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 the taxpayer (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 acquired • Liabilities of the seller assumed by the purchaser • Expenses of making 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) • Original basis of specific asset = • Total purchase price x (FMV of specific asset / FMV of all assets) • If the purchase price exceeds the value of the assets, the excess is goodwill • Alternatively, 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 any decline in value while used for personal purposes

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

9. Acquisition by Gift • Donee’s basis = donor’s basis + portion of gift taxes due to appreciation (but total cannot exceed FMV at date of gift) • This addition is gift tax paid multiplied by FMV at gift date – Donor’s Basis FMV at gift date • If FMV is less than donor’s basis, basis may be limited to lower FMV on subsequent sale

10. Acquisition by Gift • If FMV at gift date is less than donor’s basis • FMV used as basis only for loss determination (if sold at less than FMV) • Donor’s basis used for gain determination (if sold for more than donor’s basis) • No gain or loss if sold for price between FMV at gift date and donor’s basis • Holding period determined by basis used for gain or loss

11. Acquisition by Inheritance • Use date-of-death fair market value as basis for inherited property (or alternate valuation date, if elected) • Inherited property always has a long-term holding period

12. After-Tax Cost • Tax savings from depreciation deductions reduce the effective after-tax cost of an asset • The annual tax savings equal 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

13. 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

14. MACRS • Modified Accelerated Cost Recovery System assigns assets to a class with a pre-determined recovery period (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)

15. 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

16. MACRS Tables

17. 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

18. 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

19. Mid-Quarter Rates 5-year property 7-year property

20. 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

21. 39-Year Nonresidential Realty

22. 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

23. 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

24. 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

25. 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

26. ADS Tables

27. Section 179 Election • Taxpayers may elect to expense a portion of the cost of depreciable personalty in the year of acquisition (realty is not eligible) • Applies to both new and used property • Annual limit is $250,000per taxpayer for 2009 and 2010

28. 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 $800,000 for 2009 and 2010 • If more than $1,050,000 ($800,000 + $250,000) of eligible assets placed in service, then no Sec. 179 expensing allowed

29. 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

30. 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

31. Bonus Depreciation • For assets acquired in 2009 • 50% additional first-year depreciation for new personalty (used personalty and all realty ineligible) • Section 179 expensing claimed before bonus depreciation • Unlike Section 179 expensing, there were no phaseout or income limits for bonus depreciation

32. Bonus Depreciation • Basis was first reduced for Section 179 expensing before computing bonus depreciation • Basis was then reduced for bonus depreciation • Regular MACRS depreciation could be claimed on any basis remaining after reduction for both Section 179 expensing & bonus depreciation

33. Mixed-Use Assets • If an asset is used for both business and personal purposes, depreciation is only permitted for the business-use portion • 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

34. 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 to 50% or less 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

35. 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

36. Limits for Passenger Vehicles • Depreciation is limited to the lesser of: • Regular MACRS deductions (including any Section 179 expensing) or • Ceiling limit

37. Auto Ceiling Limits • Limits for autos placed in service in 2010 • $3,060 for the first year • $4,900 for the second year • $2,950 for the third year • $1,775 per year thereafter

38. Auto Ceiling Limits • Limits for autos placed in service in 2009 • $2,960 without bonus depreciation or $10,960 with bonus depreciation • $4,800 for the second year • $2,850 for the third year • $1,775 per year thereafter

39. Truck and Van Limits • Limits for trucks and vans placed in service in 2010 • $3,160 for the first year • $5,100 for the second year • $3,050 for the third year • $1,875 per year thereafter

40. Truck and Van Limits • Limits for trucks and vans placed in service in 2009 • $3,060 without bonus depreciation or $11,060 with bonus depreciation • $4,900 for the second year • $2,950 for the third year • $1,775 per year thereafter

41. Vehicle 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

42. Heavy SUVs • Heavy SUVs (gross vehicle weight over 6,000 pounds) are not subject to the vehicle depreciation ceiling limits • But the 2004 Jobs Creation Act reduced to $25,000 the cost of heavy SUVs (weighing up to 14,000 pounds) that can be expensed under Section 179

43. 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

44. Lease Inclusions • Examples of inclusion amounts for a new auto leased in 2010 • If FMV = $40,000 then $48 for year 1, $105 for year 2, $155 for year 3, $186 for year 4, and $215 for year 5 and later years • If FMV = $100,000 then $162 for year 1, $356 for year 2, $528 for year 3, $634 for year 4, and $731 for year 5 and later years

45. 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

46. 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

47. Research and Experimentation • Research and experimentation expenditures are costs incident to obtaining a patent and costs for development of an experiment or pilot model, formula or invention • Choice of three alternatives • Expense them in full in the year paid or incurred • Amortize them over 60 months or more • Capitalize them

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

49. The End