Bryant - Course 4. Tax Planning. 6. Cost Recovery Concepts

Question 1

Juan owns a farm and farmland, farming equipment, stocks, bonds, and a patent on a new farming tool. Which of these are considered intangible assets? (Select all that apply)
* Bonds
* Patent on new farming tool
* Stocks
* Farming equipment
* Farmland

Answer 1

Bonds
Patent on new farming tool
Stocks

Intangible property is property that does not have physical substance, such as goodwill, patents, stocks, and bonds.

Question 2

Depreciation must be calculated using the _ ______??______ _ method for real property.
* unrecaptured
* straight-line
* sum-of-the-years’ digits
* units of production

Answer 2

straight-line

Depreciation must be calculated using the straight-line method for real property.

Question 3

What is the Section 179 Expensing Election?

Answer 3

In lieu of capitalizing the cost of new or used tangible personal business property, taxpayers may elect to expense up to $1,160,000 (2023) of the acquisition cost as an ordinary deduction in the year of acquisition. The $1,080,000 deduction is reduced pro-rata for purchases over $2,890,000 (2023) in any year. The property must be placed into service during the year to qualify for the deduction. The immediate expensing election does not apply to real estate. The election is made annually, and the taxpayer must select the assets to which the deduction applies. Once the $1,080,000 Section 179 limit is exhausted, bonus depreciation may be used if cost basis still exists for the property.

Question 4

Describe 1231 Property Recapture

Answer 4

When you dispose of business property, your taxable gain or loss is usually a Section 1231 gain or loss.

Depreciable business property held long-term is known as Section 1231 property and includes the following:
* Timber, coal, or domestic iron ore
* Livestock
* Unharvested crops
In addition to the property listed above, Section 1231 property includes:
* All property used in a trade or business
* All property held for the production of income

Depreciable 1231 business property has the benefit of capital gain treatment in the case of a gain on the sale and ordinary loss treatment if the sale results in a loss. This gives the taxpayer the best of both worlds with income getting favorable capital gain rates and losses being deductible from ordinary income.

Question 5

Describe recapture of depreciation

Answer 5

An additional government-imposed element called recapture of depreciation potentially limits the favorable Section 1231 tax treatment outlined above (i.e., capital gains & ordinary losses). Under the depreciation recapture rules, part or all of the gains on the sale of depreciable property may be taxed as ordinary income. The amount of gain taxed as ordinary income depends on the type of property and the depreciation method used.

The government also requires the taxpayer to recapture any Section 1231 ordinary losses taken in the five-year period before the tax year in which a 1231 capital gain has occurred. Before the net Section 1231 gain can become a long-term capital gain, taxpayers must look back over the past five years and compute the amount of unrecaptured Section 1231 losses. Unrecaptured section losses equal the excess of the net Section 1231 losses (deducted as ordinary losses) over the Section 1231 gains taxed as ordinary income. This excess of ordinary loss reduces the amount of 1231 gain, which may be treated as capital gain.

Question 6

What is needed to calculate Section 1231 gain?

Answer 6

To figure any Section 1231 gain that must be reported as ordinary income, you must keep permanent records of the facts necessary to figure the depreciation or amortization allowed or allowable on your property. This includes the date and manner of acquisition, cost or other basis, depreciation or amortization, and all other adjustments that affect basis.

Question 7

In 2023, Ben has a $2,000 net Section 1231 gain. To figure how much he has to report as ordinary income and long-term capital gain, he must first determine his section 1231 gains and losses from the previous 5-year period.

From 2018 through 2022, he had the following Section 1231 gains and losses:
Year Amount
2018 -0-
2019 -0-
2020 ($2,500)
2021 -0-
2022 $1,800

Answer 7

Ben uses this information to figure out how to report his net section 1231 gain for 2023:

1) Net 1231 gain (2023)
…………
$2,000
2) Net 1231 loss (2020)
($2,500)
3) Net 1231 gain (2022)
1,800
4) Remaining net 1231 loss from
prior 5 years
($700)
5) Gain treated as ordinary income
…………
$700
6) Gain treated as LTCG
…………
$1,300

Question 8

Tom has $10,000 of 1231 gain in 2023. In 2018, he took a $4,000 ordinary loss on the sale of 1231 property. He had no 1231 sales in any other year.
Calculate the amount of the 1231 gain in 2023 that may be categorized as capital gain.
* $10,000
* $6,000
* $4,000
* $0

Answer 8

$6,000

In 2023, Tom may take $6,000 of the gain as capital gain ($10,000 - $4,000), but the other $4,000 will be treated as ordinary income.

Had the $10,000 1231 gain occurred in 2024, the entire amount would have been reportable as capital gain. This is because the $4,000 loss experienced in 2018 would have been beyond the five-year look-back period before the current tax year.

Question 9

Describe 1245 Property Recapture

Answer 9

Section 1245 property is a subcategory of Section 1231 property. For purposes of our discussion on the recapture of depreciation, 1245 property is 1231 depreciable business-use property, which is not real estate.

