Chapter 8 Reading Notes Flashcards
The Internal Revenue Code provides for a deduction for the consumption of the
cost of an asset through
depreciation, cost recovery, amortization, or depletion
Taxpayers may write off the cost of certain assets that are used in a trade or business
or held for the production of income. A write-off may take the form of
depreciation
(or cost recovery), depletion, or amortization
What are two types of property?
real (realty) and personal property
Realty generally includes
land and buildings permanently affixed to the land
Personalty is defined as
any asset that is not realty
Personalty includes
furniture, machinery,
equipment, and many other types of assets. Do not confuse personalty (or
personal property) with personal use property
Personal use property is
any property
(realty or personalty) that is held for personal use rather than for use in a trade or
business or an income-producing activity. Write-offs are not allowed for personal
use assets.
Assets used in a trade or business or for the production of income are eligible
for cost recovery if they are subject to
wear and tear, decay or decline from natural
causes, or obsolescence.
Assets that do not decline in value on a predictable basis
or that do not have a determinable useful life (e.g., land, stock, and antiques) are
eligible for cost recovery
False. They are not eligible
In summary, both realty and personalty can be either
business use/incomeproducing
property or personal use property.
When classifying assets, what 4 things are important.
classification of an
asset (realty or personalty) and the use to which the asset is put (business or personal)
be understood.
The key date for the commencement of depreciation is the date an asset is placed
in
service
The key date for the commencement of depreciation is the date an asset is placed
in service. This date, and not the purchase date of an asset, is the relevant date?
True
MACRS provides separate cost recovery tables for?
realty and personalty
Classification of Property. What property goes into 3 year, 5 year, or 7 year, etc is on what exhibit
exhibit 8.1
MACRS is allowed for what years.
3,5,7, and 10
150 declining balance is allowed for what ears
15 and 20
on qualified property acquired after December 31, 2007, and before January 1,
2009, and placed in service before January 1, 2009. The American Recovery and
Reinvestment Tax Act of 2009 extended additional first-year depreciation for an
additional year (qualified property acquired and placed in service before January
1, 2010). The Small Business Jobs Act of 2010 extended additional first-year depreciation
for one more year (qualified property acquired and placed in service before
January 1, 2011). The provision allows for an additional 50 percent cost recovery in
the year the asset is placed in service. The term qualified property includes most types
of new property other than buildings. The term new means original or first use of
the property. Property that is used but new to the taxpayer does not qualify.
additional first year depreciation
If more than 40 percent of the value of property other than eligible real estate (see
Realty: Recovery Periods and Methods for a discussion of eligible real estate) is placed
in service during the last quarter of the year
a mid-quarter convention applies
MACRS views property as placed in service in the middle of the first year (the
half-year convention).6 Thus, for example, the statutory recovery period for threeyear
property begins in the middle of the year an asset is placed in service and ends
three years later
If your using mid-quarter convention and the 400,000 asset was sold on november 30, how much depreciation is recognized for that asset.
4000,000 * .34 * ((3/5)/4))
Under MACRS, the cost recovery period for residential rental real estate is how many ears.
27.5
Residential rental real estate includes property where 80 percent or more of
the gross rental revenues are
from nontransient dwelling units (e.g., an apartment
building)
Would Hotels, motels, and similar establishments be considered a residential rental real estate
No
Low-income housing is classified as
residential rental real estate
Nonresidential
real estate has a recovery period of
39 years (31.5 years for such property placed in service before May 13, 1993) and is also depreciated using the straight-line method.
For example, single-purpose agricultural structures are what year class
10 year MACRS class
Land improvements are in what year class
15 year MACRS class
All eligible real estate is depreciated using the
mid-month convention
Regardless
of when during the month the property is placed in service, it is deemed to have
been placed in service at
the middle of the month
If you sold a building that costed 800,000 on october 7th and you were using mid-month conventions, how much would be depreciated in the year it was sold?
