Cost Recovery Concepts

Question 1

Depreciation

Answer 1

systematic allocation of asset cost over its estimated economic life, creates deductions for tangible property used in business, to enable cost recovery

Question 2

Depreciation methods

Answer 2

-Prior to 1981: IRC 167 -financial accounting principles
-1/1/1981-12/31/1986: Section 168 ACRS
- After 1986: IRC Section 168 ACRS: MACRS (accelerated not permissible for real property) and Section 197 (intangible assets)

Question 3

Types of property

Answer 3

Tangible: real or personal, cost other than land is systematically written off through depreciation or depletion
Intangible: no physical substance, eg stocks, bonds patents- cost written off through amortization

Question 4

Factors in deciding capitalization over expense

Answer 4

Betterment/improves life of asset -would be depreciated/amortized (added back into basis of property) versus maintenance

Question 5

Conversion of personal use property

Answer 5

Any tangible/intangible/real/personal property that is used by taxpayer for own use that is converted for business or income producing use, then the basis for depreciation is the lesser of adjusted basis or FMV on conversion date

Question 6

Half-year convention

Answer 6

Used in year of acquisition & zero salvage value assumed, required for MACRS.
all tangible personal property - assumes acquisitions/dispositions made at midpoint of tax year. Mid-month convention for real-estate

Question 7

Mid-Quarter convention

Answer 7

applies when 40% of firm’s assets placed in service in the 4th quarter

Question 8

How to use MACRS table

Answer 8

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 9

MACRS for real property

Answer 9

Residential rental property: 27.5years (property from which 80% of gross rental income is from dwelling)
Non-residential real property: 39 years- any real property other than residential rental property

Question 10

Alternative Depreciation system (ADS)

Answer 10

required for certain property:
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 11

Limitations and rules for Section 179 election

Answer 11

• property must be purchased for use in active trade/business
• cannot be acquired from a related party/gift/inheritance
• tax benefits are recaptured if property is converted to personal use
• permanent at $1MM. 2023: $1,160,000. Businesses with over $2.89MM of purchases in qualifying equipment have the deduction phase out dollar-for-dollar and eliminated above $2.89MM
• cannot exceed taxpayer’s taxable income, if over, can carry over for unlimited years and added to other future eligible amounts. Special break is made for a sole proprietor

Question 12

Listed property rules

Answer 12

Business usage (for convenience of employer and required as employment condition) of the following need to be >50% to be able to use MACRS for the business use portion. If <50%, must use ADS:
-automobiles
computers & peripheral equipment
-mobile phones
-property generally used for entertainment, recreation or amusement

Question 13

Recapture of excess cost-recovery deductions

Answer 13

If business-use percentage falls below 50%, then ADS must be used for current and all future years, and excess depreciation is recaptured as income

Question 14

1231 property recapture

Answer 14

depreciable business property held LT (benefit of capital gain treatment or ordinary loss treatment, limited by recapture of depreciation in 5 year period):
-timber, coal, domestic iron ore
-livestock
-unharvested crop

-all property used in trade/business
-all property held for production of income

Question 15

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.

Answer 15

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 16

1245 property recapture

Answer 16

subcategory of 1231 property- depreciable business-use property, which is NOT real estate. Gain is captured as ordinary income cannot exceed amount of depreciation (cost recovery)

Question 17

1250 property recapture

Answer 17

all real property subject to allowance for depreciation and is not/has never been section 1245 property (does not include fee simple interest in land since not depreciable).
1250 recapture uses accelerated depreciation:
-residential rental real estate placed in service before 1987
-non residential real estate before 1981
Amount of recapture (taxed as ordinary income) is the difference between what was taken and what would have been allowed if SL method was used. Any gain beyond recaptured amount is taxed as 1231 capital gain, which is subject to unrecaptured 1250 gain rule at 25%

Question 18

Unrecaptured 1250 gain

Answer 18

-residential rental properties before 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 19

Limitations on Luxury automobiles

Answer 19

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
This change applies to property placed in service after Dec. 31, 2017.