The recapture provisions for Section 1245 apply to the total amount of depreciation or cost recovery allowed for Section 1245 property, irrespective of the method used for depreciation. The gain recaptured as ordinary income cannot exceed the amount of depreciation (i.e., cost recovery) that was taken. Recapture never increases the amount of gain; it merely determines how much of the gain will be taxed as ordinary income and how much as capital gain.

Generally, the entire gain from the disposition of Section 1245 property is recaptured as ordinary income because the total amount of depreciation or cost recovery is usually greater than the gain realized. A portion of the gain will receive Section 1231 treatment only if the realized gain exceeds total depreciation or cost recovery. This would only occur if the disposition or selling price of the asset were greater than the original, in-service cost of the asset. In other words, the asset appreciated (versus depreciated), i.e. an antique piece of furniture used in a trade or business.

Question 10

Describe 1250 Property Recapture

Answer 10

Section 1250 property includes all real property that is subject to an allowance for depreciation and that is not and never has been section 1245 property. It includes a leasehold of land or section 1250 property subject to an allowance for depreciation. A fee simple interest in land is not included because it is not depreciable.

There are two types of treatment for recapture under section 1250. The first is known as 1250 recapture. The second is called unrecaptured 1250 gain.

There are two basic situations for which the 1250 recapture rules will apply. In both cases, accelerated depreciation will have been used:
* Residential rental real estate placed in service prior to 1987.
* Nonresidential real estate placed in service before 1981.

The key to both of these situations is that accelerated depreciation was taken. The maximum amount of recapture (i.e., taxed as ordinary income) will be the difference between what was taken as depreciation under an accelerated method, and what would have been allowed had the straight-line method been used. In both situations, any gain beyond this recaptured amount is taxed as 1231 capital gain. However, the 1231 gain portion is subject to the special unrecaptured 1250 gain rule and taxed at a special 25% rate (described in more detail on the next page).

Question 11

Describe the Unrecaptured 1250 Gain

Answer 11

Unrecaptured 1250 gain applies to residential rental properties placed in service prior to 1987 (for which an amount has been recaptured under Section 1250), all non-residential property placed in service prior to 1981, as well as all property that was recently placed into service (after 1987) and used straight-line depreciation. Similar to section 1245 in structure, the amount of the realized gain that is attributable to the depreciation, is taxed at a special rate of 25%. Any gain beyond the depreciation taken, (i.e. sales price greater than the original cost basis of the asset being depreciated) is taxed at LTCG rates. The amount that is taxed at this special 25% rate will have been reduced to the extent that some of the depreciation (i.e., incremental accelerated vs. straight-line amount) would have been recaptured as ordinary income.

Question 12

What are the Limitations on Luxury Automobiles?

Answer 12

The Modified Accelerated Cost Recovery System (MACRS) placed additional MACRS depreciation deduction restrictions on the purchase of luxury automobiles. The limitations apply even if such automobiles are used 100% of the time for business.

The Tax Cuts and Jobs Act changed depreciation limits for passenger vehicles placed in service after Dec. 31, 2017. If the taxpayer doesn’t claim bonus depreciation, the greatest allowable depreciation deduction is:
* $10,000 for the first year
* $16,000 for the second year
* $9,600 for the third year
* $5,760 for each later taxable year in the recovery period

If a taxpayer claims 100 percent bonus depreciation, the greatest allowable depreciation deduction is:
* $18,000 for the first year
* $16,000 for the second year
* $9,600 for the third year
* $5,760 for each later taxable year in the recovery period

Question 13

What are the Additional Computations for Leased Luxury Automobiles?

Answer 13

If a taxpayer leases an automobile for business purposes, the deduction for rental payments is reduced to reflect the limitations on depreciation deductions that are imposed on owners of automobiles under Section 280F. If these restrictions were not applied to leased automobiles, the limitations could be avoided by leasing instead of purchasing an automobile. The leasing restriction is accomplished by requiring taxpayers to include in their gross income an “inclusion amount” obtained from an IRS table. This amount is based on the automobile’s fair market value (FMV) and the tax year in which the lease commences, and is prorated for the percentage of business use and number of days used during the year.

Question 14

What is Depreciation and Cost Recovery?

Answer 14

Depreciation is the systematic allocation of the cost of an asset over its estimated economic life. Using depreciation, taxpayers can deduct a reasonable allowance for the exhaustion, wear& tear, and obsolescence of property. Specifically, depreciation creates deductions for tangible property used in business. The purpose of allowing a depreciation deduction is to enable taxpayers to recover the cost of an asset. The term cost recovery was used under the Accelerated Cost Recovery System (ACRS) system because the costs could be recovered ahead of the economic useful life of the asset. The post-1986 Modified Accelerated Cost Recovery System (MACRS) rules more closely follow the concept of economic useful life and, therefore, the MACRS rules refer to depreciation rather than cost recovery.

Question 15

What are the three distinct depreciation and cost recovery systems are currently in place as a result of tax law changes in 1981 and 1986?

Answer 15

The depreciation and cost recovery systems that taxpayers must use are as follows:
* Property placed into service prior to 1981: Taxpayers must use the rules contained in IRC Section 167 and these rules basically follow financial accounting principles.
* Property placed into service after December 31, 1980, and before January 1, 1987: Taxpayers must follow the Accelerated Cost Recovery System (ACRS) as provided in Section 168.
* Property placed into service after December 31, 1986: Taxpayers must follow the Modified Accelerated Cost Recovery System (MACRS) as provided in IRC Section 168.

