Property Acquisitions and Cost Recovery Deductions

1. Property AcquisitionsandCost Recovery Deductions Chapter6

2. Capital Expenditures • The cost of a business asset with a useful life extending beyond the current year may be • Deducted currently • Capitalized until disposal or • Capitalized with the cost allocated to the years the asset’s use benefits (cost recovery period)

3. Basis of Property • Basis is the taxpayer’s unrecovered investment in an asset that can be recovered without tax cost • As the asset’s basis is recovered (through depreciation, depletion or amortization deductions), basis is reduced and is called adjusted basis

4. Basis of Property • The original basis of an asset includes • Cash plus fair market value of property given up by the purchaser • Money borrowed and used to pay for the property • Liabilities of the seller assumed by the purchaser • Expenses of the purchase such as attorney fees or brokerage commissions

5. Multiple Asset Purchase • If more than one asset is acquired in a single transaction, the cost is apportioned to each using their relative fair market values (FMV) • If the purchase price exceeds the value of the assets, the excess is goodwill • Alternatively, the buyer and seller can agree to a written allocation of the purchase price to individual assets

6. Adjusted Basis • The original basis of an asset is • Increased for nondeductible capital expenditures that prolong its useful life or enhance its usefulness • Decreased by cost recoveries (depreciation, depletion, or amortization) • Decreased by other recoveries (casualty losses)

7. Basis of Converted Property • If the property is converted from personal use to business use, the basis for depreciation is the lesser of the property’s fair market value (FMV) or adjusted basis at the date of conversion • This prevents taxpayers from depreciating the portion of the property’s decline in value while it was used for personal purposes

8. Acquisition in aTaxable Exchange • Basis of acquired asset equals the FMV of the property given up or the services performed • Gain or loss is recognized as if cash had been exchanged for the property surrendered

9. Acquisition by Gift • Donee’s basis is the donor’s basis + portion of gift taxes due to appreciation (but total cannot exceed FMV at date of gift) • FMV at gift date – Donor’s Basis FMV at gift date • If FMV at gift date is less than donor’s basis: • FMV basis used for loss determination • Donor’s basis used for gain determination • No gain or loss between FMV and donor’s basis

10. Acquisition by Inheritance • Use date-of-death Fair Market Value as basis for inherited property (or alternate valuation date, if elected) Will Will

11. After-Tax Cost • Tax savings from depreciation deductions reduce the effective after-tax cost of an asset • The annual tax saving equals the depreciation deduction multiplied by the marginal tax rate • Recovering an asset’s basis over a shorter time period reduces the after-tax cost of the asset

12. Categories of Assets • Realty includes land and buildings • Personalty is any asset that is not realty and includes machinery and equipment • Personal-use property is any property used for personal purposes

13. MACRS • Modified Accelerated Cost Recovery System assigns assets to a class with a predetermined recovery period (and ignores salvage value) • Recovery periods for personalty are 5 years (autos and computers) or 7 years (machinery and furniture) • Recovery periods for realty are 27½ years (residential rental property) or 39 years (commercial and industrial buildings)

14. MACRS • Depreciation for personalty uses • 200% declining-balance method (with a switch to straight-line to maximize deductions) or • Straight-line method • Realty must use the straight-line method • IRS provides tables with annual allowable depreciation expressed as a percentage • Annual deduction equals the asset’s original basis multiplied by % from table

15. MACRS Tables

16. Averaging Conventions • Under the half-year convention a depreciation deduction is taken for half of a full year’s depreciation in the year of acquisition, regardless of when the asset was actually acquired • This averaging convention is built into the MACRS tables for personalty • If a taxpayer elects straight-line, the half-year convention still applies

17. Averaging Conventions • Mid-quarter convention is required if more than 40% of the personalty (not buildings) is placed in service during the last quarter of the tax year • This usually results in smaller deductions than the half-year convention and is intended to discourage taxpayers from waiting until the end of the year to make their purchases

18. Averaging Conventions • Realty is depreciated using a mid-month convention • Depreciation is calculated from the midpoint of the month in which the property is placed in service • Table amount for all years determined by the month of acquisition

19. Dispositions • When an asset is disposed of before it is fully depreciated, the same averaging convention applies in the year of disposition • An asset that was depreciated under the half-year convention will be allowed one-half year’s depreciation in the year of disposal • Taxpayer must adjust the deduction determined by the table to reflect this half-year

20. Dispositions • For mid-quarter convention property, depreciation is allowed from the beginning of the year to the mid-point of the quarter in which the asset is disposed of • First quarter dispositions, 1.5 /12 months • Second quarter dispositions, 4.5/12months • Third quarter dispositions, 7.5/12 months • Fourth quarter dispositions, 10.5 /12 months

21. Dispositions • For realty, depreciation is taken from the beginning of the year until the midpoint of the month in which the disposition takes place • Table amount must be adjusted for the month of disposition: 3rd month disposition = 2.5/12

22. Alternative Depreciation System (ADS) • Under ADS, depreciation is computed using the straight-line method and the appropriate averaging convention • Under ADS, recovery periods for some assets are longer than MACRS • ADS must be used • For certain listed property • To compute earnings and profits • To compute AMT adjustment

