Lesson 4 of Income Tax Planning: Depreciation, Amortization, and Depletion

Question 1

Introduction to Cost Recovery!
(heading)

Answer 1

Cost of Business or Income Producing Assets is Recovered Through

What is Depreciation?

The Purpose of Depreciation?

Question 2

Cost of Business or Income Producing Assets is Recovered Through

Answer 2

Cost recovery or depreciation for tangible assets

Amortization for intangible assets, and

Depletion for natural resources.

Question 3

What is Depreciation?

Answer 3

Depreciation is an annual income tax deduction
that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration or obsolescence of the property.

Question 4

The Purpose of Depreciation?

Answer 4

The purpose of depreciation is to
match the cost of a productive asset (that has a useful life of more than a year) to the revenues earned from using the asset.

Question 5

The Basis in an asset is reduced by?

Answer 5

The basis in an asset is reduced by the amount of cost recovery that is allowed or allowable.

Question 6

What Can Be Depreciated?

Answer 6

Most types of tangible property (except land) can be depreciated, such as buildings, machinery, vehicles,furniture, and equipment.

Certain intangible property is also depreciable, such as patents, copyrights, and
computer software.

Question 7

To be Depreciable, the property must meet the following requirements:

Answer 7

It must be property you own.

It must be used in your business or income-producing activity

It must have a determinable useful life.

It must be expected to last more than one year.

Question 8

Property That CANNOT be Depreciated

Answer 8

You cannot depreciate property that you use solely for personal activities.

• If you use property for business or investment purposes and for personal purposes, you can deduct
  depreciation based only on the business or investment use.

Cannot Depreciate Inventory, because it is not held for use in your business. it is held for sale to customers.

Cannot Depreciate the cost of land. Land does not wear out or become obsolete. Cost of land includes clearing, grading, planting, and landscaping.

• You can depreciate certain land preparation costs, such as landscaping costs, incurred in preparing land for business use. These costs must be so closely associated with other depreciable property that you can determine a life for them along with the life of the associated property.

Question 9

Example

Answer 9

Rick constructed a new building for use in his business and paid for grading, clearing, seeding, and planting of bushes and trees. Some of the bushes and trees were planted right next to the building, while others were planted around the outer border of the lot. If Rick had to replace the
building, he would have to destroy the bushes and trees right next to it.

These bushes and trees are closely associated with the building, so they have a determinable useful life. Therefore, Rich can depreciate
them. Rick should add his other land preparation costs to the basis of his land; however, because they have no determinable life, Rick cannot depreciate them.

Question 10

The Following can NEVER be Depreciated, as it is expected property.

Answer 10

Property placed in service and disposed of in the
same year.

Certain term interests.

Equipment used to build capital impprovements. You must add otherwise allowable depreciation on the equipment during the period of construction to the basis of your improvements.

Section 197 intangibles. You must amortize these costs. Intangible property, such as certain computer software, that is not Section 197 intangible property, can be depreciated if it meets certain requirements.
-Example Goodwill.

Question 11

When Does Depreciation Begin and End?

Answer 11

Depreciation begins when you place the depreciable property in service for use in your trade or business or for the production or income.

Depreciation stops when the taxpayer has fully recovered his cost or other basis or
when the taxpayer retires the property from service, whichever happens first.

Question 12

Example of When Depreciation Begins and Ends

Answer 12

On April 6, Roberta bought a house to use as residential rental property. She made several
repairs and had it ready to rent on July 5. At that time, she began to advertise it for rent in the
local newspaper. The house is considered placed in service in July when it was ready and available for rent. She can begin to depreciate it in July even if the house is not actually rented until a
later date.

Question 13

Property Is Retired From Service When?

Answer 13

Property is retired from service when it is permanently withdrawn from use in a trade or business or from use in the production of income because of any of the following events:

-The property is sold or exchanged,
-The property is converted to personal use,
-The property is abandoned,
-The property is transferred to a supplies or scrap account, or
-The property is destroyed.

Question 14

What do ACRS and MACRS Stand For?

Answer 14

Accelerated Cost Recovery System

Modified Accelerated Cost Recovery System

Question 15

ACRS and MACRS apply to?

Answer 15

Assets placed in service after 1980,

Assets subject to wear and tear, obsolescence, etc.

Assets must have a determinable useful life, and

Assets that are tangible personalty or realty.

Note that MACRS must be used to depreciate most property.

Question 16

Methods of Depreciation!

Answer 16

Straight Line Method

ACRS

MACRS

Question 17

Straight Line Method (SLM)

Answer 17

This method of depreciation allows the taxpayer to deduct the same amount of depreciation each year over the useful life of the property.

Question 18

To Calculate Depreciation Deduction

Answer 18

First determine Adjusted Basis, Salvage Value, and Estimated Useful Life.