Question 16

Describe the different Types of Property - tangible, intangible, personal use, inventory

Answer 16

Intangible property - Property that does not have physical substance, such as goodwill, patents, and stocks and bonds.
* The cost of intangible property is written off through amortization.

Tangible property is Property that has physical substance, such as land, buildings, natural resources, equipment, etc..
* The cost of tangible property other than land is systematically written off through depreciation or depletion.

It is further classified as either real property or personal property. **Real property **(often referred to as real estate or realty) is defined as land or any structure permanently attached to the land, such as buildings. Personal property is any tangible property that is not real property and includes items such as equipment, vehicles, and furniture.

It is important to distinguish between personal property and personal-use property. Personal-use property is any property, tangible or intangible, real or personal, that is used by the taxpayer for his own personal use rather than in a trade or business or for the production of income.

Similarly, property that is held to be sold to customers in the ordinary course of business is inventory. Inventory is not depreciable.

Question 17

Describe Conversion of Personal-use Property

Answer 17

Personal-use property is any property, tangible or intangible, real or personal, that is used by the taxpayer for his or her own personal use rather than in a trade or business or for the production of income. If personal-use property is either converted to business use or held for the production of income, the property’s basis for depreciation purposes is the lesser of:
* its adjusted basis or
* its fair market value (FMV) determined as of the conversion date.
This lower cost or market rule is intended to prevent taxpayers from depreciating the portion of the cost that represents a nondeductible loss on a personal-use asset.

Question 18

Describe when a half-year convention is used

Answer 18

A half-year convention is used in the year of acquisition and zero salvage value is assumed. Half-year convention is** required for all tangible personal property **and assumes that all asset acquisitions or dispositions are made at the midpoint of the tax year, regardless of when the actual acquisition or disposition is made. In the year of disposition, the amount calculated from the table must be reduced by one-half in order to properly apply the half-year convention.

Question 19

What convention is used for real estate?

Answer 19

For real estate, the mid-month convention is used which assumes that all the asset acquisitions or dispositions are made at the midpoint of the month in which the transaction occurs.

Question 20

Describe when a Mid-Quarter Convention is used

Answer 20

The Modified Accelerated Cost Recovery System (MACRS) system generally requires the use of the half-year convention. However, under IRC Section 168(d)(3)(A), the mid-quarter convention applies to depreciable property (other than certain real property described in IRC Section 168(d)(2)) placed in service during a taxable year if the aggregate basis of property placed in service during the last three months of the taxable year exceeds 40 percent of the aggregate basis of property placed in service during the taxable year (“the 40-percent test”). Thus, if the depreciable property is placed in service during a taxable year that consists of three months or less, the mid-quarter convention applies to the property.

Question 21

During the year, Yvette bought a machine (7-year property) for $4,000, office furniture (7-year property) for $1,000, and a computer (5-year property) for $5,000. She placed the machine in service in January, the furniture in September, and the computer in October. Yvette did not elect a Section 179 deduction and none of these items is qualified property for purposes of claiming a special depreciation allowance. She placed property in service during the last 3 months of the year and must first determine if the mid-quarter convention applies.

What convention method should Yvette use?

Answer 21

The total basis of all property Yvette placed in service during the year is $10,000. The $5,000 basis of the computer, which she placed in service during the last 3 months (i.e., the fourth quarter) of her tax year, is more than 40% of the total basis of all property ($10,000) she placed in service during the year. Therefore, Yvette must use the mid-quarter convention for all three items.

Question 22

When does a Mid-quarter convention apply?

Answer 22

Mid-quarter convention applies when 40% or more of a firm’s assets are placed in service in the fourth quarter

Question 23

For property depreciated under MACRS, each property acquired must be classified into one of six categories. The depreciation can be computed using the percentages contained in the given table. The classification of assets is based on determining a class life from a listing of assets published by the IRS.

The following classifications apply to personal property placed in service after December 31, 1986, under the MACRS system.

What are the 6 categories?

Answer 23

• 3-Year Property: Property with a class life of 4 years or less, including tractor units, race horses over 12 years old, and special tools.
• 5-Year Property: Property with a class life of more than 4 years but less than 10 years, including automobiles, trucks, computers, and research and experimental equipment.
• 7-Year Property: Property with a class life of 10 years or more but less than 16 years, including office furniture, equipment, and most types of machinery.
• 10-Year Property: Property with a class life of more than 16 years, but less than 20 years, including barges, vessels, petroleum, and food processing equipment.
• 15-Year Property: Property with a class life of more than 20 years, but less than 25 years, including billboards, service station buildings, and land improvements.
• 20-Year Property - Property with a class life of 25 or more years, including utilities and sewers.

Question 24

The Tax Cuts and Jobs Act allowed 100% expensing for property acquired and placed in service after September 27, 2017, and before January 1, 2023. Beginning in the 2023 tax year, this bonus depreciation will decline by 20% each year until it is completely phased out in 2027. In 2023, bonus depreciation is 80%.

