Tax 3-4 Analyze a situation to calculate the cost recovery deductions over the recovery period.

Question 1

Cost Recovery

When a taxpayer purchases tangible property to be used in a trade or business (such as manufacturing equipment) or held for the production of income (such as a rental property), and when that property has a useful life of more than one year, the taxpayer generally [is / is not] allowed to deduct the full cost of the property in the year of acquisition.

(3-4, pg 28)

Answer 1

is not

Question 2

Cost Recovery

A taxpayer may be entitled to deduct a portion of the cost of the property each year for a number of years through cost recovery (depreciation) deductions. A similar deduction also may be available for intangible assets, but in the case of intangibles, this allowance is referred to as _____.

(3-4, pg 28)

Answer 2

“amortization.”

Question 3

Cost Recovery

Both personalty and realty may be subject to the depreciation rules. However, keep in mind that certain assets, such as the value of land itself (viewed separately from the value of a building, which is subject to depreciation), [is / is not] subject to depreciation.

(3-4, pg 28)

Answer 3

is not

Rather, the acquisition cost of such assets simply gives the taxpayer “basis” in the asset, to be used in computing the gain or loss to be recognized upon the eventual sale of the asset.

Question 4

Cost Recovery

Inventory, securities, personal-use property, natural resources subject to depletion deductions, and assets that do not have a reasonably ascertainable useful life [are / are not] subject to depreciation.

(3-4, pg 28)

Answer 4

are not

Their cost merely gives rise to basis, which is used to compute the gain or loss upon the sale of the asset.

Question 5

Cost Recovery

Depreciation or “cost recovery” refers to the various methods available for recovering (deducting) the cost of a wasting asset with a useful life of more than ____ year over a period of time that approximates the asset’s useful life.

(3-4, pg 28)

Answer 5

one

Question 6

Cost Recovery

A _____ asset is one that decreases in value over time, due to exhaustion, wear and tear, or obsolescence.

(3-4, pg 29)

Answer 6

wasting

Thus, a building purchased as a rental property is subject to depreciation; the land that the building sits on is not depreciable because it is not a wasting asset.

Question 7

Cost Recovery

Three basic methods of depreciation are available under the broad heading of the Modified Accelerated Cost Recovery System (MACRS):

1. _____ depreciation,
2. _____ depreciation,
3. Section _____ expensing.

(3-4, pg 29)

Answer 7

1. accelerated depreciation,
2. straight-line depreciation,
3. Section 179 expensing.

Question 8

Cost Recovery

In computing the depreciation deduction for personalty, the _____ convention is typically used. This convention treats the asset as being placed in service at the exact midpoint of the tax year. Also, in the year of sale of the asset, it treats the asset as being sold at the exact midpoint of the tax year. Thus, in the year of acquisition, or disposition, of an asset, only one-half of a full year’s depreciation deduction is allowed.

(3-4, pg 29)

Answer 8

half-year (or mid-year)

This half-year convention is built into the first year of the MACRS table, but must be separately computed when using the straight-line option. Note that the effect of the half-year convention is to extend out the depreciation period into an extra year. In other words, due to the half-year convention, five-year property is depreciated over six years and seven-year property is depreciated over eight years.

Question 9

Cost Recovery

Depreciation on personalty placed in service after 1986 is calculated using the modified accelerated cost recovery system (MACRS) method. The modified accelerated cost recovery system is the system under which all assets placed in service after 1986 will be depreciated. Under MACRS, there are several different methods for depreciating property. Realty is depreciated using _____. Personalty may be depreciated _____. Section 179 or bonus depreciation may also be available to recover the cost of personalty.

(3-4, pg 29)

Answer 9

a mandatory straight-line method

under the straight-line option, or may be depreciated using the MACRS table

Question 10

Cost Recovery

The MACRS table is the “default” method for depreciating personalty. The MACRS table reflects accelerated depreciation. This simply means that the depreciation deductions are _____, that is the deductions are larger in the earlier years than they are in the later years.

(3-4, pg 29)

Answer 10

“front-loaded”

Question 11

Cost Recovery

The straight-line method is an option available under MACRS. Under this method, a ____ share of the cost of the asset is taken as depreciation each year.

Thus, for an asset with a five-year useful life, the taxpayer would expect to take one-fifth, or 20%, of the asset’s basis as depreciation each year. For an asset with a seven-year useful life, the taxpayer would expect to take one-seventh, or 14.29%, of the asset’s basis as depreciation each year.

(3-4, pg 30)

Answer 11

pro rata

However, when using the declining balance or the straight-line methods, the taxpayer is not entitled to take a full year’s depreciation in the year an asset is placed in service. As a result of the half-year convention, an asset placed in service during the tax year is treated as being placed in service at the exact midpoint of the year. As a result, a taxpayer is entitled to take only one-half of one year’s depreciation during the year of acquisition. This is generally be true regardless of whether the asset was placed in service during January or December.

