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Chapter 9

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Chapter 9

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  1. Chapter 9 Capital Recovery: Depreciation, Amortization, & Depletion

  2. Amortize Deplete Depreciate Asset Breakdown Overview Intangible Tangible Natural Resources Everything Else Realty Personalty 3, 5, 7 10, 15, 20 MACRS • Statutory Period • Est Useful Life • If no EUL = 0 • % Depletion • Cost Depletion 27.5 39

  3. History of Depreciation Methods • Revenue Act of 1913: • “Reasonable allowance for depreciation” • Taxpayer could choose rates • Controversies over rates and salvage • 1971 Class Life System with ADR or F&C • 1981-Present: ’81 ACRS and ’86 MACRS • Eliminates estimates • Specifies recovery period (useful life) • No salvage value

  4. History of Depreciation Methods • Revenue Act of 1913: • “Reasonable allowance for depreciation” • Taxpayer could choose rates • Bulletin F, 1920 • 1933: New Deal Financing • Taxpayer to prove reasonableness of rates • Bulletin F revised -- specified unusually long “reasonable lives” • Controversies over rates and salvage value

  5. History of Depreciation Methods • 1953 - 1980 • Accelerated methods allowed, 1954 • AFY - 1954 • IRS given burden of proof on rates • 1962: Rev. Proc. 62-21: more reasonable useful lives specified • 1971 Class Life System with ADR or F&C • 1981-Present: ’81 ACRS and ’86 MACRS • Eliminates estimates • Specifies recovery period (useful life) • No salvage value

  6. MACRS Depreciation

  7. Sec. 167 Depreciation • General rule • There shall be allowed as a depreciation DEDUCTION a reasonable allowance for the exhaustion wear and tear (including a reasonable allowance for obsolescence) OF • Property used in a TRADE OR BUSINESS; • Property held for the PRODUCTION OF INCOME

  8. Sec. 167 DepreciationWhat is Eligible for Depreciation? • Property used in a TRADE OR BUSINESS; • Property held for the PRODUCTION OF INCOME • ADDITIONAL CONSIDERATIONS • Dual use property: business and personal • Converted property • Gifted • Determinable life required

  9. MACRS • Property not covered by MACRS • Pre-1981 property • Property depr. with nontime-based methods, e.g. units of production, standard mileage rates • Special public utility property and specified amortization property (leasehold improvements & rehab expenditures on low income housing) • Videotapes & motion picture films • Intangible assets

  10. Problem 9-2 Indicate whether a taxpayer could claim deductions for depreciation or amortization of the following property: a. Land used in the taxpayer’s farming business. b. A duplex—taxpayer lives in one half while he rents the other half out. c. Portion of the taxpayer’s residence that she uses as a home office. d. Taxpayer’s former residence, which he listed for rental temporarily until he is able to sell it. The residence was listed in late November and was not rented as of the end of the taxable year. e. A mobile home that the taxpayer initially purchased and used while he was in college and this year began renting to several students. f. The costs attributable to goodwill and a covenant not to compete. g. An automobile used for business. The taxpayer accounts for his deductible car expenses using the standard mileage rate.

  11. Problem 9-27 F purchased a mobile home to live in while at college. The home cost $12,000. When he graduated, he left the home in the trailer park and rented it. At the time he converted the home to rental property, it had a fair market value of $10,000. What is F’s basis for depreciation? $10,000. F must use lesser of FMV or basis at time of conversion Same as above except the value of the home at the time it was converted was $18,000. What is F’s basis for depreciation 12,000. F must use lesser of FMV or basis at time of conversion F now lives 75 miles away from his alma mater. Can he deduct the cost of traveling back to check on his rental property (including those trips on which he also attended a football game)? Yes. Because the property is held for the production of rents, the traveling expenses incurred to check on his property are deductible for A.G.I. It is irrelevant that the property is near his alma mater.