What tests qualifies that a property is eligible for bonus depreciation?

Answer 24

Property that qualifies for bonus depreciation must meet the following tests:
* Must be depreciable under the MACRS system,
* Must have a useful life of 20 years or less (which eliminates real estate, except for certain leasehold improvements from qualifying); and,
* The asset that is used first by the taxpayer must be new.

Question 25

Exam Tip - using the MACRS Table to determine depreciation, and the straight-line depreciation method

Answer 25

When using the above MACRS Table, remember that half-year convention has already been factored into the table. (Multiply the table percentage times the full in-service cost, to determine the depreciation for any particular year). This is in contrast with the straight-line depreciation method, where you must remember to divide the first year by two, to account for half-year convention (i.e., $40,000 asset, 5-year life would be ($40,000/5) = $8,000 per year). However, the first year would need to be cut in half, which would necessarily mean that the asset would actually be depreciated for six (6) years ($4,000 in years 1 and 6).

Question 26

How is Real Property classified and what are the Recovery rates?

Answer 26

Real property is referred to as real estate or realty. It is defined as land or any structure permanently attached to the land, such as buildings.

The Modified Accelerated Cost Recovery System (MACRS) recovery periods that apply to real property placed in service in years after 1986 are as follows:
* Residential rental property: 27.5 years
* Non-residential real property: 39 years

Depreciation of real property must be calculated using the straight-line method. A mid-month convention is used in the year of acquisition and in the year of disposition.

Question 27

Describe the straight-line method for the depreciation

Answer 27

A taxpayer may elect the straight-line method for the depreciation of tangible personal property. If the straight-line election is made, the taxpayer must use either the same depreciation period or an extended period based on the alternative depreciation system. It is calculated by dividing the total cost of the asset minus the estimated salvage value by the asset’s useful life.

Question 28

Describe the Alternative Depreciation System

Answer 28

The Modified Accelerated Cost Recovery System (MACRS) system provides an Alternative Depreciation System (ADS) that is required for certain property. It is also available for other depreciable assets if the taxpayer so elects.

Some features of ADS include:
* Required for any tangible property that is used predominantly outside the United States.
* Specified recovery periods that are often longer than the recovery periods under MACRS.
* Personal property with no specific class life is assigned a 12-year life and real property is assigned a 30-year life.
* The ADS requires the use of the straight-line method with a half-year, mid-quarter, or mid-month convention, whichever is applicable.
* A taxpayer who wants to use the straight-line method over a longer recovery period may elect to use ADS. These taxpayers frequently have net operating losses or are subject to the alternative minimum tax.
* The ADS is an elective provision made on a year-by-year basis. Once made for the specified property, it is irrevocable.
* For personal property, the ADS election applies to all property within a class, (e.g., all five-year property).
* The ADS election may be made on an individual property basis, in the case of real property.
* The ADS is also used to compute earnings and profits for a corporation and to compute the alternative minimum tax for both individuals and corporations.

Question 29

What are the limitations and special rules to the Section 179 election?

Answer 29

The following limitations and special rules apply to the Section 179 election:
* The property must be purchased for use in an active trade or business as distinguished from property acquired for income production (e.g., personal property used in a rental activity held by an investor does not qualify).
* The property cannot be acquired from a related party under IRC Section 267 or by gift or inheritance.
* The Section 179 tax benefits are recaptured if the property is no longer predominantly used in a trade or business (e.g., the property is converted to personal use) at any time. In the year of recapture, the taxpayer must include in gross income the amount previously expensed reduced by the amount of depreciation that would have been allowed for the period the property was held for business use.
* Until further notice, Section 179 is permanent at the $1,000,000 level. This maximum limit is adjusted for inflation. For 2023, the limit is $1,160,000. Businesses exceeding a total of $2.89 million of purchases in qualifying equipment have the Section 179 deduction phase-out dollar-for-dollar and eliminated above $2.89 million.
* A second limitation on the total Section 179 deduction is that it cannot exceed the taxpayer’s taxable income before deducting the Section 179 expense from the trade or business. Any acquisition cost that cannot be deducted because of the limitation based on taxable income is carried forward for an unlimited number of years and is added to the other amounts eligible for the Section 179 deduction in the future year. The carryover amount is subject to the taxable income limitation in the carryover year. A special tax break is made for a sole proprietor (with unrelated wages as an employee), wherein the business income is aggregated with the unrelated W-2 income (sole proprietor spouse only) to measure for the availability of the Section 179 deduction.

Question 30

Can you depreciate the personal-use portion of an asset’s cost?

Answer 30

The personal-use portion of an asset’s cost is not depreciable. For example, if a taxpayer owns a duplex and uses one unit as a personal residence, only the portion of the unit that is rented to tenants qualifies for depreciation.

Question 31

What are the Listed Property Rules?

Answer 31

Congress was concerned about taxpayers claiming large depreciation deductions, using accelerated methods on certain types of assets that are conducive to mixed business/personal use. They placed restrictions on assets that are classified as listed property.

Listed property includes:
* automobiles,
* computers and peripheral equipment,
* mobile phones,
* and property generally used for purposes of entertainment, recreation, or amusement, (e.g., video recorder).

