Capital Recovery: Depreciation, Amortization and Depletion

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

2. NOTE: There are a LOT of changes to the tax code in this chapter as a result of the May 6, 2003 Act! This chapter examines the various cost allocation methods allowed by the Code: depreciation, amortization and depletion. Each of these methods relates to a process of allocating the cost of an asset over time. Depreciation concerns tangible property, amortization concerns intangible property and depletion concerns natural resources.

3. Tangible Property There are two types of tangible property: real property and personal property. Real property (or realty) is land and anything attached to the land such as buildings, curbs, streets, fences and other improvements. Personal property is property that is not realty and is usually movable. The concept of personal property or personality should be distinguished from property that a person owns and uses for his or her benefit � usually referred to as personal-use property.

4. Depreciation and Amortization for Tax Purposes The Code allows as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property that is either used in a trade or business or held for the production of income. Only property that wears out or becomes obsolete can be depreciated. This requirement means that depreciation is allowed only for property that has a determinable life.

5. Depreciation and Amortization for Tax Purposes (cont�d) Property used for personal purposes cannot be depreciated. However, a single asset may be used for both personal purposes and profit-seeking activities. The taxpayer is permitted to deduct depreciation on the portion of the asset used for business or production of income. The basis for depreciation is the adjusted basis of the property as used for computing gain or loss on a sale or other disposition. Where property used is converted to use in business or the production of income, the basis for depreciation purposes is the lesser of the fair market value or the adjusted basis at the time of conversion.

6. Depreciation and Amortization for Tax Purposes (cont�d) The basis for depreciation must be reduced by depreciation allowed or allowable. When a taxpayer fails or forgets to claim a depreciation to which he or she was entitled in prior years, future depreciation charges may not be increased to correct for the error. The taxpayer can file an amended return to claim the depreciation not taken in that year. Congress revised the method for computing depreciation by enacting Code section 168 and the Accelerated Cost Recovery System (ACRS). The current version of this system is known as the Modified Accelerated Cost Recovery System (MACRS). An alternative to MACRS, called the Alternative Depreciation System (ADS), is also available.

7. MACR System Taxpayers are required to calculate depreciation for most property using the Modified Accelerated Cost Recover System (MACRS). Under MACRS, useful lives for assets are termed recovery periods and are prescribed by statute. Each asset is deemed to have a particular useful life of 3,5,7,10,15, 20,27.5 or 39 years. Salvage value is ignored under MACRS.

8. Property Subject to MACRS Taxpayers must use MACRS to compute depreciation for all tangible property. MACRS is not used to amortize intangible assets. MACRS may not be used with respect to: Property depreciated using a method that is not based on years (e.g., the units-of production method). Automobiles if the taxpayer has elected to use the standard mileage rate. Property for which special amortization is proved and elected by the taxpayer (e.g., amortization of pollution control facilities) Certain motion picture films, video tapes, sound recordings, and public utility property. Generally, any property that the taxpayer owned or used (e.g., leased) prior to 1987.

9. Property Subject to MACRS (cont�d) As a practical matter the taxpayer is allowed to elect out of MACRS and use the Alternative Depreciation System (ADS). In addition, in lieu of depreciation, the taxpayer may be allowed to expense up to $102,000 annually of the aggregate costs of certain assets placed in service during the year. Exhibit 9-1 identifies the depreciation methods and accounting conventions available under the MACRS and ADS systems.

10. Classes of Property All property subject to MACRS is assigned to one of eight classes. Classification is important because the recovery periods, methods and accounting conventions to be used in calculating depreciation can vary among the different classes of property. Property is assigned to a particular class based on its class life as prescribed in Revenue Procedure 87-56. An excerpt of Revenue Procedure 87-56 is provided in Exhibit 9-2.

11. Calculating Depreciation Under MACRS, depreciation is a function of three factors: the recovery period, the method, and the accounting convention. Recovery periods run various lengths of time based on the class of property (see Exhibit 9-1). Certain property is assigned to a class without regard to its class life. Note also that the current structure provides different recovery periods for real property, depending on whether it is residential or nonresidential real estate. Realty qualifies as residential real estate if 80% of the gross rents are for the dwelling units.

12. Calculating Depreciation (cont�d) The depreciation method to be used varies depending on the class of the property. The variation is actually between real and personal property. Real property is depreciated using the straight-line method Personal property is depreciated using either straight-line or a declining balance method.

13. Calculating Depreciation (cont�d) The final factor to be considered is computing depreciation is the accounting convention. The Code establishes three conventions: the half-year, mid-month and mid-quarter conventions. The half-year convention applies to all property other than non-residential real property and residential rental property. Under the half-year convention, one-half year of depreciation is allowed regardless of when the asset is placed in service or sold during the year. The recovery period is effectively extended one year so that the remaining one-half may be claimed.

14. Calculating Depreciation (cont�d) To simplify the computation of depreciation, the IRS provides optional tables as shown in Exhibits 9-4 to 9-7. The basic steps necessary to compute annual depreciation are as follows: Identify the depreciable basis of the asset Determine the MACRS property class Identify the depreciation convention Determine the recovery period and method. Locate the appropriate table based on the depreciation convention, recovery period and method. Choose the table percentages relating to the recovery period of the asset. Multiply the table percentages by the depreciable (cost) basis of the asset to compute annual depreciation amounts.