800,000 * .0363 * (9.5/12) = 23,028
Jane acquired a building on March 2, 1993, for $1 million. If the building is classified as
nonresidential real estate, the cost recovery deduction for 2012 is
$31,740 (.03174 ×
$1,000,000)
If the building is sold on January 5, 2012, the cost recovery deduction for
2012 is
1,323[.03174 × (.5/12) × $1,000,000].
Although MACRS requires straight-line depreciation for all eligible real estate as
previously discussed, the taxpayer may elect to use the _____ ___ ____ for personal property.
straight-line method
Terry acquires a new 10-year class asset on August 4, 2012, for $100,000. He elects the straight-line method of cost recovery. Terry’s cost recovery deduction for 2012 and 2013 is?
Terry’s cost recovery deduction for 2012 is
$5,000 ($100,000 × .050). His cost recovery deduction for 2013 is $10,000 ($100,000 ×
.100). (See Table 8.3 for percentages.)
Assume the same facts as in Example 15, except that Terry sells the asset on Novem
ber 21, 2013. His cost recovery deduction for 2013 is
$5,000 [$100,000 × .100 × (½)
Table 8.3
When tangible personal property is used in a farming business, generally the cost
of the asset is recovered under
MACRS using the 150 percent declining-balance
method.
However, the MACRS straight-line method is required for any
tree or
vine bearing fruits or nuts.13 The cost of real property used in the farming business
is recovered over the normal periods (27.5 years and 39 years) using the straightline
method.
A farming business is defined as the trade or business of farming,
which includes
operating a nursery or sod farm and the raising or harvesting of
trees bearing fruit, nuts, or other crops, or ornamental tree
Under the uniform capitalization
rules, the costs of property produced or acquired for resale must be
capitalized
When this election is made, the cost recovery method required is the
alternative depreciation system (ADS) straight-line method
This method must be applied to all assets placed in service in any taxable
year during which the
election is in effect
James purchased new farm equipment on July 10, 2012, for $80,000. If James does not
elect to expense any of the cost under § 179, his cost recovery deduction for 2012 is
$8,568 [(.1071 × $80,000) (Table 8.4)].
Assume the same facts as in Example 17, except that James has made an election not
to have the uniform capitalization rules apply. His 2012 cost recovery deduction is
His 2012 cost recovery deduction is
$4,000 [(.05 × $80,000) (Table 8.5)]
The recovery period for residential rental
real estate is
27.5 years
For these real property leasehold improvements, the ____ _____ method is used.
straight line
On April 7, 2012, Mary signed a 10-year lease with John on a building to be used for
her business. The lease period begins on May 1, 2012, and ends on April 30, 2022. Prior
to the signing of the lease, John paid $300,000 to have a unique storefront added to
the building. John’s cost recovery deduction for 2012 for the addition is
$4,815
[(.01605 × $300,000)
Assume the same facts as in Example 19. John’s cost recovery deduction for 2022
$2,244 {[.02564 × (3.5/12) × $300,000] (Table 8.6)}.
At the end of the lease, John has to
remove the unique storefront so he can lease the building to other tenants. John’s loss
as a result of the termination of the lease and the removal of the unique storefront is
$223,713 computed as follows: Cost $300,000 Less: Cost recovery 2012 (Example 19) (4,815) 2013–2021 (.02564 × $300,000 × 9 years) (69,228) 2022 (2,244) Loss (unrecovered cost) $223,713
The Tax Relief Act of 2010 allows for ____percent additional first-year depreciation
for a qualified leasehold improvement to an interior portion of a building that is
nonresidential real property
50
A qualified leasehold improvement is an
improvement
made pursuant to a lease by the lessee or lessor and placed in service more
than three years after the date the building was first placed in service.
On June 20, 2012, Jim signed a 15-year lease with Mary on a building, first placed in E X A M P L E 2 1
service five years ago, to be used in his business. The lease period begins July 1, 2012.
Prior to the signing of the lease, Mary paid $200,000 to have the interior of the building
changed for Jim’s business. This change of the interior is a qualified leasehold
improvement. If Mary takes additional first-year depreciation, her cost recovery for
2012 would be
$101,177.