If a listed property’s business usage is greater than 50% of its total usage, the taxpayer may use the regular MACRS tables for the business-use portion of the asset’s cost. However, if the business use is 50% or less, the taxpayer must use the Alternative Depreciation System (ADS). Since such property may not use the MACRS, it must use the less favorable ADS system. For example, the five-year, straight-line cost recovery period for automobiles and computers.

Additional restrictions apply to employees who acquire listed property (for example, automobile or personal computer) for use in employment-related activities. In addition to the “more than 50% test,” the use must be for the convenience of the employer and required as a condition of employment. The IRS strictly interprets this rule.

Question 32

What is the Recapture of Excess Cost-Recovery Deductions?

Answer 32

If the Modified Accelerated Cost Recovery System (MACRS) rules were used for listed property, and the business-use percentage decreases to 50% or less in a subsequent year, the property is subject to depreciation recapture, that is, recovery by IRS of benefits or deductions that were permitted earlier. The depreciation deductions for all years are recomputed using the alternative depreciation system. The excess depreciation that has been taken is recaptured as ordinary income. The excess amount is included in the taxpayer’s gross income in the year that the business-use percentage first falls to 50% or below. Once the business use falls to 50% or below, the alternative depreciation system must be used for the current year and for all subsequent years, even if the business-use percentage increases to more than 50% in a subsequent year.

Question 33

Mrs. Abbott has a priceless painting she has inherited. Her friend advises her that she should claim depreciation on this. Has her friend advised her correctly?
* False
* True

Answer 33

False

Assets such as works of art have an indefinite life and are not depreciable. No depreciation is permitted on assets that have an indefinite life.

Question 34

Roy Baxter owns a printing shop. Roy purchased and placed into service $100,000 worth of equipment in the current year (assume the mid-quarter convention does not apply). This equipment has a useful life of 7 years and will be depreciated using MACRS. To answer this question, consider both a Section 179 expense and MACRS depreciation and that Roy’s business profit for the current year is $30,000. How much is Roy’s maximum deduction in the current year?
* $0
* $30,000
* $40,003
* $100,000

Answer 34

$40,003

By electing to expense under Section 179 an amount equal to the firm’s profit ($30,000), Roy would then be able to depreciate the residual amount of $70,000 ($100,000 - $30,000). $70,000 X 0.1429 (year 1 using MACRS) = $10,003. This amount plus the elected expense of $30,000 = $40,003.

Please note that this additional depreciation deduction would not be allowed if Roy had elected to expense the entire amount of $100,000.

Question 35

WXYZ, a local business solutions company, purchased a computer on January 1 for use by its administration division. For tax purposes, what MACRS recovery period will be assigned to the computer?
* 3 years
* 5 years
* 7 years
* 10 years

Answer 35

5 years

According the classification of assets based upon the determination of a class life from a listing of assets published by IRS, a recovery period of 5 years will be assigned to the computer. Under the MACRS system any property with a class life of more than 4 years but less than 10 years including automobiles, trucks, computers, research and experimental equipment will be assigned under the 5 year classification.

Question 36

If personal use property is either converted to business use or held for the production of income (e.g., a rental house), the property’s basis for depreciation purposes is the lesser of its adjusted basis or the fair market value.
* False
* True

Answer 36

True

If personal-use property is either converted to business use or held for the production of income the property’s basis for depreciation is the lesser of its adjusted basis or its fair market value (FMV) determined as of the conversion date. This lower of cost or market rule is intended to prevent taxpayers from depreciating the portion of the cost that represents a nondeductible loss on a personal-use asset.

Question 37

Describe amortization deduction

Answer 37

An amortization deduction is allowed for a variety of intangible assets. While the amortization period varies greatly depending on the type of asset, a characteristic of all intangible assets is that they are amortized on a straight-line basis. The major intangible assets that may be amortized are as follows:
* Goodwill and Other Purchased Intangibles, Section 197
* Research and Experimental Expenditures, Section 174
* Start-up Expenditures, Section 195
* Organizational Expenditures, Section 248
* Pollution Control Facilities, Section 169

Question 38

Describe IRC Section 197

Answer 38

IRC Section 197 was enacted in 1993 to provide greater certainty as to the amortization of many acquired intangible assets and to specifically allow the amortization of purchased goodwill. An amortization deduction is permitted for certain acquired Section 197 intangible assets. The amortization is deducted on a ratable basis over a 15-year period, beginning with the month of acquisition of the asset.

In general, Section 197 applies only to intangible assets that are acquired in connection with the conduct of a trade or business, or an activity engaged in for the production of income. Section 197 does not apply to an intangible asset that is internally created by the taxpayer, such as a patent resulting from the taxpayer’s research and development lab. Internally created patents and copyrights have definite and limited lives, and are therefore amortizable over the defined period. Internally created patents are generally amortized over 17 years and internally created copyrights over 28 years.

Question 39

What time period are patents and copyrights amoritized over?

Answer 39

Internally created patents are generally amortized over 17 years and internally created copyrights over 28 years.

Question 40

Which of the following is an internally created intangible asset? (Select all that apply)
* Land
* Building
* Copyright
* Patent

Answer 40

Copyright
Patent

Patents resulting from the taxpayer’s research and development lab or a copyright are internally created intangible assets.