1. Subtract Salvage value, if any, from the adjusted basis.
2. The balance is the total depreciation you can take over the useful life of property. The Depreciable Amount.
3. Divide the balance by number of years in useful life. This gives you yearly depreciation deduction.

Unless there is a big change in useful life or adjusted basis, this amount will stay the same throughout the time you depreciate the property.

If, in the first year, you use the property for less than a full year, you must prorate your depreciation deduction for the number of monthsin use.

Question 19

Annual Depreciation Deduction Formula

Answer 19

Question 20

Example

Answer 20

In April, Hans bought a patent for $5,100 that is not a Section 197 intangible. He depreciates the
patent under the straight line method, using a 17-year useful life and no salvage value divides the $5,100 basis by 17 years to get his $300 yearly depreciation deduction.

He only used the patent for 9 months during the first year, so he multiplies $300 by 9/12 to get his deduction of $225 for the first vear. Next year, Hans can deduct $300 for the full year.

Question 21

If you can depreciate the cost of a patent or copyright use the?

Answer 21

Use the straight line method over the useful life.

• The useful life of a patent or copyright is the lesser of the life granted to it by the government or the remaining life when you acquire it.
• If the patent or copyright becomes valueless before the end of its useful life, you can deduct any of its remaining cost or other basis in that year.

Question 22

Computer Software

Answer 22

Computer software is considered an intangible under IRC Section 197 and cannot be depreciated if it was acquired in connection with the acquisition of assets constituting a business or a substantial part of a business.

Computer software is not a Section 197 intangible, however, and can
be depreciated even if acquired in
connection with the acquisition of a business, if:

It is readily available for purchase by the general public,

It is subject to a nonexclusive license, and

It has not been substantially modified.

• If the software meets the tests above, it may also qualify for the Section 179 deduction and the special depreciation allowance, discussed later. If you can depreciate the cost of computer software, use the straight line method over a useful life of 36 months.

Question 23

Accelerated Cost Recovery System (ACRS)

Answer 23

ACRS is a system of depreciation introduced by the Economic Recovery Tax Act of 1981.

ACRS Depreciation is based on recovery periods instead of useful life. Periods are predetermined by the IRS.

The MACRS replaced ACRS for property placed into service after 1986.

Question 24

Modified Accelerated Cost Recovery System (MACRS)

Question 25

You Cannot Use MACRS to Depreciate the Following Property

Answer 25

Property placed in service before 1987.

Certain property owned or used in 1986.

Intangible property.

Films, video tapes, and recordings.

Certain corporate or partnership property acquired in a nontaxable transfer.

Property you elected to exclude from MACRS.

Question 26

MACRS Consists of 2 Depreciation Systems

Answer 26

Alternative Depreciation System (ADS)

General Depreciation System (GDS)

Question 27

Alternative Depreciation System (ADS) Must be Used for the Following Property:

Answer 27

Listed property used 50% or less in a qualified business use.

Any tangible property used predominantly outside the United States during the year.

Any tax-exempt use property.

Any tax-exempt bond-financed property.

All property used predominantly in a farming business and placed in service in any tax year during which an election not to apply the uniform capitalization rules to certain farming costs is in effect.

Any property imported from a foreign country for which an Executive Order is in effect because
the country maintains trade restrictions or engages in other discriminatory acts.

Question 28

The Nine Property Classifications under GDS

Answer 28

3 Year
5 Year
7 Year
10 Year
15 Year
20 Year
25 Year
27.5 Year
39 Year

Question 29

3 Year Property

Answer 29

-Tractor units for over the road use.
-Race Horse 2+ years in service.
-Any Other Horse 12+ years in service.
-Rent to own property.

Question 30

5 Year Property

Most Likely to be be Tested.

Answer 30

Automobiles, taxis, buses, and trucks.

Computers and peripheral equipment.

Office machinery (such as typewriters, calculators. and copiers)

Any property used in research and experimentation.

Breeding cattle and dairy cattle.

Appliances, carpets, furniture, etc., used in a residential rental real estate activity.

Certain geothermal, solar, and wind energy property.

Question 31

7 Year Property

Most Likely to Be Tested

Answer 31

Office furniture and fixtures (such as desks, files, and safes).

Agricultural machinery and equipment.

Any property that does not have a class life and has not been designated by law as being in any
other class.

Certain motorsports entertainment complex property (defined later) through December 31, 2020.

Any natural gas gathering line placed in service after April 11, 2005. Natural gas gathering line,
natural gas distribution line, and electric transmission property (defined

Question 32

10 Year Property

Answer 32

Vessels, barges, tugs, and similar water transportation equipment.

Any single purpose agricultural or horticultural structure.

Any tree or vine bearing fruits or nuts.

Question 33

15 Year Property

Answer 33

Certain improvements made directly to land or added to it (such as shrubbery, fences, roads, and
bridges).