23. Special First-YearDepreciation • Two special provisions apply to tangible personalty that increase the first year’s depreciation • Section 179 expensing election • Bonus depreciation • If the asset is eligible for both provisions, Section 179 expensing applies first

24. Section 179 Election • Taxpayers may elect to expense a portion of the cost of depreciable personalty in the year of acquisition • Applies to both new and used property • Annual limit is $102,000per taxpayer for 2004 • Amounts not expensed may be eligible for bonus depreciation and then regular MACRS depreciation

25. Section 179 Limits • When the total cost of eligible property placed in service for the year exceeds a dollar limit, the maximum annual expensing limit is reduced dollar-for-dollar • Limit is $410,000 for 2004 • If more than $512,000 ($410,000 + $102,000) of eligible assets placed in service, then no Sec. 179 expensing allowed

26. Section 179 Limits • The expense deduction cannot exceed taxable income from the business using the asset • The unused cost (due to this income limitation only) is carried forward to the next year and added to the amounts eligible for the expense deduction in that year

27. Section 179 Strategy • Expensing the assets with the longest class life generally maximizes the value of the Section 179 deduction • Section 179 expensing can also alter the application of the mid-quarter convention because property expensed under Section 179 is not counted in calculating the 40% test for the mid-quarter convention

28. Bonus Depreciation • Permits additional first-year depreciation for new personalty • For assets acquired between 5/6/03 and 12/31/04, 50% is allowed • For new assets acquired after 9/11/01, 30% bonus depreciation allowed • Basis is reduced for this bonus depreciation before taking regular MACRS depreciation

29. Mixed-Use Assets • If an asset is used for both business and personal purposes, depreciation is only permitted for the business-use portion • No depreciation allowed for the personal-use • If asset not used more than 50% for business, ADS must be used and Sec. 179 may not be elected • Business use does not include investment use

30. Mixed-Use Assets • Once ADS is required, it must be used for all future years for that asset • If business use is more than 50% in the first year, but business use declines in a future year, a change to ADS must be made • Any excess depreciation claimed in earlier years must be recaptured as income in the year of change to ADS

31. Employee-Owned Property • Two additional tests must be met to depreciate employee-owned property • The use of the property must be for the convenience of the employer and • The use of the property must be required as a condition of employment

32. Limits for Passenger Vehicles • Depreciation is limited to the lesser of regular MACRS deductions (including any Section 179 expensing) or the ceiling limit • Limits for autos placed in service in 2003 • $3,060 for first year without bonus and $10,710 with 50% bonus depreciation • $4,900 in the second year • $2,950 in the third year • $1,775 per year thereafter

33. Revised 2004 Auto Limits • Rev. Proc. 2004-20 revised the 2004 ceiling limits for auto by reducing the limits $100 for each year • New limits for autos placed in service in 2004 • $2,960 for first year without bonus and $10,610 with 50% bonus depreciation • $4,800 in the second year • $2,850 in the third year • $1,675 per year thereafter

34. Truck and Van Limits • Rev. Proc. 2004-20 also revised the 2004 ceiling limits for trucks and vans • New 2004 limits for trucks and vans • $3,260 for first year without bonus and $10,910 with 50% bonus depreciation • $5,300 in the second year • $3,150 in the third year • $1,875 per year thereafter

35. Ceiling Limits • When a vehicle is used less than 100% for business purposes, the ceiling limit allowed is reduced accordingly • If an employee uses an employer’s car for personal use but is taxed on that use, the employer calculates depreciation as if all use is business use • Special rules apply to cars used by a more-than-5% owner or someone related to the employer

36. Leased Automobiles • Taxpayers who lease autos can deduct the business portion of lease payments but must add a lease inclusion amount to income • The inclusion amount is obtained from an IRS table, based on the car's FMV and the tax year in which the lease commences, and is prorated for the number of days the car is leased

37. Revised Lease Inclusions • Rev. Proc 2004-20 also revised the 2004 lease inclusion amounts • Examples of inclusion amounts for a new auto leased in 2004 • If FMV = $40,000 then $90 for year 1, $197 for year 2, $292 for year 3, $351 for year 4, and $405 for year 5 and later years • If FMV = $50,000 then $126 for year 1, $277 for year 2, $411 for year 3, $493 for year 4, and $570 for year 5 and later years

38. Depletion • The cost of minerals, other natural resources, and timber are recovered through depletion • Taxpayers can elect to claim the greater of the two depletion deductions • Cost depletion – depletion per unit calculated by dividing adjusted basis by estimated recoverable units • Percentage depletion – calculated as a percentage of gross income

39. Intangibles • Intangible assets are grouped into 3 categories • Intangibles with perpetual life that cannot be amortized • 15-year intangibles (including goodwill) acquired as part of a business purchase (Section 197 assets) • Intangibles amortizable over a life other than 15 years

40. Research and Experimentation Expenses • Three alternatives for research and experimentation expenditures • Expense them in full in the year paid or incurred • Amortize them over 60 months or more • Capitalize them

41. Software • Off-the-shelf software can be deducted on a straight-line basis over 36 months beginning in the month placed in service • It is eligible for both Section 179 expensing and bonus depreciation

42. The End