Question 41

Section 197 intangible assets are subject to _ ______??______ _ -year ratable amortization. What is included?

Answer 41

Section 197 intangible assets are subject to 15-year ratable amortization and they include the following:
* Goodwill is an intangible asset that is neither separately identified nor valued. It possesses characteristics that allow a business to earn greater returns than would be possible without such characteristics. Goodwill is defined as the value of a trade or business that is attributable to expected patronage due to the trade or business of the company or the name of the business.
* Going concern value is the added value that is attached to the acquired property.
* Intangible assets relate to the workforce, information base, know-how, customers, and suppliers. For example, the portion of the purchase price of an acquired business that is attributable to an existing employment contract for a key employee may be amortized over a 15-year period.
* Intangible assets also include licenses, permits, or other rights granted by a governmental unit or agency, such as, the capitalized cost of acquiring a radio broadcasting license.
* A covenant not to compete represents an agreement between a buyer and seller of a business that the seller (the selling corporation and/or its shareholders) will not compete with the buyer for a limited period. The covenant may also be limited to a geographic area. A covenant not to compete must be amortized over 15 years even if the agreement was only for five years.
* A franchise includes any agreement that gives one of the parties the right to distribute, sell, or provide goods, services, or facilities within a specified area.

Question 42

Describe the Classification and Disposition of Intangible Assets

Answer 42

If the intangible asset is held for more than a year, then a Section 197 intangible asset is treated as a depreciable property so that Section 1231 treatment is accorded to the disposition. Gain from the disposition of a Section 197 intangible is subject to depreciation recapture under Section 1245. A loss on the disposition of a Section 197 intangible asset, however, is not deductible if other intangibles acquired in the same asset acquisition of a trade or businesses are retained. In such a case, the basis of the retained Section 197 intangibles is increased by the unrecognized loss.

Question 43

Describe Research and Experimental Expenditures

Answer 43

Research and Experimental (R&E) expenditures, as defined in IRC Section 174, include experimental and laboratory costs incidental to the development of a product. Section 174 was enacted to clarify the income tax treatment of R&E expenditures. The regulations define items that do and do not qualify as research and experimental expenditures. For income tax purposes, the following alternatives are available for R&E expenditures:
* For income tax purposes, the following alternatives are available for R&E expenditures:
* Expense in the year paid or incurred
* Defer and amortize the costs as a ratable deduction over a period of 60 months or more
* Capitalize and write off the costs only when the research project is abandoned or is worthless

A taxpayer must make an election to expense or defer and amortize the costs in the initial year that the R&E expenditures are incurred. If no election is made, the costs must be capitalized. The taxpayer must continue to use the same accounting method for the R&E expenditures unless IRS approval to change methods is obtained. It is also important to note that a 20% tax credit applies to certain incremental research expenditures, even if they are immediately expensed under Section 174.

Question 44

ABC builds a new building for research purposes. They are able to expense the entire cost of the building.
* False
* True

Answer 44

False

False. It is sometimes mistakenly believed that if a company constructs a new building to be used entirely as a research facility, the entire cost of the building can be expensed. However, the expenses election applies only to the depreciation allowances on the building.

Question 45

A 20% tax credit applies to certain incremental research expenditures, even if they are immediately expensed under Section 174.
* False
* True

Answer 45

True

A 20% tax credit does apply to certain incremental research expenditures, even if they are immediately expensed under Section 174.

Question 46

Each of the following alternatives is available in accounting for research and experimental expenditures EXCEPT:
* Expense R&E costs in the year paid or incurred.
* Expense R&E costs in the year in which a product or process becomes marketable.
* Defer and amortize R&E costs as a ratable deduction over a period of 60 months or more.
* Capitalize and write off R&E costs only when the research project is abandoned or worthless.

Answer 46

Expense R&E costs in the year in which a product or process becomes marketable.

For income tax purposes the following alternatives are available for R&E expenditures: expense R&E costs in the year paid or incurred; defer and amortize R&E costs as a ratable deduction over a period of 60 months or more; or capitalize and write off R&E costs only when the research project is abandoned or worthless.

Question 47

Each of the following costs qualifies as a research and experimental expenditure EXCEPT:
* Attorney fees incurred in obtaining a patent
* Costs incurred in developing product improvements
* Marketing research
* Depreciation of laboratory equipment

Answer 47

Marketing research

Marketing research and advertising etc. are items that do not qualify as research and experimental expenditures.

Question 48

Describe Alternative Depreciation System (ADS) Under MACRS

Answer 48

There is an alternative Modified Accelerated Cost Recovery System (MACRS) depreciation system known as ADS. In ADS depreciation is deducted over longer periods than under regular MACRS, using the straight-line method. This depreciation method recovers the cost of the asset before its useful life is up. Assets are depreciated by a schedule; depending on the type of asset, it goes into one of six classes (3-, 5-, 7-, 10-, 15-, and 20-year classes). Generally, you divide the asset’s cost by the number of years for its class and depreciate it that much each year (except for the first year and the year following the last, when you depreciate half of that amount).

