Tax 3-2 Analyze a situation to determine the correct treatment for property related expenditures.

Question 1

Capital expenditures, like improvements

a. Currently deductible
b. Not currently deductible
c. Currently deductible but can be recovered over a specified period of time

(3-2, pg 12 of text)

Answer 1

Not currently deductible but can be recovered over a specified period of time

A capital expenditure is incurred in the purchase of property or for improvements to property that extend beyond the tax year or provide a benefit for more than one tax year. The taxpayer is typically not allowed a full deduction for these expenditures in the year the property is acquired or in the year these expenses are incurred for the improvements. Rather, the taxpayer can recover the cost of these expenses over a specified period of years through depreciation or cost recovery, amortization, or depletion.

Question 2

Personal expenditures like life/home insurance premiums, home maintenance costs

a. Currently deductible
b. Not currently deductible
c. Currently deductible but can be recovered over a specified period of time

(3-2, pg 16)

Answer 2

Generally not deductible

Examples of this type of expense include premiums paid for life insurance by the insured, the cost of insuring a personal residence, and the costs incurred to maintain a household, such as rent, water, and utilities. These types of expenses, for the most part, are never deductible by the taxpayer. There are, however, some exceptions to this general rule, such as interest on a home mortgage, charitable contributions, unreimbursed medical expenses, and gambling losses to the extent of gambling winnings. All of these are personal expenses incurred by the taxpayer that can also be deducted.

Question 3

Management, repairs

a. Currently deductible
b. Not currently deductible
c. Currently deductible but can be recovered over a specified period of time

(3-2, pg 16)

Answer 3

Currently deductible

Internal Revenue Code Section 162 provides the authority for the second type of expense (those that are currently deductible). It states that the taxpayer can
deduct ordinary and necessary expenses incurred to carry on a trade or business in the year they are incurred.

This type of expense includes expenses for management, certain commissions, labor, supplies, incidental repairs, advertising, and other selling expenses.

Question 4

Any cost associated with the acquisition of an asset must be _____.

(3-2, pg 18)

Answer 4

Capitalized

Capitalizing a cost simply means that the cost of the expenditure is added to the basis of the property. If an individual purchases stock and incurs commission
expenses, these commissions are capitalized, added to the basis of the stock. If the individual purchases equipment for use in his or her business, any acquisition costs would be capitalized. These capitalized costs may include sales taxes, freight, installation charges, or legal fees.

Question 5

An important distinction that must be made is the difference between an improvement and a repair.

A _____ merely maintains an asset in normal working condition.

(3-2, pg 18)

Answer 5

Repair

Generally, a repair to business or investment property (a rental home, for example) is a currently deductible expense

For example, the cost of replacing a couple of shingles on the roof of a rental property would likely be a repair, and would be currently deductible.

Question 6

An important distinction that must be made is the difference between an improvement and a repair.

An _____ materially prolongs the life or the value of the asset involved, or adapts it to a new use.

(3-2, pg 18)

Answer 6

Improvement

Generally, an improvement to business or investment property (a rental home, for example) must be capitalized.

The cost of replacing the entire roof has been deemed by the IRS to be an improvement, and the cost would be recovered using depreciation deductions over a period of years.

Recently issued temporary regulations also require that expenses that would normally be classified as repairs are instead treated as improvements (capitalized) if they are performed prior to the property being placed in service.

Question 7

A _____ expenditure is incurred in the purchase of property or for improvements to property that extend beyond the tax year or provide a benefit for more than one tax year.

(LO 3-2, pg 13 of text)

Answer 7

Capital

The taxpayer is typically not allowed a full deduction for these expenditures in the year the property is acquired or in the year these expenses are incurred for the improvements. Rather, the taxpayer can recover the cost of these expenses over a specified period of years through depreciation or cost recovery,

Question 8

Capital Expenditure

In 2015, Ace Corp. buys a building for use as a business office. Before placing the building in service, Ace incurs costs to repair cement steps, refinish wood floors, patch holes in walls, and paint the building’s interior and exterior. In 2016, Ace places the building in service and begins using it as its business office. None of the work was an improvement to the building or its structural components. Nevertheless, the amounts paid must be _____ as costs of acquiring the building because they were for work performed before Ace placed the building in service.

(3-2, pg 18)

Answer 8

Capitalized

Note that these costs would be treated as repairs (currently deductible) if they had been incurred after the property had been placed in service. The term “placed in service” refers to the time that property is first placed by the taxpayer in a condition or state of readiness and availability for a specifically assigned function.

Question 9

Capital Expenditure

In addition, there is a de minimis rule that allows qualifying taxpayers to elect to currently deduct costs that normally would be capitalized. This provision applies to “Eligible _____ _____”

(3-2, pg 15 of text)

Answer 9

“Eligible building property.”

Eligible building property consists of the building itself and all of the structural components of the building—the walls, floors, HVAC systems, plumbing and electrical systems, escalators and elevators, fire protection and alarm systems, security systems, and gas distribution systems. The eligible building property must have an unadjusted basis (basis without taking into account any depreciation deductions) of less than $1 million.

Question 10

Capital Expenditure

Qualifying taxpayers may elect to deduct the cost of improvements made to an eligible building property if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on the eligible building does not exceed the lesser of:

(a) _% of the eligible building’s unadjusted basis

or

(b) $_ _, _ _ _.

(3-2, pg 15 of text)

Answer 10

(a) 2% of the eligible building’s unadjusted basis

or

(b) $10,000.