Additional first-year depreciation ($200,000 × .50) $100,000
MACRS cost recovery [($200,000 − $100,000) × .01177 (Table 8.6)] 1,177
Total cost recovery $101,177
Assume the same facts as in Example 21, except that either the building was first E X A M P L E 2 2
placed in service two years ago or the improvement was to the exterior of the building.
In either case, the improvement would not be a qualified leasehold improvement,
and the cost recovery for 2012 would be
$2,354.
MACRS cost recovery [$200,000 × .01177 (Table 8.6)] $2,354
Section 179 is what?
(Election to Expense Certain Depreciable Business Assets) permits the
taxpayer to elect to write off up to $139,000 in 2012 of the acquisition cost of tangible
personal property used in a trade or business
The § 179 expensing election is an
annual election that applies to the acquisition cost of property placed in service
that year?
True
The immediate expense election is generally not available for what two things?
real property
or for property used for the production of income.
In addition, any elected § 179 expense is taken before what?
additional first-year depreciation
is computed
additional first-year depreciation is what?
50 percent for
assets placed in service in 2012
Kelly acquires machinery (five-year class asset) on February 1, 2012, at a cost of
$200,000 and elects to expense $139,000 under § 179. Kelley takes the statutory percentage
cost recovery (see Table 8.1 for percentage) for 2012. As a result, the total
deduction for the year is calculated as follows:
§ 179 expense $139,000
50% additional first-year depreciation [($200,000 − $139,000) × 50%] 30,500
Standard MACRS calculation [($200,000 − $139,000 − $30,500) × .20] 6,100
$175,600
Two additional limitations apply to the amount deductible under § 179. What are they?
First, the
ceiling amount on the deduction is reduced dollar for dollar when § 179 property
placed in service during the taxable year exceeds $560,000 in 2012. Second, the
amount expensed under § 179 cannot exceed the aggregate amount of taxable
income derived from the conduct of any trade or business by the taxpayer.
What is done with Any § 179 expensed amount in excess of taxable income?
arried forward
to future taxable years and added to other amounts eligible for expensing
The § 179 amount eligible for expensing in a carryforward year is limited to the
lesser of (1) the statutory dollar amount ($139,000 in 2012) reduced by the cost of § 179 property placed in service in excess of $560,000 (in 2012) in the carryforward year or (2) the business income limitation in the carryforward year.
Jill owns a computer service and operates it as a sole proprietorship. In 2012, she will
net $80,000 before considering any § 179 deduction. If Jill spends $600,000 on new
equipment, her § 179 expense deduction is computed as follows:
§ 179 deduction before adjustment $139,000
Less: Dollar limitation reduction ($600,000 − $560,000) (40,000)
Remaining § 179 deduction $ 99,000
Business income limitation $ 80,000
§ 179 deduction allowed $ 80,000
§ 179 deduction carryforward ($99,000 − $80,000) $ 19,000
Assume the same facts as in Example 24, and assume that the new equipment is five-
year class property. Jill elects not to take additional first-year depreciation. After considering
the § 179 deduction, Jill’s cost recovery deduction for 2012 (see Table 8.1 for
percentage) is calculated as follows
Standard MACRS calculation [($600,000 − $99,000) × .20] $100,200
A property is converted to personal use if it is not used predominantly in a
trade or business.
Limits exist on MACRS deductions for automobiles and other listed property that
are used for both
personal and business purposes
If the listed property is predominantly
used for business, the taxpayer is allowed to use the
statutory percentage method
to recover the cost.
In cases where the property is not predominantly used for business,
the cost is recovered using the
straight-line method
What is the Listed Property talked about in the previous 2 questions?
• Any passenger automobile.
• Any other property used as a means of transportation.
• Any property of a type generally used for purposes of entertainment, recreation,
or amusement.
• Any computer or peripheral equipment, with the exception of equipment used
exclusively at a regular business establishment, including a qualifying home office.
• Any other property specified in the Regulations.
For listed property to be considered as predominantly used in business, its business
usage must exceed
50 percent
On September 1, 2012, Emma places in service listed five-year recovery property. The
property cost $10,000. She elects not to take additional first-year depreciation. If
Emma uses the property 40% for business and 25% for the production of income. Is the property considered as predominantly used for business?