In some instances, it may be preferable to use the ADS system of depreciation rather than MACRS rules. A taxpayer who attempts to report a profit in three out of five years, to avoid the hobby loss rules, might want to use the alternative depreciation system rather than the regular MACRS rules. This would reduce deductions, and allow a business to report a marginal gain rather than a marginal loss and thus avoid the hobby loss rules. Also, a taxpayer who anticipates losses during the next few years or who currently has net operating loss (NOL) carryovers may elect to use the alternative depreciation system, which employs the straight-line method of depreciation over a longer recovery period.

The ADS generally is an elective provision made on a year-by-year basis. Once the election is made for specified property, it is irrevocable. Also, for personal property, the ADS election applies to all property within a class (e.g., all five-year property). For real property, the ADS election may be made on an individual property basis. If an election to use ADS is made, the taxpayer may still elect the bonus depreciation as long as the assets would have qualified for MACRS deduction but for the election to use ADS.

Question 49

What asset classes have different depreciation time frames when comparing MACRS & ADS?

Answer 49

MACRS vs ADS

Office furniture and equipment
* 7 years vs 10 years

Residential rental property
* 27.5 years vs 40 years

Nonresidential rental property
* 31.5 or 39 years vs 40 years

Question 50

Describe Use of Units of Production Depreciation

Answer 50

Many times, the MACRS depreciation system requires taxpayers to use a recovery period that is much longer than the actual useful life of the asset. Assume that a taxpayer uses a machine in her business that is required to be classified as 7-year property under MACRS. However, the machine is operated 24 hours a day, seven days a week, and will completely wear out in two years. The use of the 7-year recovery period substantially understates the depreciation for the machine.

Under IRC Section 168(f), taxpayers may exclude property from the MACRS system, if the property is depreciated under the unit-of-production method or any other method not expressed in terms of years. Therefore, if a taxpayer can express the useful life of the machine in terms of some base other than years such as machine hours, units produced and so on, it may be possible for the taxpayer to depreciate the machine over a much shorter period than the seven years required under MACRS.

Question 51

What should be considered when Structuring a Business Combination?

Answer 51

If a business is acquiring the assets of another company as part of a business combination, tax planning needs to be conducted to ensure favorable consequences for the acquiring company. The sales agreement must specify the amounts that have been paid for the tangible depreciable and non-depreciable assets and the intangible assets, and the reporting requirements that must be complied with.

**The amount paid for the tangible assets should be documented by appraisals **and evidence of negotiations between the buyer and seller. Within reason, the purchaser should attempt to allocate as much of the total price to the tangible depreciable assets. The purchaser should also consider allocating part of the purchase price to amortizable Section 197 intangible assets such as goodwill, a covenant not to compete, patents, copyrights, licenses, and customer lists because such asset costs are recovered over a 15-year period. This is preferable to allocating to depreciable real estate because it must be depreciated over 39 years.

Question 52

List reporting requirements

Answer 52

Reporting is necessary for individuals engaged in business, taxpayers as investors, employees who own a business property, non-corporate taxpayers, and S corporations. Some ways of reporting are:
* If an individual is engaged in a trade or business as a sole proprietor, depreciation, cost recovery, depletion, and amortization deductions are initially computed and reported on Form 4562 (Depreciation and Amortization) and the totals are then carried to Schedule C.
* Depletion and depreciation on rental properties are reported on Schedule E instead of Schedule C if the taxpayer is an investor.
* Depreciation on employee business property is reported on Form 2106. Separate Form 4562s are required for each different activity.
* The election to expense property under Section 179 is made by claiming the deduction on Part I of Form 4562. The taxpayer must specify the items of property and the portion of the cost for each asset being expensed.
* Form 4562 is not required of individuals and non-corporate taxpayers including S corporations when filing their current year tax returns if the depreciation deduction is for assets, other than listed property, that were placed in service in a prior year. In such cases, the depreciation deduction is entered directly on Form 1040 or other equivalent tax forms. However, even though Form 4562 may not be required to be filed with the return, detailed depreciation records must still be maintained by the taxpayers to support the deduction.

Question 53

What report needs to be completed for Research and Experimental Expenditures?

Answer 53

Attaching a statement to the tax return for the first tax year in which the expenditures are incurred makes the election to expense or defer R&E expenditures. Once the election is made, it is applicable to all R&E expenditures paid or incurred in the current and subsequent years. The capitalization method is not an election and applies only if no election is made in the initial year. Once a method has been adopted, the taxpayer is required to obtain the permission of the IRS to change to another method.

Question 54

Module Summary

Depreciation is the systematic allocation of the cost of an asset over its estimated economic life. Amortization relates to deductions for intangible property. Depletion relates to deductions for natural resources. Income tax rules are unique for each of them. The concepts of cost recovery covered in this module focus on the ability of taxpayers to deduct a reasonable allowance for the wear and tear of property used in a trade or business or held for the production of income.

