Adj. basis of traded property, and • Cash paid (max. Sec. 179 deduction)

43. Basis of Assets • Taxable & partially taxable • Gifts, inherited property • Property received for services

44. Basis of Assets • Allocation: Multiple assets • Increases in basis • Decreases in basis

45. Disposition • Compute gain or loss • After recovery period • Adj basis = 0; “depreciated out” • Gain = Selling price

46. Disposition • Early disposition • Adj basis > 0 • Gain (loss) = selling price - adj basis • For property for which you used a half-year convention, the deduction for the year of disposition is half the depreciation determined for the full year

47. Mid-quarter convention percentages for early disposition