No so The cost is recovered
using straight-line cost recovery
Using previous problem. Emma’s cost recovery allowance for the year is
$650
$10,000 × 10% × 65%
If, however, Emma uses the property 60% for business and
25% for the production of income, the property is considered as used predominantly
for business. Therefore, she may use the statutory percentage method. Emma’s cost
recovery allowance for the year is
$1,700 ($10,000 × .200 × 85%).
The law places special limitations on the cost recovery deduction for passenger
automobiles. These statutory dollar limits were imposed on passenger automobiles
because of the belief that the tax system was being used to underwrite automobiles
whose cost and luxury far exceeded what was needed for their business use?
True
A passenger automobile is
any four-wheeled vehicle manufactured for use on public
streets, roads, and highways with an unloaded gross vehicle weight (GVW) rating of
6,000 pounds or less
This definition specifically excludes vehicles used directly in
the business of transporting people or property for compensation, such as taxicabs,
ambulances, hearses, and trucks and vans, as prescribed by the Regulations
The following limits apply to the cost recovery deductions for passenger automobiles. What page?
8-17
In the event a passenger automobile used predominantly for business qualifies
for additional first-year depreciation (i.e., new property), the first-year recovery
limitation is increased by
8,000
Therefore, for acquisitions made in 2011, the initial-
year cost recovery limitation increases from what to what? Use table on 8-17
3,060 to 11,060
The cost recovery allowed is the lesser of the
MACRS amount or the recovery limitation.
On July 1, 2012, Dan places in service a new automobile that cost $40,000. He does E X A M P L E 2 7
not elect § 179 expensing. The car is always used 80% for business and 20% for personal
use. Dan chooses the MACRS 200% declining-balance method of cost recovery
(see the 5-year column in Table 8.1). The depreciation computation for 2012–2017 is
summarized below if Dan elects not to take additional first-year depreciation Use page 8-17 to compute
.
The cost recovery allowed is the lesser of the MACRS amount or the recovery limitation.
If Dan continues to use the car after 2017, his cost recovery is limited to the lesser
of the recoverable basis or the recovery limitation (i.e., $1,775 × business use percentage).
For this purpose, the recoverable basis is computed as if the full recovery limitation
was allowed even if it was not. Thus, the recoverable basis as of January 1, 2018,
is
$23,765 ($40,000 − $3,060 − $4,900 − $2,950 − $1,775 − $1,775 − $1,775)
If Dan takes additional first-year depreciation, the calculated amount of additional
first-year depreciation is
$16,000 ($40,000 × 50% × 80%).
However, the recovery
limitation in 2012 would be
$8,848 [($8,000 + $3,060) × 80%].
Note that the cost recovery limitations apply only to
passenger automobiles and
not to other listed property.
The American Jobs Creation Act of 2004 (AJCA) placed a limit of $25,000 on the
§ 179 deduction for certain vehicles not subject to the statutory dollar limits on cost
recovery deductions that are imposed on passenger automobiles. The limit applies
to
sport utility vehicles (SUVs) with an unloaded GVW rating of more than 6,000
pounds and not more than 14,000 pounds
The cost of listed property that does not pass the more-than-50 percent business
usage test in the year the property is placed in service must be recovered using the
straight-line method
If the listed property fails the more-than-50 percent business usage test, the
straight-line method must be used for
the remainder of the property’s life. This
applies even if at some later date the business usage of the property increases to more
than 50 percent.
Excess cost recovery is
the excess of the cost recovery deduction taken in prior years
using the statutory percentage method over the amount that would have been allowed
if the straight-line method had been used since the property was placed in service
How do you find the excess cost recovery when the listed property falls from over 50% business use to lower than 50%?
You find the excess in each year before when the business use was above 50% and add the excess all up for each year above 50%. To find the excess you take the MACRS amount - the straight line amount.