Any retail motor fuels outlet (defined later), such as a convenience store.

Any municipal wastewater treatment plant.

Any qualified leasehold improvement property (defined later) placed in service before January 1.

Any qualified restaurant property (defined later) placed in service before January 1, 2008.

Initial clearing and grading land improvements for gas utility property.

Electric transmission property (that is Section 1245 property) used in the transmission at 69 or
more kilovolts of electricity placed in service after April 11, 2005.

Any natural gas distribution line placed in service after April 11. 2005

Question 34

20 Year Property

Answer 34

Farm buildings (other than single purpose agricultural or horticultural structures).

Municipal sewers not classified as 25-year property.

Initial clearing and grading land improvements for electric utility transmission and distribution
plants.

Question 35

25 Year Property

Answer 35

This class is water utility property, which is either of the following;

• Property that is an integral part of the gathering, treatment, or commercial distribution of
  water, and that, without regard to this provision, would be 20-year property.
• Municipal sewers other than property placed in service under a binding contract in effect at all
  times since June 9, 1996.

Question 36

27.5 Year Property

Most likely to be tested.

Answer 36

Residential rental property.

This is any building or structure, such as a rental home (including a mobile home), if 80% or more
of its gross rental income for the tax year is from dwelling units.

A dwelling unit is a house or apartment used to provide living accommodations in a building or
structure. It does not include a unit in a hotel, motel, or other establishment where more than half the units are used on a transient basis.

If the taxpayer occupies any part of the building or structure for personal use, its gross rental
income includes the fair rental value of the part the taxpayer occupies.

Uses the mid month convention.

Question 37

39 Year Property

Most likely to be tested.

Answer 37

Nonresidential real property.

This is Section 1250 property, such as an office building, store, or warehouse, that is neither
residential rental property nor property with a class life of less than 27.5 years.

Uses the mid month convention.

Question 38

CAT O R N

Answer 38

CAT = Computer, automobile, trucks. 5 year, 1245 recapture.

O = Office Furniture 7 year, 1245 recapture

R = Residential real property, 27.5 year, 1250 recapture.

N = Nonresidential real property, 39 year, 1250 recapture.

Ways to Remember 5, 7, 27.5, and 39 Year Property

Question 39

Exam Tip

Answer 39

Just know that nonresidential rental property and residential rental property uses the mid-month convention.

Question 40

Under MACRS, what does Averaging the Conventions Establish?

Answer 40

Under MACRS, averaging conventions establish when the recovery period begins and ends. The convention you use determines the number of months for which you can claim depreciation in the year you place property in service and in the year you dispose of the property.

Question 41

The Three Mid Convention Methods?

Answer 41

Mid-Month Convention

Mid-Quarter Convention

Half-Year Convention

Question 42

Mid Month Convention

Answer 42

Use this convention for nonresidential real property and residential rental property.

Under this convention, you treat all property placed in service or disposed of during a month as placed in service or disposed of at the midpoint of the month.

This means that a one-half month of depreciation is allowed for the month the property is placed in service or disposed of.

Question 43

Mid Quarter Convention

Answer 43

The mid-quarter convention. Use this convention if the mid-month convention does not apply and the total depreciable basis of MACRS property you placed in service during the last 3 months of the tax year (excluding nonresidential real property and residential rental property, property placed in service and disposed of in the same year, and property that is being depreciated under a method other than MACRS) are more than 40% of the total depreciable bases of all MACRS property you placed in service during the entire year.

Under this convention, you treat all property placed in service or disposed of during any quarter of the tax year as placed in service or disposed of at the midpoint of that quarter. This means that 1.5 months of depreciation is allowed for the quarter the property is placed in service or disposed of.

Question 44

Half Year Convention

Answer 44

Use this convention if neither the mid-quarter convention nor the mid-month convention applies.

Under this convention, you treat all property placed in service or disposed of during a tax year as placed in service or disposed of at the midpoint of the year. This means that a one-half year of depreciation is allowed for the year the property is placed in service or disposed of.

Question 45

MACRS Provides how many depreciation methods under the GDS and how many under the ADS?

Answer 45

The 200% declining balance method over a GDS recovery period.

The 150% declining balance method over a GDS recovery period.

The Straight Line method over a GDS recovery period.

The Straight Line method over an ADS recovery period.

Question 46

Various Depreciation Methods

Answer 46

The Following Chart Summarizes when the various depreciation methods are used.

Question 47

How to Figure Out the Depreciation Deduction under MACRS?

Answer 47

1. First determine the depreciation system, property class, placed-in-service date, basis amount, recovery period, convention, and depreciation method that applies to the property.
2. Then, figure the depreciation deduction. It can be figured using a percentage table provided by the IRS, or it can be figured without using the table.