Question 20

Section 197

Answer 20

Amortization of intangible assets acquired with trade/business/income producing activity over 15 years, beginning with month of acquisition (does not apply to internally created patents/copyrights that are amortized over 17/28 years)

-Goodwill (value that is attributable to expected patronage due to business name/trade
- going concern is added value attached to 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 21

Treatment of intangible assets

Answer 21

If held more than a year, then treated as a depreciable property / 1231 treatment. Gain is subject to depreciation recapture under Section 1245.
Loss on disposition is not deductible if other intangibles acquired at the same asset acquisition are retained, in which case the basis of the retained Section 197 intangibles is increased by the unrecognized loss

Question 22

Research and Experimental (R&E) expenditures (Section 174)

Answer 22

• Expense in the year paid/incurred
• defer & amortize costs as ratable deduction over 60 months or more
  -capitalize and write off costs only when the research project is abandoned or worthless

-Election to expense/defer & amortize costs in initial year must be made; otherwise capitalized
-20% tax credit applies to certain incremental research expenditures even if expensed under 174

Question 23

When would ADS be preferred over MACRS?

Answer 23

To reduce deductions and allow business to report a marginal gain instead of marginal loss and avoid hobby loss rule. Also if anticipating losses during next few years/currently has net operating loss carryovers. Elective provision made on year by year basis; however once made for a specific property is irrevocable, may still elect bonus depreciations as long as assets would have qualified under MACRS

Question 24

Units of Production depreciation

Answer 24

Under 168, property may be excluded from MACRS system if taxpayer can express useful life of machine in other terms like machine hours, then it may be depreciated over a much shorter time than 7 years

Question 25

Tax planning considerations when acquiring assets of company

Answer 25

Purchaser should allocate part of purchase price to amortize Section 197 intangible assets like goodwill, covenant not to compete, patents etc to recover costs within 15 years instead of allocating to depreciable real estate over 39 years

Question 26

Reporting as business, taxpayers as investors, employees who own a business property, non-corporate taxpayers, and S corporations

Answer 26

• If sole proprietor, then depreciation, cost recovery, depletion, and amortization deductions are reported on reported on Form 4562, totals carried to Schedule C
  -Depletion and depreciation on rental properties are reported on Schedule E
  -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 27

Research and Experimental Expenditures

Answer 27

The election to expense or defer R&E expenditures is made by attaching a statement to the tax return for the first tax year in which the expenditures are incurred. Once the election is made, it is applicable to all R&E expenditures paid or incurred in the current and subsequent years.

Question 28

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.

Answer 28

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 29

The amount of unrecaptured 1250 gain that is attributable to depreciation, is taxed at a rate of _____.

Answer 29

25%

Question 30

Classifications of personal property

Answer 30

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 31

Under the MACRS system, office furniture, equipment, and most types of machinery are classified as ____________ property.

Answer 31

7-Year property

Question 32

To determine the holding period of an asset, the day of acquisition is _________ and the disposal date is _________.

Answer 32

the day of acquisition is excluded; the disposal date is included

Question 33

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)

Answer 33

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 34

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

Answer 34

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 35

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 ___________.

Answer 35

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 36

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.

Answer 36

4562 (Depreciation and Amortization)

Question 37

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.

Answer 37

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 38

Sid made a personal loan to his friend Adele in the amount of $55,000. Adele has received net investment income of $2,250 from loan funds. The current Applicable Federal Rate is 4.5% and the Consumer Price Index is 3.5%.

Calculate the imputed interest on Sid’s loan.

Answer 38

When loans are greater than $10,000 and up to and including $100,000, the imputed interest is the lesser of the AFR or the borrower’s net investment income. If the borrower’s net investment income is $1,000 or less, imputed income will not apply.

Since Adele’s net investment income is above $1,000 and Sid’s loan is between $10,000 and $100,000, the imputed interest is the lesser of the AFR applied to the loaned amount ($55,000 x 0.045 = $2,475) or the net investment income ($2,250). In this instance, the imputed interest will be $2,250.