After the business usage of the listed property drops below the more-than-50 percent
level, the _____ ______ _____ must be used for the remaining life of the property even if it goes back up past 50%
straight-line method
A taxpayer who leases a passenger automobile must report an ________ amount in gross income.
inclusion
Listed property is now subject to the substantiation requirements of § 274. This
means that the taxpayer must
prove the business usage as to the amount of expense
or use, the time and place of use, the business purpose for the use, and the business
relationship to the taxpayer of persons using the property
The alternative depreciation system (ADS) must be used for the following 6 things?
• To calculate the portion of depreciation treated as an alternative minimum
tax (AMT) adjustment for purposes of the corporate and individual AMT
(see Chapter 15).34
• To compute depreciation allowances for property for which any of the following
is true:
• Used predominantly outside the United States.
• Leased or otherwise used by a tax-exempt entity.
• Financed with the proceeds of tax-exempt bonds.
• Imported from foreign countries that maintain discriminatory trade practices
or otherwise engage in discriminatory acts.
• To compute depreciation allowances for earnings and profits purposes (see
Chapter 19)
In general, ADS depreciation is computed using
straight-line recovery without
regard to salvage value
However, for purposes of the AMT, depreciation of personal
property is computed using
the 150 percent declining-balance method with
an appropriate switch to the straight-line method.
Polly acquires an apartment building on March 17, 2012, for $700,000. She takes the
maximum cost recovery allowance for determining taxable income. Polly’s cost recovery
allowance for computing 2012 taxable income is
$20,153 [$700,000 × .02879 (Table
8.6)].
Polly acquires an apartment building on March 17, 2012, for $700,000. She takes the
maximum cost recovery allowance for determining taxable income. Polly’s cost recovery
allowance for computing 2012 taxable income is $20,153 [$700,000 × .02879 (Table
8.6)]. However, Polly’s cost recovery for computing her earnings and profits is only
$13,853 [$700,000 × .01979 (Table 8.7)].
Taxpayers can claim an _________ deduction on intangible assets called “amortizable
§ 197 intangibles
amortization
An amortizable § 197 intangible is any
§ 197 intangible acquired after August 10, 1993,
and held in connection with the conduct of a trade or business or for the production of
income
Section 197 intangibles include
goodwill and going-concern value, franchises,
trademarks, and trade names. Covenants not to compete, copyrights, and patents are
also included if they are acquired in connection with the acquisition of a business
Generally,
self-created intangibles are § 197 intangibles
False. They are not
are also partially amortizable under § 195. This treatment is
available only by election.38
startup expenditures
The elective treatment for startup expenditures allows the taxpayer to deduct
the lesser of
(1) the amount of startup expenditures with respect to the trade or business or (2) $5,000, reduced, but not below zero, by the amount by which the
startup expenditures exceed $50,000
Green Corporation begins business on August 1, 2012. The corporation has startup
expenditures of $47,000. If Green Corporation elects § 195, the total amount of startup
expenditures that Green Corporationmay deduct in 2012 is
$6,167, computed as follows:
Deductible amount $5,000
Amortizable amount {[($47,000 − $5,000)/180] × 5 months} 1,167
Total deduction $6,167
Assume the same facts as in Example 39, except that the startup expenditures are
$53,000. The total deduction for 2012 is
$3,417, computed as follows:
Deductible amount [$5,000 − ($53,000 − $50,000)] $2,000
Amortizable amount {[($53,000 − $2,000)/180] × 5 months} 1,417
Total deduction $3,417
Expenditures that are subject to capitalization and elective amortization under
§ 195 as startup expenditures generally must satisfy two requirements
First, the
expenditures must be paid or incurred in connection with any one of the following:
• The creation of an active trade or business.
• The investigation of the creation or acquisition of an active trade or business.
• Any activity engaged in for profit in anticipation of such activity becoming an
active trade or business.
Second, such costs must be the kinds of costs that would be currently deductible
if paid or incurred in connection with the operation of an existing trade or business
in the same field as that entered into by the taxpayer.
Natural resources (e.g., oil, gas, coal, gravel, and timber) are subject to
depletion
generally
cannot be depleted
land
The owner of an interest in the natural resource is entitled to
deduct depletion
In developing an oil or gas well, the producer must make four types of expenditures:
- Natural resource costs.