Question 12

Cost Recovery

Example of the straight-line method, assume a five-year property with a cost of $75,000 was placed in service during January of the current year. Under the straight-line method, the first-year depreciation deduction equals

(3-4, pg 30)

Answer 12

$7,500

20% 
× 
$75,000 
× ½
= $7,500 

During each of the next four years, the annual deduction will equal

$75,000
× 20%
= $15,000

The deduction in the sixth year will equal $7,500.

Question 13

Cost Recovery

200% declining-balance method. The MACRS table is based on the 200% declining balance method, with the half-year convention. Unlike other depreciation methods, when using the 200% declining-balance method, we must reduce the basis prior to computing the next year’s depreciation.

For example, assume a five-year property with a cost of $75,000 was placed in service during January of the current year. The annual depreciation deductions for the first three years, using the double-declining balance (MACRS) method, the first three years would be computed as follows:

(3-4, pg 27 of the text)

Answer 13

Year 1:
Twice the straight-line rate = 40%
40% × 
$75,000 
× ½ 
= $15,000 first-year deduction 

Year 2: 
$75,000 
– $15,000 
= $60,000 
× 40% = 
$24,000 second-year deduction

Year 3: 
$60,000 
– $24,000 
= $36,000 
× 40% 
= $14,400 third-year deduction

Question 14

Cost Recovery

Which method to use? As mentioned earlier, the MACRS table is the default depreciation method for personalty. However, there may be times when the use of the accelerated depreciation method doesn’t yield the greatest tax savings. Notice that in the MACRS calculation previously shown, 52% of the cost of the five-year asset is deducted in the first two years (20% and 32% from the MACRS table). With the straight-line method, only 30% is deducted in the first two years.

(3-4, pg 31)

Answer 14

If the taxpayer is in a lower marginal income tax bracket in those early years than in the later years, we may want to forgo the larger depreciation deductions in the early years by electing the straight-line method. This has the effect of pushing more of the depreciation deductions into the later years, when the tax bracket may be higher.

Question 15

Cost Recovery

Real estate. It should also be noted that real estate is subject to special rules. All real estate placed in service after 1986 is depreciated using the straight-line method with a mid-month convention. Tables are typically used for computing the depreciation deductions. Nonresidential (commercial) real estate is depreciated using a __-year recovery period, and residential property is depreciated using a __-year recovery period.

(3-4, pg 35)

Answer 15

Nonresidential (commercial) real estate is
depreciated using a 39-year recovery period

Residential property is depreciated using a 27½-year recovery period.

Question 16

Cost Recovery

Under Internal Revenue Code Section 197, certain intangible assets that are acquired after August 10, 1993, and held in connection with a trade or business or an activity engaged in for the production of income may be amortized ratably over a __-year period beginning in the month of acquisition. With certain limited exceptions, Section 197 does not apply to intangible assets created by the taxpayer.

(3-4, pg 35)

Answer 16

15

Intangible assets amortizable under Section 197 include goodwill, going-concern value, workforce in place, an information base (e.g., customer and subscription lists), know-how (e.g., patents and copyrights), any customer-based intangible, any supplier-based intangible, any license, permit, or other right granted by a governmental unit or agency, any covenant not to compete entered into in connection with the acquisition of a trade or business or a substantial portion of a trade or business, and any franchise, trademark, or trade name. Note that the 15- year amortization period applies regardless of the actual useful life of the intangible asset.

Question 17

Cost Recovery

9. Margaret purchased a used pickup truck at a cost of $12,400 and sales taxes of $600 to use in her floral business. She purchased the pickup (five-year property) and placed it in service on June 1 of the current tax year.

Using MACRS, what is the first-year cost recovery deduction that Margaret can claim?

1. $1,240
2. $1,300
3. $2,600
4. $5,200

(LO 3-4)

Answer 17

3. $2,600

The first-year percentage for five-year property from the MACRS table is 20%. This is multiplied by the basis of $13,000 (including the capitalized cost, the sales taxes of $600) to give a deduction of $2,600. The half-year convention is built into the MACRS table. (The MACRS table will be provided on the end-of-course exam.)

Question 18

Cost Recovery

10. Bill purchased an automobile at a cost of $7,500 to use in his pizza delivery business. He also paid $500 in sales taxes on the vehicle. He purchased the automobile (five-year property) and placed it in service on March 1 of the current tax year.

Using the straight-line method, what is the first-year cost recovery deduction that Bill can claim?

