Ch. 7 - Property Acquisitions and Cost Recovery Deductions Flashcards
Explain what is a capitalized cost? How is it different than a deduction? How does cost recovery work?
Capitalized = an expenditure recorded as an asset instead of as a current expense.
If an asset is going to benefit multiple future time periods then it is usually capitalized and CANNOT be deducted in the current tax year. (ie a deduction)
The tax law allows the firm to recover capital expenditures in the form of future deductions. (Depreciation, amortization)
If a building is bought and then further improved/ renovated are the improvements deductible?
No, an expenditure that substantially increases the value or useful life of an asset must be capitalized and then depreciated.
Restoration = capital improvement
If a piece of property is being restored to its original state at the time of purchase, is that deductible?
Yes, if the expenditures merely return the property to its original condition that it is classified as a deduction (ordinary and necessary business expense). Ex: Clean up costs for farmland are deductible.
Warning: the costs must be returning property to original state. If property is bought in contaminated state, then initial clean up would be capitalized.
What are the preferential rules for Research and Development (R&D)?
Beginning in 2022, R&D must be amortized over a 5 year period for domestic research or a 15 year period for research conducted outside the US. S/L amortization is applied and the mid-year convention is applied.
GAAP requires companies to expense in the year of expenditure so this will create temporary book to tax differences.
What are the preferential rules for farmers and the oil & gas industry?
Farmers: deduct costs for preparing the land for future food production.
Oil & Gas: Drilling and drilling development costs are deductible in period of expenditure.
Give the definition for tax basis and what is computed into the “adjusted basis”.
Definition of tax basis = unrecovered dollars of the original capitalized amount.
Included in cost basis: invoice costs, sales tax, any costs associated to put asset into production, legal costs, etc. (form of payment does not matter)
These costs will then be reduced by any deductions that happen in that year or future years as the asset is depreciated or amortized.
Explain the Leveraged Cost basis.
Interest expense (ie payment of interest on debt) are tax deductible in the year of payment. (Deduct interest as it is accrued and not all at once)
Leverage: By borrowing cash to purchase an asset, the taxpayer can deduct the interest expense and create a tax savings, which reduces cash outflows, beginning immediately with interest expense payments.
By discounting the cash flows that are paid in the future “leverage” can reduce the after tax cost of the asset purchase.
Explain the capitalization process of inventory for large companies.
Cost of purchased or manufactured inventory must be capitalized and cannot be expensed until sold. (COGS deduction)
For a retailer, whatever you pay to supplier is capitalized.
For a manufacturer, what is capitalized includes:
1. Direct materials
2. Direct labor
3. Overhead = indirect costs for producing product
Explain the “unicap rule”.
For large companies (over $27 million in sales), all direct costs of manufacturing or purchasing and storing inventory, AND any indirect costs must be capitalized to the extent that they relate to a firm’s production or resale function.
Explain the three methods for computing COGS and the Lifo conformity rule.
- Job Order cost systems: for large items where the actual cost is known for each item, this will be in unicap rule.
- FIFO: First in, first out
- LIFO: Last in, first out
The cost flow does not match the physical flow of product.
Lifo conformity rule: If a company uses Lifo for tax purposes it must use Lifo for financial statement purposes too.
*using LIFO for tax purposes results in a higher COGS.
Explain the MACRS depreciation for the personalty classification.
Personalty are smaller assets with recovery periods between 3-20 years.
Tools are 3 year recoveries, computers or cars are 5 year recoveries, and furniture is a 7 year recovery.
For recovery between 3-10 yrs., USE DDB (ie 200% of S.L. (straight line) rate)
For recovery of 15 & 20 yrs, use 150% of S.L. rate.
When using MACRS, an asset does not have any salvage value.
What qualifies as a “qualified” improvement property and how is it handled for tax purposes.
(Made after 2017) An improvement to the interior of a building. 15 year recovery life and depreciated at
150% * S.L
Explain the depreciation for the realty classification.
Realty are buildings with recovery periods of 25-50 years. Straight line depreciation is used.
What is the 1/2 (mid) year convention?
For personalty, No matter what time of the year it is placed in service, for the first year of depreciation it will be as if it is placed in service July 1st. (1/2 depreciation for first year)
What is the mid-quarter convention for personalty?
If more than 40% of personalty acquired in the taxable year is placed in service in the last three months of the year then use the mid-quarter convention.
This means that assets are grouped by quarter of purchase, and can take depreciation for the quarter purchased, from the middle of the quarter until the end of the year, for each quarter.
This would penalize companies trying to buy all their personalty at the end of the year, this rule encourages even spending throughout the year.