  12. Depreciation Methods 1981- Present: ’81 ACRS and ’86 MACRS • Eliminates estimates • Specifies recovery period (useful life) • No salvage value • Simplicity at its best

  13. Calculation of Depreciation Depreciable unadjusted basis x Percentage for year Annual depreciation Depends on type of property: Recovery period, method, conventions

  14. Recovery Period and Method • Rev. Proc. 87-56 • Specifies recovery period • Periodically updated by rulings, etc. • Excerpt of Rev. Proc. 87-56

  15. Exhibit 9-2: Excerpt from Rev Proc. 87-56Recovery PeriodAsset GDS ADSClassDescription of Assets Included Class Life System System SPECIFIC DEPRECIABLE ASSETS USED IN ALLBUSINESS ACTIVITIES, EXCEPT AS NOTED: 00.11 Office Furniture, Fixtures, and Equipment: Includes furniture and fixtures that are not structural com- ponents of a building. Includes such assets as desks, files, safes, and communications equipment…. 10710 00.13Data Handling Equipment, except Computers: Includes only typewriters, calculators, adding and ac- counting machines, copiers, and … 6 5 600.21 Airplanes … 6 5 6 00.22 Automobiles, Taxis3 5 5 00.23 Buses 9 5 9 00.241 Light General Purpose Trucks: 4 5 5

  16. Exhibit 9-3 Examples of MACRS Property Class Examples   3 yrs Special tools, race horses, tractors, class life of 4 yrs or less 5 yrs Automobiles, trucks, computers and peripheral equipment (such as printers, external disk drives, and modems), typewriters, copiers, R&E equipment, class life of > 4 years and < 10 yrs 7 yrs Office furniture, fixtures, office equipment, most machinery, class life of > 10 yrs but < 16 yrs, property no assigned class life 10 yrs Single-purpose agricultural and horticultural structures, … 15 yrs Land improvements (e.g., sidewalks, roads, parking lots, irrigation systems, sewers, fences, landscaping), service stations, billboards, …and class life of > 20 yrs and < 25 yrs 27.5 yrs Residential rental real estate, apartment buildings, duplexes, etc. 39 yrs Nonresidential real estate, including office buildings, warehouses, factories and farm buildings

  17. Recovery Period and Method • Rev. Proc. 87-56 • Personal (non-realty) and some realty • 3, 5, 7 yr • 200% DB (may elect straight-line) • Convention: • Half-year: • ½ yr of depreciation in yr of acquisition and disposition • Mid-quarter • ½ qtr of depreciation for qtr of acquisition and disposition • Realty • Residential 27.5 yrs, nonresidential 39 years • Straight-line • Convention: • Mid-month • ½ month of depreciation in month of acquisition and disposition

  18. Exhibit 9-4: MACRS Depreciation Percentages Using DDB and Half-Year Convention for 3, 5, 7 Year Property Year 3-Year 5-Year 7-Year 1 33.33% 20.00% 14.29% 2 44.45 32.00 24.49 3 14.81 19.20 17.49 4 7.41 11.52 12.49 5 11.52 8.93 6 5.76 8.92 7 8.93 8 4.46 .

  19. Exhibit 9-4: MACRS Depreciation Percentages Using DDB and Half-Year Convention for 3, 5, 7 Year Property Year 3-Year 5-Year 7-Year  1 20.00% Recovery period 5 yrs Straight line ANNUAL rate 1/5 = 20% Double declining balance x 2 Annual DDB rate 40% Half year convention x ½ First year rate 20%

  20. Exhibit 9-4: MACRS Depreciation Percentages Using DDB and Half-Year Convention for 3, 5, 7 Year Property Year 3-Year 5-Year 7-Year 1 20.00% 2 32.00 Year 2 Straight line ANNUAL rate 1/5 = 20% Double declining balance x 2 Annual DDB rate 40% Declining balance (100% - 20% yr 1) x 80% Year 2 rate 32% Note this rate is applied to unadjusted basis and NOT the declining balance!