1. $750
2. $800
3. $1,500
4. $1,600

(LO 3-4)

Answer 18

2. $800

$7,500
+ $500
= $8,000

1st Year
  $8,000
* 20%
= $1,600 
* 50% (b/c half year convention)
= $800

An automobile is a 5 year depreciated item (pg 30 of text)

Question 19

Cost Recovery

19. Fred Calhoun purchased a light-duty truck at a cost of $12,000 to use in his package delivery business. Assume Fred purchased the truck and placed it in service in August of the current tax year. The truck is five-year property. Using the MACRS table, what is the amount of the first-year cost recovery deduction that Fred can claim?
20. $1,200
21. $1,715
22. $2,400

(LO 3-4)

Answer 19

3. $2,400

Simply multiply the first-year percentage of 20% times the basis of the asset. The half-year convention is built into the table. (The MACRS table will be provided on the end-of-course exam.)

Question 20

Cost Recovery

26. A covenant not to compete that is entered into in connection with the acquisition of a business may be amortized
27. over its actual life.
28. over 7 years.
29. over 15 years.

(LO 3-4)

Answer 20

3. over 15 years.

A covenant not to compete that is entered into in connection with the acquisition of a business must be amortized over 15 years.

Question 21

Cost Recovery Accelerated Depreciation

Assume that in April of the current year, a taxpayer
purchased computers for a total cost of $75,000. The computers are five-year property.

Using the MACRS table, we compute the
depreciation as follows:

(LO 3-4)

Answer 21

1st Year
$75,000
* 20%
= $15,000 depreciation

2nd Year
$75,000
* 32%
= $24,000 depreciation

3rd Year
$75,000
* 19.2%
= $14,400 depreciation

4th Year
$75,000
* 11.52%
= $8,640 depreciation

5th Year
$75,000
* 11.52%
= $8,640 depreciation

6th Year
$75,000
* 5.76%
= $4,320 depreciation

Total = $75,000

Note that the half-year convention (previously discussed) is built into the MACRS table, thus no separate adjustment is necessary.

Question 22

Cost Recovery Straight-line Method

Assume a five-year property with a cost of $75,000 was placed in service during January of the current year. Under the straight-line method:

(LO 3-4)

Answer 22

1st Year
  $75,000
* 20%
= $15,000 
* 50% (b/c half year convention)
= $7,500

2nd Year
$75,000
* 20%
= $15,000 depreciation

3rd Year
$75,000
* 20%
= $15,000 depreciation

4th Year
$75,000
* 20%
= $15,000 depreciation

5th Year
$75,000
* 20%
= $15,000 depreciation

6th Year
  $75,000
* 20%
= $15,000 depreciation
* 50% (b/c half year convention)
= $7,500

Question 23

Practice Test 2

Cost Recovery

25. In February, Richard Jones purchased a new computer (five-year property) for use in his business. The cost of the computer was $4,300, while freight and setup charges totaled $600.

What is the first-year cost recovery deduction using the straight-line method?

$430

$490

$790

$860

$980

(LO 3-4)

Answer 23

$490

The freight and setup charges of $600 must be capitalized, that is, added to the cost of the computer, to give a total basis of $4,900. The straight-line rate for five-year property is 20% (100% divided by 5), but the half-year convention limits the deduction to 50% in the year of acquisition. Thus, $4,900 times 10% equals $490. Note that bonus depreciation is not used, as the fact pattern states to use straight-line.

Question 24

Practice Test 2

Cost Recovery

26. In February, Richard Jones purchased a new computer (five-year property) for use in his business. The cost of the computer was $4,300, while freight and setup charges totaled $600. What is the first-year cost recovery deduction using the MACRS table?

$430

$490

$790

$860

$980

(LO 3-4)

Answer 24

$980

The freight and setup charges of $600 must be capitalized—that is, added to the cost of the computer—to give a total basis of $4,900. The first-year deduction using the MACRS table is 20%. Thus, 20% times $4,900 equals $980. Please note that the MACRS table has all applicable conventions already built into the table; therefore, no adjustment is necessary for the half-year convention. Note that bonus depreciation is not used, as the fact pattern states to use the MACRS table.

Question 25

45. Frank Swift owns and operates a landscaping service as a sole proprietorship. During March of the current year, he purchased and placed into service a truck (five-year property) with a cost of $9,200 plus sales tax of $650. The truck will be used exclusively in the business.

Assume Frank chooses to use the straight-line option under MACRS. What is the cost recovery deduction for the current year?

$920

$985

$1,570

$1,840

$1,970

(LO 3-4)

Answer 25

$985

“Straight-line option under MACRS” simply refers to the straight-line method. Do not use the MACRS table. The cost recovery would be computed on a basis of $9,850. Any cost associated with the acquisition of an asset must be capitalized; that is, added to the basis of the property acquired. The straight-line percentage for year one is 10% (100% divided by the class life of the property [five years], adjusted for the half-year convention).