Asset Basis and Depreciation

Question 1

What is the basis of a property?

Answer 1

The value imputed to a property, which is useful for determining how much its value has changed over the time the taxpayer has possessed it (i.e. the holding period)

Question 2

What is a property’s basis usually calculated as?

Answer 2

The cost or FMV of any property given in exchange for it, in addition to expenses related to the purcahse

If the property is received as a matter of income (e.g. a new car as a real estate agent’s commission), then its basis must be its FMV, since that is what is included in the person’s income

Question 3

What is a property’s adjusted basis?

Answer 3

The original basis of a property adjusted for increases and decreases – increases due to capital expenditures on it and decreases due to depreciation (or a similar reduction in value)

E.g. if one owns a car and then spends money improving it, then the money spent improving it becomes part of the car’s basis

Question 4

How does a recipient of a gift determine the basis of the gifted property?

Answer 4

If the donor’s basis > the property’s FMV, then the donee’s basis will be determined later, when the property is disposed

Otherwise, the donee’s basis simply is the old donor’s basis

Question 5

For gifted property, how is the donee’s basis determined upon the property’s disposal?

Answer 5

Since this sale requires the donor’s basis to exceed the FMV at the time of the gift, three things can happen: the property can sell (1) for less than the FMV, (2) for more than the FMV and the donor’s basis, (3) for more than the FMV but less than the donor’s basis

Donee’s basis for (1) = FMV

(2) = donor’s basis
(3) = doesn’t matter, since no gain or loss will be recorded

Question 6

If a donor’s basis becomes a donee’s basis, how does that affect the donee’s holding period?

Answer 6

The donee’s holding period is understood to include the donor’s holding period too

But if the FMV becomes the donee’s basis, then the holding period begins at the time the property was given

Question 7

How is the basis determined for inherited property?

Answer 7

It is usually the FMV at the date of the decedent’s death, but a different date can also be elected: six months after his death

The basis under this latter option is called the “step-up basis”

Question 8

Under what circumstances is the step-up basis the basis of inherited property?

Answer 8

Only if it decreases the value of the gross estate and the estate tax liability

Exception: if the step-up basis is elected but the property is sold before the six-month date arrives, then its basis is the FMV on the date it was sold

Question 9

What are different ways in which business property’s basis can be reduced?

Answer 9

Depreciation, amortization, depletion, and Section 179 expenses

Question 10

How are many acquired intangible assets amortized?

Answer 10

Straight-line over 15 years

Applies to goodwill, know-how, licenses, permits, non-competition covenants, franchises, trademarks, going-concern value, etc.

Does NOT apply to self-generated intangibles, interests in a business (e.g. a partnership), interests in land, interests in films or books, etc.

Question 11

Can acquired computer software be amortized over 15 years?

Answer 11

No, though it can be amortized over 36 months, starting with when it was put into use

Question 12

What are two ways to account for the depletion of natural resources?

Answer 12

(1) cost depletion = calculates a cost depletion per unit and bases the depletion on the number of units extracted
(2) percentage depletion = based on a percentage of gross income estimated to be taken from the resources

(2) cannot be more than 50% per year

Question 13

What are the two different means by which assets can generally be depreciated for tax purposes?

Answer 13

(1) straight-line
(2) Modified Accelerated Cost Recovery System (MACRS)

(2) is more common, and it permits taxpayers to deduct a greater amount for depreciation in the asset’s earlier years

Question 14

What kind of property can be depreciated?

Answer 14

Property used for business purposes

Land, inventory, and any property reserved for personal use (e.g. cars or boats) cannot be depreciated

Question 15

What are the six different MACRS classes for personal property?

Answer 15

3-, 5-, 7-, 10-, 15-, and 20-year items

They each are depreciable over these durations

Question 16

What are the three different MACRS classes for real property?

Answer 16

15-, 27.5-, and 39-year property

They each are depreciable over these durations

Question 17

What items are included in the first three MACRS classes for personal property?

Answer 17

(1) 3-year = hogs, race horses over two years old, tractors used over the road
(2) 5-year = cars, light trucks, research equipment, some technological equipment (e.g. computers), farm machinery
(3) 7-year = office furniture and equipment; this category is also a catch-all

Question 18

What items are included in the last three MACRS classes for personal property?

Answer 18

(4) 10-year = vessels, barges, other equipment for water transportation
(5) 15-year = water treatment plants, assets used to produce cement
(6) 20-year = sewers, farm buildings

Question 19

What items are included in the three MACRS classes for real property?

Answer 19

(1) 15-year = retail improvements (if done in 2010 or 2011), leasehold improvements, restaurants
(2) 27.5-year = residential rental property (e.g. apartments)
(3) 39-year = nonresidential property (e.g. office buildings) after May 1993

Question 20

Which depreciation rates do the different MACRS classes of property use?

Answer 20

(i) The first four personal property classes (3, 5, 7, and 10) use double-declining balance but change to SL when that has a greater deduction
(ii) The last two personal property classes (15 and 20) use the 150% declining balance, but also change to SL when it’s better
(iii) All real property classes (15, 27.5, and 39) use the SL method

Question 21

When calculating depreciation deductions under MACRS, how does the salvage value affect the deduction?

Answer 21

It doesn’t – MACRS calculations are not supposed to involve any salvage value

Question 22

How is double-declining balance (DDB) depreciation calculated?

Answer 22

(2 / useful life) x (cost)

Question 23

How is 150% declining balance depreciation calculated?