Answer 54

The key concepts to remember are:
* Depreciation and Cost Recovery: Taxpayers must use specific depreciation methods depending on when an asset is placed into service. Three separate depreciation and cost recovery systems are currently in place. The method of depreciation required for income tax purposes depends on the date that the asset was placed into service. The immediate expensing election is not applicable to real estate. The election is made on an annual basis. Restrictions include personal-use assets, listed property rules, recapture of excess, and cost-recovery deductions. Depreciation deducted is reported in different ways. When an election to expense or defer R&E expenditures is made, it is applicable to all R&E expenditures paid or incurred in the current and subsequent years.
* Amortization: A variety of intangible assets can be amortized. The amortization period varies greatly depending on the type of asset. Intangible assets are amortized on a straight-line basis.
* Tax Planning Considerations: Tax planning considerations include alternative depreciation systems under MACRS, calculation of depreciation under the unit-of-production method, and structuring a business combination.
* Compliance and Procedural Considerations include reporting for an individual engaged in a trade or business as a sole proprietor, depletion and depreciation on rental properties, and election to expense property. The decision to incur or defer an expense in R&E is made by attaching a statement to the tax return for the first tax year in which the expenditures are incurred. Once the decision is made, it is applicable to all R&E expenditures paid or incurred in the current and subsequent years.

Question 55

Depreciable Section 1231 business property receives _ ______??______ _ treatment on gain from a sale and _ ______??______ _ treatment if the sale results in a loss.
* capital gain; ordinary loss
* capital gain; capital loss
* ordinary gain; capital loss
* ordinary gain; ordinary loss

Answer 55

capital gain; ordinary loss

Depreciable 1231 business property has the benefit of capital gain treatment in the case of a gain on the sale and ordinary loss treatment if the sale results in a loss. This gives the taxpayer the best of both worlds with income getting favorable capital gain rates and losses being deductible from ordinary income.

Question 56

Under the MACRS system, office furniture, equipment, and most types of machinery are classified as ____________ property.
* 5-year
* 10-year
* 7-year
* 20-year

Answer 56

7-year

Property with a class life of 10 years or more but less than 16 years, including office furniture, equipment, and most types of machinery is considered 7-Year property under the MACRS system.

Question 57

BIF-Man Co. buys $3,015,000 of property for their trade and business in 2023.
Calculate the maximum Section 179 expense election for BIF-Man Co.
* $1,160,000
* $2,890,000
* $1,285,000
* $1,035,000

Answer 57

$1,035,000

The maximum Section 179 expense election is $1,035,000 [$1,160,000 less $125,000 (i.e., the excess over the $2,890,000 limitation in 2023)].

Question 58

What is the MACRS recovery period for Desks, files, & safes?

Answer 58

7 years

Question 59

What is the MACRS recovery period for Non-residential real property?

Answer 59

39 years

Question 60

What is the MACRS recovery period for Automobiles & trucks?

Answer 60

5 years

Question 61

What is the MACRS recovery period for Residential rental property?

Answer 61

27.5 years

Question 62

When real estate intended for business purposes is placed into service, the _ ______??______ _ is used to determine the amount of depreciation allowable.
* mid-month convention
* half-year convention
* mid-quarter convention
* full-year convention

Answer 62

mid-month convention

When real estate intended for business purposes is placed into service, the mid-month convention is used to determine the amount of depreciation allowable.

Question 63

If an expenditure either improves the efficiency of an asset or extends the life of an asset beyond the end of the year, the expenditure should generally be _ ______??___ _.
* capitalized
* sold
* amortized
* expensed

Answer 63

capitalized

If an expenditure either improves the efficiency of an asset or extends the life of an asset beyond the end of the year, the expenditure should generally be capitalized.

Question 64

Johanna purchased a vintage typewriter for her copywriting business for $4,500. The salvage value is estimated to be $500 and the useful life of the property is five years.
Calculate the annual depreciation for Johanna using the straight-line method.
* $800
* $100
* $0
* $900

Answer 64

$800

The annual depreciation would be $800 [($4,500 - $500) ÷ 5] using the straight-line method.

Question 65

The amount of unrecaptured 1250 gain that is attributable to depreciation, is taxed at a rate of _ ______??___ _.
* 21%
* 15%
* 20%
* 25%

Answer 65

25%

The amount of the unrecaptured 1250 gains that is attributable to depreciation, is taxed at a special rate of 25%.

Question 66

Jalen has recently purchased an old factory in Milltown and intends to convert the space into apartment lofts. Which of the following BEST categorizes Jalen’s new factory/apartment building? (Select all that apply)
* Intangible
* Personal
* Personal-Use
* Tangible
* Real

Answer 66

Tangible
Real

Tangible property that has physical substance, such as land, buildings, natural resources, equipment, etc.

Tangible property is further classified as either real property or personal property. Real property (often referred to as real estate or realty) is defined as land or any structure permanently attached to the land, such as buildings.

Jalen’s building is tangible, real property.

Question 67

If an individual is engaged in a trade or business as a sole proprietor, depreciation, cost recovery, depletion, and amortization deductions are initially computed and reported on _ ______??______ _ and the totals are then carried to Schedule C.
* Form 4562
* Schedule E
* Form 1065
* Schedule K-1

Answer 67

Form 4562

If an individual is engaged in a trade or business as a sole proprietor, depreciation, cost recovery, depletion, and amortization deductions are initially computed and reported on Form 4562 (Depreciation and Amortization) and the totals are then carried to Schedule C.