  21. Double Declining Balance Depreciation with a Change to SL Example Asset with 5 year life, $20,000 purchase cost. Step 1: Calculate Rate 1/years useful life = 1/5 = 20% 2 x 1/5 = 2/5 = 40% is DDB

  22. Double Declining Balance Depreciation with a Change to SL Example Step 2: Calculate depreciation: Undep. Depr. Year Balance Rate Exp. 1 $20,000 X 40% = $8,000 2 12,000 X 40% = 4,800 3 7,200 X 40% = 2,880 * 4 4,320 X 1/2 = 2,160 5 2,160 X remainder = 2,160 $20,000 * DDB would be $4,320 X 40% = $1,728 Change to SL with 2 yrs. life remaining gives greater depreciation: $4,320/2 = $2,160. Tables automatically switch.

  23. ACRS/MACRSDepreciation of Real Property Post 1980

  24. Exhibit 9-5: MACRS Residential Realty (Post 1986 SL 27.5 Yr) Using Mid-Month Convention Month Placed in Service 1 2 3-26 27 28 29 1 3.485% 3.636% 3.636% 3.636% 1.970% 0.000% 2 3.182 3.363 3.636 3.636 2.273 0.000 3 2.879 3.636 3.636 3.636 2.576 0.000 4 2.576 3.636 3.636 3.636 2.879 0.000 5 2.273 3.636 3.636 3.636 3.182 0.000 6 1.970 3.636 3.636 3.636 3.485 0.000 7 1.667 3.636 3.636 3.637 3.636 0.152 8 1.364 3.636 3.636 3.637 3.636 0.455 9 1.061 3.636 3.636 3.637 3.636 0.758 10 0.758 3.636 3.636 3.637 3.636 1.061 11 0.455 3.636 3.636 3.637 3.636 1.364 12 0.152 3.636 3.636 3.637 3.636 1.667 .

  25. Exhibit 9-5: MACRS Residential Realty (Post 1986 SL 27.5 Yr) Using Mid-Month Convention Month Placed in Service 1 2 3-26 27 28 29 1 3.485% 3.636% 3.636% 3.636% 1.970% 0.000% 2 3.182 3.363 3.636 3.636 2.273 0.000   . Recovery period 27.5 yrs Straight line ANNUAL rate 1/27.5 = 3.636% Mid-month convention (1/2 for month of acquisition + 10) x 10.5/12 First year rate 3.182%

  26. Exhibit 9-6: MACRS Nonresidential Realty (Post 1986 SL 39 Yr) Using Mid-Month Convention Month Placed Yr YrYr in Service 1 2-3940 1 2.461% 2.564% 0.107% 2 2.247 2.564 0.321 3 2.033 2.564 0.535 4 1.819 2.564 0.749 5 1.605 2.564 0.963 6 1.391 2.564 1.177 7 1.177 2.564 1.391 8 0.963 2.564 1.605 9 0.749 2.564 1.819 10 0.535 2.564 2.033 11 0.321 2.564 2.247 12 0.107 2.564 2.461 .

  27. Mid-Quarter Convention • If > 40% of aggregate bases of all tangible personal property is placed in service during the year is placed in service in the last three months of the year, a mid-quarter convention will apply: • 1st qtr. gets 3.5 qtrs. depr. (87.5%) • 2nd qtr. gets 2.5 qtrs. depr. (62.5%) • 3rd qtr. gets 1.5 qtrs. depr. (37.5%) • 4th qtr. gets 0.5 qtrs. depr. (12.5%)

  28. Mid-Quarter Convention Quarter Placed in Service First Second Third FourthJan-MarApr-JunJul-SepOct-Dec 3.5 quarters2.5 quarters1.5 quarters0.5 quarters 4 4 4 4 Percent of annual Depreciation Allowed 87.5% 62.5% 37.5% 12.5%

