3.5 - Cost Recovery

Question 1

What is an annual allowance given to a trade or business for exhaustion, wear and tear, and normal obsolescence of assets used in trade or business?

Answer 1

Depreciation

Question 2

What is the depreciation method typically used for federal income tax purposes?

Answer 2

Modified Accelerated Cost Recovery Systems (MACRS)

Question 3

What is the definition of real property?
What is the definition of personal property?

Answer 3

Real = lan and al items permanently affixed to the land (buildings, paving)
Personal = tangible, movable property not affixed to the land (machinery and equipment and automobiles)

Question 4

What personal proprty assets are included in each of the following life cycles:
3 year
5 year
7 year
10 year
15 year
20 year

Answer 4

3 = special tools and racehorses
5 = automobiles, light trucks, computers, and copiers
7 = furniture & fixtures, machinery, and equipment
10 = boats and water transportation equipment
15 = improvements to the interior of existing nonresidential buildings and improvements to land
20 = farm buildings and municipal sewers

Question 5

What is the MACRS depreciation rules method for 3, 5, 7, and 10 year property?
What is the MACRS depreciation rules method for 15 and 20 year property?

Answer 5

1. Computed using 200% declining balance
2. Computed using the 150% declining balance method

Question 6

How is salvage value on machinery and equipment treated under MACRS?

Answer 6

It is ignored

Question 7

Personal property is allowed what two types of depreciation conventions?

Answer 7

Half-year convention
Mid-quarter convention

Question 8

Real property is allowed what type of depreciation conventions?

Answer 8

Mid-month convention

Question 9

What is the half-year convention?

Answer 9

A personal property asset is allowed 6 months of depreciation in the year of acquisition and disposition regardless of the date on which it is acquired or disposed

Question 10

If more than 40% of depreciable personal property is placed in service in the last quarter of the year, a mid quarter convention applies and the mid-quarter MACRS table are used to calculate depreciation. If personal property is disposed of before the last year, the full year MACRs rate must be multiplied by a mid-quarter ratio for the mid-quarter convention in the year of disposition. What are the ratios/percentages used for each quarter?

Answer 10

Q1 = .5/4 = 12.5%
Q2 = 1.5/4 = 37.5%
Q3 = 2.5/4 = 62.5%
Q4 = 3.5/4 = 87.5%

Question 11

How is residential rental property depreciated? How is nonresidential real property depreciated?

Answer 11

Residential rental = 27.5 year straight line
Nonresidential real = 39 years

Question 12

What is residential rental property? What is nonresidential real property?

Answer 12

1. Apartment buildings and rental homes
2. Office buildings and warehouses

Question 13

Each tax year, a taxpayer may elect to deduct a fixed amount of depreciable personal property and qualified real property. What are the limitations to this section 179 expense deduction?

Answer 13

The 2022 allowance is $1,080,000
The max amount is reduced dollar for dollar by the amount of property that exceeds 2,700,000
Cannot create a loss
Limit for SUVs is 27,000

Question 14

Nicholas placed into service $50,000 of 5 year property in year 1. Year 1 rate for 5 year property from MACRS depreciable tables is 20%. Compare the MACRS depreciation expense to its section 1790 expense.

Answer 14

50,000 X 20% = 10,000 MACRS depreciation expense
Or
Full 50,000 179 expense

Take the 179 expense deduction because its larger than the MACRS deduction

Question 15

Under this rule, a taxpayer can expense an additional percentage of qualified property that is place into service in the current year.

Answer 15

Bonus depreciation rule

Question 16

What is the qualifying property that can take advantage of the bonus depreciation rule?

Answer 16

Personal property (machine and equipment) with a recovery period of 20 years or less that is NEW not previously used

Question 17

What is the bonus depreciation percentage?

Answer 17

100% of property placed into service during the years 2018 - 2022 and phased to 80% in 2023, 60% in 2024, 40% in 2025, and 20% in 2026. And an additional 8,000 first year depreciation for vehicles.

Question 18

Company A places into service $2,750,000 of seven year MACRS property. Determine the total cost recovery deduction for the year on the property.

Answer 18

2,750,000 - 2,700,000 (179 expense max) = 50,000
1,080,000 - 50,000 = 1,030,000 179 expense deduction

2,750,000 - 1,030,000 = 1,720,000 X 100% = 1,720,000 bonus depreciation deduction

Question 19

Depletion is allowed on what?

Answer 19

Exhaustible natural resources such as timber, minerals, oil, and gas

Question 20

What are the two methods of depletion?

Answer 20

Cost depletion
Percentage depletion

But must use the method that results in the larger deduction

Question 21

Under this depletion method, the remaining basis of the property is divided by the remaining number of recoverable units to arrive at the unit replete on rate. The deduction for depletion is the depletion unit rate multiplied by the number of units sold for the year.

Answer 21

Cost depletion

Question 22

Oil property having an estimated 1,000,000 recoverable barrels at the beginning of the year has a cost basis of $1,000,000. In year 1, 50,000 barrels were sold. Calculate the depletion deduction for year 1.

Answer 22

1,000,000 basis / 1,000,000 barrels recoverable = $1 per barrel
$1 X 50,000 barrels sold = $50,000 depletion deduction

Question 23

Under this depletion method, you would multiply a certain percentage by gross income from the property during the tax year. The deduction is limited to 50% of taxable income from the natural resource. The allowable percentage ranges from 5% to 22% depending on the mineral or substance being extracted.

Answer 23

Percentage depletion method

Question 24

This depletion deduction may be taken even after costs have been completely recovered and there is no remaining cost basis:

Answer 24

Percentage depletion

Question 25

How are intangibles such as goodwill, licenses, franchises, and trademarks amortized?

Answer 25

Straight line basis over 15 years

Question 26

How are business organization and start up costs expensed?

Answer 26

Each is permitted to first take off $5,000 to be expensed and the remainder is amortized over 180 months. The $5,000 is reduced dollar for dollar as total cost exceeds $50,000 per item.

Question 27

How are the following expenses amortized:
Research expenses
Pollution control facilities
Reforestation costs
Geological and geophysical costs

Answer 27

Research = amortized over 60 months
Pollution = amortized over 60 months
Reforestation = amortized over 84 months
Geological = amortized over 24 months

Question 28

Royal company acquired a patent with a cost of $50,000 in august year 1. Determine the amortization on the patent in year 1.

Answer 28

50,000 / 180 months = 278 per month
278 X 5 months = $1,390

Question 29

What is the calculation for after-tax cash flow?

Answer 29

Earnings after tax + amortization + depletion + depreciation

Question 30

Why must amortization, depreciation, and depletion be added back to n income for the calculation of after tax flows?

Answer 30

Because they represent declining economic value of an asset but not an actual cash flow

Question 31

How can the tax savings associated with taking amortization, depletion, or depreciation be calculated?

Answer 31

The amount of the expense multiplied by the marginal income tax rate

Question 32

On august 1 year , graham purchased and placed into service an office building costing $264,000 including $30,000 for the land. What was grahams MACRS deduction for the office building in year 1?

Answer 32

264,000 - 30,000 land = 234,000 / 39 years = 6,000 per year
4.5 / 12 months (mid-month convention) X 6,000 = 2,250