Answer 23

(1.5 / useful life) x (cost)

The same as DDB, except 1.5 replaces 2

Question 24

What are Section 179 deductions?

Answer 24

Certain property expenditures, rather than being capitalized and then depreciated, can instead be treated (for tax purposes) as expenses

The Section 179 election can be made only during the year the property is put into use – the point is that the deduction happens all at once rather than being spread out in future years

Question 25

Which property is generally eligible for the Section 179 deduction?

Answer 25

Personal property which is tangible and depreciable, and purchased for business use, is eligible

This includes software

Question 26

Which property is excluded from the Section 179 deduction?

Answer 26

(1) A/C or heating units
(2) property used for lodging
(3) property used outside the U.S.

Question 27

Is absolutely all real property excluded from the Section 179 deduction?

Answer 27

In 2010 and 2011, $250,000 of qualified real property could also be eligible expenditures for the Section 179 deduction

Qualified = leasehold improvements, restaurants, retail improvements

Question 28

Do just any expenditures on eligible property allow for the Section 179 deduction?

Answer 28

No, the expenditure has to be a PURCHASE of eligible property, not any improvements made to it – and it must be a purchase from an unrelated party

However, the property need not be new – it could be used by its former owner before changing hands

Question 29

How is the Section 179 expense calculated?

Answer 29

For 2013, the max deduction is $500,000, so if a company spends at least that much to purchase eligible property, it can simply deduct that much

This deduction begins to phase out with $2,000,000 of such expenditures, however

Question 30

Is there anything else to the Section 179 deduction besides the simple deduction?

Answer 30

Yes, if any expenditures remain after the simple deduction ($500k for 2013), and if the expenditure was for new property, then the remaining amount of the expenditure, though it becomes capitalized, can immediately (in 2013) be depreciated 50% in the first year – in addition to the normal depreciation amount permitted over the asset’s useful life

This extra benefit doesn’t apply to used property that was purchased

Question 31

What occurs if a Section 179 deduction is greater than the business’s taxable income for the year?

Answer 31

The deduction is limited to reduce taxable income to zero for the year, although the remaining deduction can be carried forward indefinitely

Question 32

For eligible property expenditures over the phase-out threshold, how much is the Section 179 expense phased out?

Answer 32

1:1 – e.g. if a company spends $100,000 more than the threshold, then their deduction reduces from $500,000 (the 2013 max deduction) to $400,000

Question 33

What is an example of a Section 179 deduction?

Answer 33

An oil drilling company spends $2.1 million to purchase new equipment (with 10 years of useful life) and elected to depreciate it straight-line. No other eligible Section 179 property was purchased.

Since the total expenditure exceeds the $2 million limit by $100k, the deduction is reduced that much: $500k - $100k = $400k. Thus the depreciable base of the equipment = $2.1 million - $400k = $1.7 million. 50% of this ($850k) can be depreciated immediately, with the rest applicable to SL depreciation, the first year’s amount of which is $850k / 10 = $85k.

Total deduction = $400k + $850k + $85k = $1,335,000

Question 34

How does MACRS depreciation deal with the fact that assets are purchased in the middle of the year?

Answer 34

It generally does not permit a full year of depreciation, but also does not leave the calculation entirely up to the individual – instead, there are three conventions used to posit the start of an asset’s depreciation

Question 35

What are the three MACRS conventions concerning depreciation?

Answer 35

(1) half-year convention = treats the property as having been purchased in the middle of the year – also gives one half-year’s depreciation for the year it is disposed
(2) mid-quarter convention = treats the property as having been purchased in the middle of one of the four quarters of the year
(3) mid-month convention = treats the property as having been purchased in the middle of the month it was actually purchased

Question 36

Can all MACRS conventions apply to all MACRS depreciable property?

Answer 36

No, the half-year and mid-quarter conventions can only apply to personal property, and the mid-month convention can only apply to real property

Question 37

Under what circumstances are the half-year and mid-quarter conventions used?

Answer 37

The half-year convention is default, but if 40% of the total cost of the property placed in service during a year was purchased within a given quarter, then ALL property for the year is deemed to have been acquired in the middle of that quarter

Question 38

What are the percentages utilized for the mid-quarter convention?

Answer 38

87.5% of the usual yearly depreciation is charged from the middle of the first quarter, 62.5% for the second, 37.5% for the third, and 12.5% for the fourth

These are all midpoints between 0, 25, 50, 75, and 100

Question 39

How do MACRS depreciation conventions relate to the Section 179 deduction?

Answer 39

Since the Section 179 deduction determines how much of a property expenditure to expense and how much to capitalize in the purchased property, the depreciation conventions necessarily apply only AFTER the 179 deduction takes effect

Question 40

What makes the calculation of MACRS depreciation problems easier?

Answer 40

The factors to calculate MACRS problems are generally provided in tables according to % of declining balance (150 or 200), the useful life of the asset, and the depreciation convention

They also automatically take into account when the SL method would be better than the accelerated methods

Question 41

What depreciation rules apply to automobiles?

Answer 41

Cars with 100% business use can be depreciated up to $3,160 in 2013, while trucks and vans can be depreciated up to $3,360

Moreover, if there is no bonus first-year depreciation applied to these, the limits increase by $8k

Question 42

How are automobiles depreciated if they are not used 100% for business purposes?

Answer 42

This limit decreases to the extent (as a %) that they are not used solely for business

If under 50%, a different method of depreciation must be used