Question 11

Capital Expenditure

The de minimis rule applies only to qualifying taxpayers—those taxpayers who have average annual gross receipts of _____ or less for the three preceding tax years (or the average for the years of existence, if fewer than three years). Gross receipts include total sales, amounts received for services, and income from investments.

$5 million

$10 million

$10,000

(LO 3-2, page 15 of text)

Answer 11

$10 million

Question 12

Capital Expenditure

Example. Alice is a qualifying taxpayer who owns an office building in which she provides consulting services. In Year 1, Alice’s building has an unadjusted basis of $750,000. In the current year, Alice pays $5,500 for repairs, maintenance, improvements, and similar activities to the office building.

Can Alice deduct these expenses?

(LO 3-2, pg 15 of text)

Answer 12

Yes

Because Alice’s building has an unadjusted basis of $1 million or less, the building constitutes “eligible building property.”

The total amount paid by Alice during the year for repairs, maintenance, improvements, and similar activities on this eligible building property does not exceed the lesser of $15,000 (2% of the building’s unadjusted basis of $750,000) or $10,000.

(a) 2% of the eligible building’s unadjusted basis

or

(b) $10,000.

If Alice properly makes the election, and the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on a trade or business, Alice may deduct these amounts rather than capitalize them.

Question 13

A tune-up on a business automobile should be

1. currently deductible.
2. completely nondeductible.
3. depreciated over the life of the automobile.

(LO 3-2)

Answer 13

1. currently deductible.

The cost of a repair (which maintains the asset in normal working condition) to a business asset is currently deductible.

Question 14

24. An expenditure that maintains an asset in normal working condition and does not materially increase the life or the value of the asset is said to be
25. an improvement.
26. a repair.
27. a depreciable expenditure.

(LO 3-2)

Answer 14

2. a repair.

An improvement is an expenditure that materially increases the life or the value of an asset. A repair merely maintains an asset in normal working condition.

Question 15

25. A cost associated with the acquisition of a fixed asset that is used in a business
26. is currently deductible in most situations.
27. must be capitalized.
28. is currently deductible if the cost is de minimus.

(LO 3-2)

Answer 15

2. must be capitalized.

A cost associated with the acquisition of a fixed asset that is used in a business must be capitalized; that is, it must be added to the basis of the asset.

Question 16

Briefly discuss the idea of a repair versus an improvement.

LO 3-2

Answer 16

A repair merely maintains an asset in normal working condition. An improvement materially increases the useful life or the value of the asset involved, or adapts it to a new use. Generally, repairs to business or investment property (a rental home, for example) are currently deductible expenditures. Improvements must be capitalized. Expenses that would normally be classified as repairs are instead treated as improvements (capitalized) if they are performed prior to the property being placed in service.

Question 17

Certain costs must be capitalized. Briefly discuss the rules related to capitalization of a cost.

(LO 3-2)

Answer 17

Any cost associated with the acquisition of an asset (shipping, installation, legal fees, etc.) must be capitalized.

For example, If a taxpayer purchases a computer for use in her business, any acquisition costs would be capitalized. These capitalized costs may include sales taxes, freight, and setup charges.

Question 18

53. During the current tax year, Jim Prentice purchased a small warehouse for exclusive use in his manufacturing business. The cost of the property was $122,000, of which $32,000 was attributable to the land.

Which one of the following statements identifies the proper treatment of the expenditure?

1. The $90,000 attributable to the building may be currently deductible.
2. The $90,000 attributable to the building may be deducted under Section 179.
3. The $32,000 must be capitalized and may not be depreciated.
4. The entire $122,000 is currently deductible.
5. The entire $122,000 must be capitalized and depreciated.

(LO 3-2)

Answer 18

3. The $32,000 must be capitalized and may not be depreciated.

The cost associated with the land must be capitalized (establishes basis) and may not be depreciated.

Only so-called “wasting assets” may be depreciated; thus the land is not depreciable.

Because the warehouse has a useful life of greater than one year, it must be depreciated.

Section 179 is not an option for the warehouse, because Section 179 generally applies only to personalty, not realty.

Question 19

64. A taxpayer purchases a new computer for use in his consulting business. He incurs sales taxes and shipping charges in connection with the purchase.

Which of the following correctly describes the treatment of the sales taxes and shipping charges?

1. Both are currently deductible.
2. Both are capitalized.
3. The sales taxes are capitalized, and the shipping charges are currently deductible.
4. The sales taxes are currently deductible, and the shipping charges are capitalized.

(LO 3-2)

Answer 19

2. Both are capitalized.

Any cost associated with the acquisition of an asset must be capitalized. This would include both the shipping and the taxes.

Question 20

54. Derrick Johnson is about to begin receiving payments from a deferred fixed annuity that he purchased many years ago. His investment in the annuity contract was $40,500. He is to receive $300 per month for the rest of his life. His current life expectancy, based on IRS tables, is 15 years.

What amount, if any, of each monthly payment is taxable to Derrick?

$0

$75

$100

$225

$300

(LO 3-2)

Answer 20

$75

$300 Amount of payment
* 12 Months
* 15 Years
= $54,000 Total expected return

$40,500 Investment
/ $54,000 Total expected return
= 75% Exclusion ratio

$300 Payment
* 75% Exclusion ratio
= $225 Return of capital (untaxed)

$75 Taxed as ordinary income

Derrick is expected to receive $54,000 ($300 × 12 × 15). His investment in the contract ($40,500) is then divided by the total amount expected to be received ($54,000) to determine the excludible portion of each payment. $40,500 ÷ $54,000 = 75% exclusion ratio × $300 = $225 excludible from each payment. Thus, the remaining $75 of each payment is taxable.