Chapter 10 Flashcards
Cost Recovery Deductions.
Obsolescence
Obsolescence occurs when an asset becomes economically useless to the taxpayer who owns it. It may occur as a result of technological or scientific advances in a given business or industry, through changes in applicable laws that essentially prohibit the use of the asset, or simply because of changes in economic conditions that remove profitability from the use of the asset. Another form of obsolescence is where the asset’s actual condition deteriorates much more rapidly than was expected so that the asset can no longer be used for the purpose for which
it was placed in service. Obsolescence involves a loss of usefulness resulting from abnormal conditions rather than from normal wear and tear on the property.
Calculation of a deduction?
Depreciation and other cost recovery deductions are calculated under a number of different formulas. The amount of the deduction in a given year is basically a function of the following two elements:
• the rate at which the asset’s cost is recovered (the “recovery method”)
• the period of time over which the cost is recovered (the “recovery period”)
Basic conditions for the allowance of cost recovery deductions
- The asset must be either used in the taxpayer’s business activity or held for the production of income.
- The taxpayer must generally have an ownership interest in the asset.
- The taxpayer must have a depreciable basis in the property.
- The asset must be considered to have a limited useful life.
ACRS
Rules for assets placed in service between 1981 and 1986. These rules are referred to as the “accelerated cost recovery system”
pre-ACRS assets, four established methods were used to compute depreciation. These four methods are?
- the straight-line method
- the declining-balance method
- the “sum-of-the-years-digits” method
- any other consistent method that during the first two-thirds of the depreciable asset’s recovery period does not result in cost recovery greater than that obtainable under the declining-balance method. Such methods, including the unit of production method, were employed less frequently than the first three methods listed.
Straight-line Method
Under this method, the taxpayer simply divides the depreciable basis in the property by the number of years of the property’s applicable recovery period to arrive at an annual deduction that remains the same over the course of the recovery period.
Straight-line Method Example
Assume that Dominic places property in service in early January of this year under the straight-line method of depreciation with a 25-year recovery period. Assume there is no special convention for determining depreciation in the year the property is placed in service. The basis of the property is $100,000. Dominic can claim $4,000 per year ($100,000 ÷ 25) in depreciation deductions for the property.
Declining-balance Method
Under the declining-balance method, a fixed percentage of the taxpayer’s original basis in the depreciable property is allowed in the first year. The following year the same percentage is applied to the basis of the property as adjusted to that point. Unlike the straight-line method that applies a fixed percentage to the initial basis of the property and then allows the same dollar amount of depreciation each year, the declining-balance method applies the same percentage to the property’s current adjusted basis each year.
Declining-balance Method Example
The declining-balance method is typically an accelerated method of depreciation because a percentage higher than that used under the straight-line method is allowable. That percentage cannot be more than twice the percentage used in applying the straight-line method.
For example, assume that property having a recovery period of 10 years is depreciated under the straight-line method. Depreciation equal to 10 percent of the property’s initial basis would be allowable each year. Under the declining-balance method, up to 20 percent of the basis would be allowable each year (this would be the “double-declining-balance” method). Twenty percent would then be applied to the property’s basis each year as adjusted for previous depreciation.
“Sum-of-the-years-digits” Method
Under this method, a changing percentage, not a fixed percentage, is applied to the basis of the property to calculate allowable depreciation. The fraction is determined as follows:
• The numerator of the fraction is the number of years remaining in the cost recovery period as of the year the depreciation is being claimed.
• The denominator of the fraction is the sequential sum of the numbers representing each year in the total recovery period of the property.
“Sum-of-the-years-digits” Method Example
For example, suppose the recovery period for the property being depreciated under the sum-of-the-years-digits method is 5 years. The denominator of the fraction will be equal to 1+2+3+4+5, or 15. In the first year, the numerator of the fraction will be 5. Therefore for tax purposes in the first year the property will be depreciated by multiplying its basis by 5/15 or 1/3. In the second year, the fraction will be 4/15. Note that the fraction is applied to the original basis of the property under this method (the basis on the date the property was placed in service) and not to the basis as already adjusted for depreciation, as under the declining-balance method.
MACRS
The “modified accelerated cost recovery system” currently applies to most depreciable property placed in service after 1986. Certain property is not depreciated under the MACRS system including most public utility property, motion pictures, sound recordings, intangible property, and property for which a depreciation method not determined by an annual recovery period (such as the unit of production method that is available for certain property) has been elected by the taxpayer. However, most depreciable property placed in service after 1986 is governed by MACRS.
The property “classes” or applicable recovery periods for MACRS are as follows.
3 year - 5 year - 7 year - 10 year - 15 year - 20 year - 27 1/2 year - 39 year -
Typical “Recovery Periods” • Automobiles: 5 years • Computers: 5 years • Office furniture: 7 years • Most heavy machinery: 7 years • Residential real estate: 27.5 years • Nonresidential real estate: 39 years
Example of recapturing of a 1245 asset
Example
Sophie sells a piece of machinery that was used in her business as an architect. Her original cost for the property was $6,600 and the adjusted basis in the machine at the time of the sale is $3,600. The machine is sold for $6,800. Sophie has claimed a total of $3,000 of depreciation deductions for the machine. Her realized gain from the sale is $3,200 ($6,800 sale price – $3,600 adjusted basis). Of that $3,200 in gain, $3,000 is taxable as ordinary income because of depreciation recapture. The balance of Sophie’s gain ($200) is taxable as capital gain. It should be noted that the real gain (that is, the excess of selling price over original cost) is taxed as a capital gain.
The half-year convention is used for all recovery classes of property.
False
The half-year convention is used for all property classes other than real property and certain intangible assets. The recovery deduction for real property is based on the month of the first year that the property was placed in service. The convention used for intangible assets is also based on the month of acquisition.