  29. Mid Quarter Convention Example Four machines placed in service during the year. All are 7 year property. Machine Cost Date put in service A 10,000 Jan. 10 B 5,000 July 1 C 20,000 Oct. 15 D 5,000 Dec. 1 40,000 20,000 + 5,000 = 25/40 = 62.5% > 40%, thus mid-quarter convention applies Machine Date Qtr Factor X Basis Depr. A 1/10 1 25% 10,000 2,500 B 7/1 3 10.71 5,000 536 C 10/15 4 3.57 20,000 714 D 12/1 4 3.57 5,000 179 Total depreciation. $3,939

  30. Exhibit 9 - 7: MACRS Depreciation Percentages Using DDB and Mid Quarter Convention for 3 and 5 Year Property 3-year property: Quarter Placed in Service Recovery Year 123 4 1 58.33% 41.67% 25.00% 8.33% 2 27.78 38.89 50.00 61.11 3 12.35 14.14 16.67 20.37 4 1.54 5.30 8.33 10.19 5-Year Property: 1 35.00 25.00 15.00 5.00 2 26.00 30.00 34.00 38.00 3 15.60 18.00 20.40 22.80 4 11.01 11.37 12.24 13.68 5 11.01 11.37 11.30 10.94 6 1.38 4.26 7.06 9.58 .

  31. Exhibit 9 - 7: MACRS Depreciation Percentages Using DDB and Mid Quarter Convention for 3 and 5 Year Property 3-year property:   Quarter Placed in Service Recovery Year 123 4 1 58.33% 41.67% 25.00% 8.33% . Recovery period 3 yrs Straight line ANNUAL rate 1/3 = 33% Double declining balance x 2 Annual DDB rate 66% Mid quarter convention x 3.5/4 First year rate 58.33%

  32. Problem 9-28

  33. Problem 9-28 T decided to move her insurance business into another office building. She purchased a used building for $70,000 on March 15. T also purchased new office furniture for the building. The furniture was acquired for $20,000 on May 1. The first‑year expensing option is not elected, yet T wants to depreciate her assets as rapidly as possible. Depreciation for first year: Used office building placed in service in March Property type: Office building is nonresidential New or used: Irrelevant (except for bonus & N/A to buildings) Life: 39 yrs Method: Post 1986: Straight-line Convention:mid-month (1/2 mth for mth placed in service & yr of sale) Salvage value: irrelevant Depreciation Rate: 1/39 annual SL rate x (.5 month for March + 9 months = 9.5)/12 =2.033% Building: $70,000 x 2.033% = $1,423

  34. Problem 9-28 (cont.) Exhibit 9-6: MACRS Nonresidential Realty (Post 1986 SL 39 Yr) Using Mid-Month Convention Month Placed Yr YrYr in Service 1 2-3940 1 2.461% 2.564% 0.107% 2 2.247 2.564 0.321 3 2.033 2.564 0.535 4 1.819 2.564 0.749 5 1.605 2.564 0.963 6 1.391 2.564 1.177 7 1.177 2.564 1.391 8 0.963 2.564 1.605 9 0.749 2.564 1.819 10 0.535 2.564 2.033 11 0.321 2.564 2.247 12 0.107 2.564 2.461 .

  35. Problem 9-28 (cont.) Depreciation for first year:New furniture placed in service in May; cost $20,000 Property type: 7-year New or used: Relevant for bonus depreciation Life: 7 yrs Method: DDB Convention: Which convention applies: half year or mid-quarter? Was > 40% of PERSONALTY placed in service in last 3 months of year? Half-year: ½ year for year placed in service and year of sale Salvage value: Irrelevant Depreciation Rate: 1/7 annual SL rate x 2 DDB x ½ half-year convention = 14.29% Furniture: $20,000 x 14.29% = $2,858

  36. Problem 9-28 (cont.) Exhibit 9-4: MACRS Depreciation Percentages Using DDB and Half-Year Convention for 3, 5, 7 Year Property Year 7-Year 1 14.29% 2 24.49 3 17.49 4 12.49 5 8.93 6 8.92 7 8.93 8 4.46 .