- Intangible drilling and development costs.
- Tangible asset costs.
- Operating costs.
Natural resources are physically limited, and the costs to acquire them (e.g., oil
under the ground) are, therefore, recovered through depletion. Costs incurred in
making the property ready for drilling, such as the cost of labor in clearing the
property, erecting derricks, and drilling the hole, are
intangible drilling and development
costs (IDC)
Costs for tangible assets such as tools, pipes, and engines are capital
in nature. These costs must be capitalized and recovered through
depreciation
cost recovery
Costs incurred after the well is producing are operating costs.
These costs would include expenditures for such items as labor, fuel, and supplies.
Operating costs are deductible when
incurred (on the accrual basis) or when paid
on the cash basis
Intangible drilling and development costs can be handled in one of two ways at the
option of the taxpayer
They can be either charged off as an expense in the year in
which they are incurred or capitalized and written off through depletion
As a general rule, it is more advantageous to
expense IDC. The obvious benefit
of an immediate write-off (as opposed to a deferred write-off through depletion) is
not the only advantage. Because a taxpayer can use percentage depletion, which is
calculated without reference to basis (see Example 44), the IDC may be completely
lost as a deduction if they are capitalized.
There are two methods of calculating depletion
cost and percentage
can be used on any wasting asset (and is the only method allowed for timber).
cost depletion
is subject to a number of limitations, particularly for oil and
gas deposits
percentage depletion
Depletion should be calculated both ways, and the method that results
in the larger ________ should be used.
deduction
The choice between cost depletion and
percentage depletion is an annual election. Thus, the taxpayer can use cost depletion
in one year and percentage depletion in the following year?
True
Cost depletion is determined by using
the adjusted basis of the asset.
When finding cost deletion, how do you find the depletion per unit?
adjusted basis/estimated recoverable units
How do you find cost depletion
depletion per unit * units sold. Do not use units produced
Percentage depletion (also referred to as statutory depletion) is a specified percentage provided for in
the code
The percentage varies according to the type of mineral
interest involved. A sample of these percentages is shown in Exhibit 8.3 on 8-27. The
rate is applied to the
gross income from the property, but in no event may percentage
depletion exceed 50 percent of the taxable income from the property before
the allowance for depletion
Assuming gross income of $100,000, a depletion rate of 22%, and other expenses E X A M P L E 4 3
relating to the property of $60,000, the depletion allowance is determined as
follows:
Gross income $100,000 Less: Other expenses (60,000) Taxable income before depletion $ 40,000 Depletion allowance [the lesser of $22,000 (22% × $100,000) or $20,000 (50% × $40,000)] (20,000) Taxable income after depletion $ 20,000
Iris purchased the rights to an oil interest for $1 million. The recoverable barrels were
estimated to be 200,000. During the year, 50,000 barrels were sold for $2 million. Regular
expenses amounted to $800,000, and IDC were $650,000. If the IDC are capitalized,
the depletion per unit is
$8.25 ($1,000,000 + $650,000 ÷ 200,000 barrels)
The treatment of IDC has an effect on the depletion deduction in two ways.
If the
costs are capitalized, the basis for cost depletion is increased. As a consequence, the cost depletion is increased. If IDC are expensed, they reduce the taxable
income from the property. This reduction may result in application of the provision
that limits depletion to 50 percent (100 percent for certain oil and gas wells)
of taxable income before deducting depletion.
See example 44 on page 8-28 to see more what happens when adding IDC
.
If a taxpayer has a new business with little income or a business with a net operating
loss carryover, the taxpayer’s goal may be to slow down cost recovery. In such a
situation, the taxpayer should:
• Elect not to take additional first-year depreciation.
• Choose the straight-line cost recovery method.
• Make no election under § 179.
• Defer placing assets in service in the current tax year or postpone capital outlays
until future tax years.
When a business is purchased, goodwill and covenants not to compete are both
subject to a statutory amortization period of 15 years. Therefore, the purchaser
does not derive any
tax benefits when part of the purchase price is assigned to a
covenant rather than to goodwill.