Question 48

Example

Answer 48

Ginny bought and placed an asset in service on March 15. Ginny’s tax year end is December 31.
Ginny’s asset is treated as placed in service June 30. Ginny will have six months cost recovery in
year 1 (and the year disposed of, if within recovery period).

Question 49

Example

Answer 49

In February, YR1, you placed in service depreciable property with a 5-year recovery period and a basis of $1,000. You do not elect to take the Section 179 deduction and the property does not qualify for a special depreciation allowance. You use MACRS (GDS) and the 200% declining balance (DB) method to figure your depreciation. You did not place any property in service in the last 3 months of the year, so you must use the half-year convention.

Question 50

Depreciation of a 5 Year Asset Using MACRS (GDS)

Answer 50

Question 51

MACRS Chart on CFP Exam Explanation

Answer 51

In most instances, the MACRS chart will be provided if you are required to calculate depreciation. The MACRS chart would look similar to the chart below. If this information is needed during the CFP Board exam, an exhibit
will be available for viewing on that question.

Question 52

MACRS Chart

Answer 52

Question 53

MACRS Chart

Answer 53

Question 54

Exam Question

Robin purchased a computer for her office and paid $2,000. Using MARS cost recovery and
the above chart, how much depreciation can Robin recognize in the first year?
a) $500
b) $1,000
c) $400
d $2,000

Answer 54

Answer: C

The computer that Robin purchased is 5-year property. Therefore, in the first year, Robin can
deduct 20% of the cost of the computer or $400 ($2,000 x20%)

Question 55

Election to Expense Assets - Section 179!

Answer 55

General Rules

Income Tax Planning

Question 56

General Rules

Answer 56

Can elect to immediately expense up to $1,160,000 (for 2023) of business tangible property placed in service during the year.

Cannot use Section 179 for realty or production of income property.

The amount expensed reduces depreciable basis.

Cost recovery available on remaining basis.

Question 57

Income Tax Planning

Answer 57

The Section 179 deduction is the lesser of:

-Property Placed in Service (PPS),

-Taxable Income (TI), or

-Threshold of $1,160,000 phased out for PPS > $2,890,000.

Question 58

Example

Eugene had taxable business income of $10,000 during the year and placed $200,000 of Section
179 qualifying property in service. What is Eugene’s maximum 179 deduction?

Answer 58

Answer: $10,000

Lesser of (a) PPS = $200,000. (b) TI = $10,000, or (c) $1,160,000

Question 59

Example

Kevin had taxable business income of $1,000,000 during the year and placed $100,000 of Section 179 qualifying property in service. What is Kevin’s maximum 179 deduction?

Answer 59

Answer: $100,000

Lesser of (a) PPS = $100,000. (b) TI = $1,000,000, or (c) $1,160,000

Question 60

Example

Joe had taxable business income of $6,000,000 during the year and placed $2,035,000 of Section 179 qualifying property in service. What is Joe’s maximum 179 deduction?

Answer 60

Answer: $1,160,000

Lesser of (a) PPS = $2,035,000, (b) TI = S6M, or (c) $1,160,000.

Question 61

Exam Question

Kevin and Pete own and operate K&P, Inc, a manufacturer of custom bikes. This year they
purchased a new metal cutting machine that cost $2,100,000. Assuming K&P, Inc. has taxable
income of $3,250,000 after taking the maximum 179 deduction, how much was their taxable
income before the deduction?

a) $1,160,000
b) $2,890,000
c) $4,410,000
d) $3,250,000

Answer 61

Answer: C

K&P, Inc. has sufficient taxable income before the 179 deduction since after the deduction tax-
able income is still greater than zero so we do not need to worry about any threshold there. They
placed in service $2,100,000 of property. Therefore, the maximum deduction of $1,160,000 will be used.

If the 179 deduction was $1,160,000 then their taxable income before the deduction was
$4,410,000.

Question 62

Bonus Depreciation (New TCJA 2017)

Answer 62

Immediate 100% first year deduction for qualified new or used equipment acquired and placed in
service after 9/27/2017 and before 1/1/2023.

Question 63

Amortization of Intangible Assets

Answer 63

Certain intangible assets are amortized over 15 years.

Assets subject to amortization include:
- goodwill
- trademarks
- covenants not to compete, and
- copyrights and patents used in a trade or business

Question 64

Special Depreciation Issues

Answer 64

Natural resources other than land are subject to depletion.

The two depletion methods:
- cost
- percentage.

Question 65

Cost Depletion Method

Answer 65

With the cost depletion method, the asset basis is divided by the estimated total number of recoverable units of the assets and then multiplied by the number of units sold (not produced) to determine the
amount of the deduction for the year.

Question 66

Percentage Depletion Method

Answer 66

With the percentage depletion method, a statutory percentage is applied to the gross income from the property (limited to 50% of the gross income).