  37. Problem 9-28 (cont.) Depreciation for 2nd year: Used office buildingplaced in service in March Property type: Office building is nonresidential New or used: Irrelevant (except for bonus & N/A to buildings) Life: 39 yrs Method: Post 1986: Straight-line Convention:mid-month (1/2 month for month placed in service & yr of sale) Salvage value is irrelevant Depreciation Rate: 1/39 annual SL rate x 12/12 = 2.564 % Building: $70,000 x 2.564% = $1,795

  38. Problem 9-28 (cont.) Exhibit 9-6: MACRS Nonresidential Realty (Post 1986 SL 39 Yr) Using Mid-Month Convention Month Placed Yr YrYr in Service 1 2-3940 1 2.461% 2.564% 0.107% 2 2.247 2.564 0.321 3 2.033 2.564 0.535 4 1.819 2.564 0.749 5 1.605 2.564 0.963 6 1.391 2.564 1.177 7 1.177 2.564 1.391 8 0.963 2.564 1.605 9 0.749 2.564 1.819 10 0.535 2.564 2.033 11 0.321 2.564 2.247 12 0.107 2.564 2.461 .

  39. Problem 9-28 (cont.) Depreciation for 2nd yr: New furniture placed in service in May Property type: 7-year New or used: Relevant for bonus depreciationLife: 7 yrsMethod: DDBConvention: Half-yearSalvage value: IrrelevantDepreciation Rate: 1/7 annual SL rate x 2 DDB x (100% - 14.29% = 85.71) = 24.49% Furniture: $20,000 x 24.49% = $4,898

  40. Problem 9-28 (cont.) Exhibit 9-4: MACRS Depreciation Percentages Using DDB and Half-Year Convention for 3, 5, 7 Year Property Year 7-Year 1 14.29% 2 24.49 3 17.49 4 12.49 5 8.93 6 8.92 7 8.93 8 4.46 .

  41. Problem 9-28 (cont.) Depreciation for 3rd yr: Used office building placed in service in March and SOLD on 7/20 Property type: Office building is nonresidentialNew or used: Irrelevant (except for bonus depreciation)Life: 39 yrsMethod: Post 1986: Straight-lineConvention: mid-month (1/2 month for month placed in service and sold)Salvage value is irrelevantDepreciation Rate: 1/39 annual SL rate = 2.564% x half-month for July disposition 6.5/12 Building: $70,000 x 2.564% x 6.5/12 = $ 972

  42. Problem 9-28 (cont.) Exhibit 9-6: MACRS Nonresidential Realty (Post 1986 SL 39 Yr) Using Mid-Month Convention Month Placed Yr YrYr in Service 1 2-3940 1 2.461% 2.564% 0.107% 2 2.247 2.564 0.321 3 2.033 2.564 0.535 4 1.819 2.564 0.749 5 1.605 2.564 0.963 6 1.391 2.564 1.177 7 1.177 2.564 1.391 8 0.963 2.564 1.605 9 0.749 2.564 1.819 10 0.535 2.564 2.033 11 0.321 2.564 2.247 12 0.107 2.564 2.461 .

  43. Problem 9-28 (cont.) Depreciation for 3rd yr: New furniture placed in service in May and SOLD July 20 Property type: 7-yearNew or used: Relevant for bonus depreciationLife: 7 yrsMethod: DDBConvention: Half-year in year placed in service and year of saleSalvage value: IrrelevantDepreciation Rate: 1/7 SL rate x 2 DDB x (100% - 14.29% -24.49% = 61.22%) = 17.49% Furniture: $20,000 x 17.49% x ½ yr convention in yr of sale = $1,749 Annual Rate

  44. Problem 9-28 (cont.) Exhibit 9-4: MACRS Depreciation Percentages Using DDB and Half-Year Convention for 3, 5, 7 Year Property Year 7-Year 1 14.29% 2 24.49 3 17.49 4 12.49 5 8.93 6 8.92 7 8.93 8 4.46 .

  45. Problem 9-28 (d) Depreciation for first year:New furniture placed in service in October; cost $20,000 Property type: 7-year New or used: Relevant for bonus depreciationLife: 7 yrsMethod: DDBConvention: Which convention applies: ½ yr or mid-quarter? Was > 40% of PERSONALTY placed in service in last 3 months of year? Yes Mid-quarter: ½ quarter for quarter of year placed in service and year of saleSalvage value: IrrelevantDepreciation Rate: 1/7 annual SL rate x 2 DDB x ½ x 1/4 mid qtr convention = 3.57% Furniture: $20,000 x 3.57% = $2,858

  46. Problem 9-28(d) Appendix C-9: MACRS Depreciation Percentages Using DDB and Mid Quarter Convention for 7 Year Property 7-year property:   Quarter Placed in Service Recovery Year 123 4 125.0017.85 10.713.57 2 21.43 23.47 25.51 27.55 3 15.31 16.76 18.22 19.68 4 10.93 11.37 13.02 14.06 5 8.75 8.87 9.30 10.04 6 8.74 8.87 8.85 8.73 7 8.75 8.87 8.86 8.73 8 1.09 3.33 5.53 7.64 .

  47. Problem 9-28(d) Depreciation for 2nd year:New furniture placed in service in October; cost $20,000 Property type: 7-year New or used: Relevant for bonus depreciationLife: 7 yrsMethod: DDBConvention: Which convention applies: ½ yr or mid-quarter? Was > 40% of PERSONALTY placed in service in last 3 months of year? Yes Mid-quarter: ½ quarter for quarter of year placed in service and year of saleSalvage value: IrrelevantDepreciation Rate: 1/7 annual SL rate x 2 DDB = 2/7 x (100% - 3.57% = 96.43%) = 27.55% Furniture: $20,000 x 27.55% = $5,510

  48. Problem 9-28(d) (cont.) Appendix C-9: MACRS Depreciation Percentages Using DDB and Mid Quarter Convention for 7 Year Property 7-year property:   Quarter Placed in Service Recovery Year 123 4  1 25.00 17.85 10.71 3.57 2 21.43 23.47 25.51 27.55 3 15.31 16.76 18.22 19.68 4 10.93 11.37 13.02 14.06 5 8.75 8.87 9.30 10.04 6 8.74 8.87 8.85 8.73 7 8.75 8.87 8.86 8.73 8 1.09 3.33 5.53 7.64 .

  49. Problem 9-28 (cont.) Depreciation for 3rd year:New furniture placed in service in October; sold July Property type: 7-year New or used: Relevant for bonus depreciationLife: 7 yrsMethod: DDBConvention: Which convention applies: ½ yr or mid-quarter? Was > 40% of PERSONALTY placed in service in last 3 months of year? Yes Mid-quarter: ½ quarter for quarter in year of saleSalvage value: IrrelevantDepreciation Rate: 1/7 SL rate x 2 DDB = 2/7 x (100% - 3.57 - 27.55 = 68.88) = 19.68% annual rate Annual rate 19.68% x mid qtr convention 2.5/4 Furniture: $20,000 x 19.68% x 62.5% = $2,460

  50. Appendix C-9: MACRS Depreciation Percentages Using DDB and Mid Quarter Convention for 7 Year Property 7-year property:   Quarter Placed in Service Recovery Year 123 4  1 25.00 17.85 10.71 3.57 2 21.43 23.47 25.51 27.55 3 15.31 16.76 18.22 19.68 4 10.93 11.37 13.02 14.06 5 8.75 8.87 9.30 10.04 6 8.74 8.87 8.85 8.73 7 8.75 8.87 8.86 8.73 8 1.09 3.33 5.53 7.64 .