15. Mid-Month Convention Applies only to real property (i.e., non-residential real property and residential rental property). Under the mid-month convention, one-half month of depreciation is allowed for the month the asset is placed in service or sold and a full month of depreciation is allowed for each additional month of the year that the asset is in service. Due to the mid-month convention, the recovery period must be extended one month to claim the one-half month of depreciation that was not claimed in the first month.

16. Mid-Quarter Convention The mid-quarter convention applies only to personal property. However, it only applies if more than 40 percent of the aggregate bases of all personal property placed in service during the taxable year is placed in service during the last three months of the year. Property placed in service and disposed of during the same taxable year is not taken into account. Also not taken into account is any amount immediately expensed under section 179 or property used for personal purposes. If the 40 percent test is satisfied, the mid-quarter convention applies to all personal property placed in service during the year (regardless of the quarter in which it was actually placed in service). When applicable, the mid-quarter convention treats all personal property as being placed in service in the middle of the quarter of the taxable year in which it was actually placed in service.

17. Special Adjustment A special adjustment must be made if there is a disposition of the property before its cost is fully recovered. This adjustment is similar to that used for the half-year and mid-month convention. Ex: The taxpayer is entitled to only one-half of a quarter�s depreciation for the quarter that the asset is sold.

18. Straight-Line Method There may be circumstances where the slower-paced straight-line method may be more beneficial. For example, if the taxpayer is currently in the 10 or 15% tax bracket, he or she may want to defer depreciation deductions to years when he or she is in a higher tax bracket. The MACR System offers taxpayers a straight-line method of depreciation. The depreciation percentages to be used where the taxpayer elects the straight-line method are contained in Exhibit 9-8 (half-year convention property) for 3-, 5-, and 7-year property. Appendix C has straight-line depreciation tables for the half-year convention. The depreciation percentages for the mid-quarter convention are in Revenue Procedure 87-58.

19. Straight-Line Method (cont�d) The Alternative Depreciation System (ADS) is an option for taxpayers. The major differences between MACRS and ADS consist of different recovery periods (longer for most assets and slower for others). The recovery periods for ADS are summarized in Exhibit 9-9. Taxpayers electing ADS for real property are restricted to straight-line depreciation. The ADS depreciation percentages for real property are found in Exhibit 9-10. Except for real property, the taxpayer may elect to use ADS on property-by-property basis. The taxpayer must use ADS straight-line for depreciating: Certain �listed property� property Foreign use property (i.e., property used outside the U.S. more than half of a taxable year), Property leased to a tax-exempt entity (and foreign persons unless more than 50% of the income is subject to U.S. tax), and Property that is financed either directly or indirectly by the issuance of tax-exempt bonds.

20. Limited Expensing Election: Code Section 179 When Congress introduced ACRS, it also enacted a provision allowing taxpayers (other than estates or trusts) to elect to treat the cost of qualifying property as a currently deductible expense rather than a capital expenditure subject to depreciation. The maximum amount that can be expensed by a taxpayer is $102,000 (for acquisitions made in 2004). However, two limitations may restrict the amount that the taxpayer may otherwise expenses: Acquisitions of Eligible Property Exceeding $400,000. Where the aggregate cost of qualifying property placed in service during the year exceeds $410,000 (2004), the $102,000 amount must be reduced $1 for each $1 for each $1 of cost in excess of $410,000.

21. Code Section 179 (cont�d) However, two limitations may restrict the amount that the taxpayer may otherwise expenses (cont�d): Taxable Income Limitation. The deduction under section 179 cannot exceed the amount of taxable income (prior to consideration of this deduction) derived from all of the taxpayer�s trades or businesses (including wage income). Any amount that cannot be deducted can be carried over indefinitely to following years to be used against future income. The $102,000 maximum amount that can be expensed in subsequent years is not increased by the carryover amount, however. Rather than carry over the amount that could not be expensed because of the taxable income limitation, the taxpayer has the option of not reducing the property�s basis by the carryover amount so it can be depreciated along with the rest of the property�s cost.

22. Code Section 179 (cont�d) The taxpayer may elect to expense all or a portion of an asset so long as the total amount expensed does not exceed the dollar limitation. Only certain property is eligible for expensing: Recovery property; Property that would have qualified for the investment credit (e.g., most property other than buildings and their components); Property used in a trade or business, as distinguished from property held for the production of income; and Property acquired by purchase from someone who is generally not a �related party� under section 267 (e.g., gifted or inherited property usually does not qualify nor would property acquired from a spouse or parent).

23. Code Section 179 (cont�d) Certain property is designated as ineligible for expensing includes Property used predominantly to furnish lodging or in connection with furnishing lodging unless the business is a hotel or motel that provides accommodations used (e.g., apartments, duplexes and the like) Property that is primarily used by a tax-exempt organizations; Air conditioning and heating units; and Property used outside the U.S.

24. Code Section 179 (cont�d) If the property is converted to non-business use at any time, the taxpayer must be recapture the benefit derived from expensing. Recapture requires the taxpayer to include in income the differences between the amount expensed and the MACRS deductions that would have been allowed for the actual period of business use.

25. Bonus Depreciation The Act allows taxpayers to claim an additional first-year depreciation deduction equal to 50% of the adjusted basis of new qualified property (section 168(k)) for property placed in service on or after May 6, 2003 and before January 1, 2005 . This �bonus� depreciation is in addition to any amount expensed under section 179 and regular depreciation. Observe that while the section 179 allowance phases out, taxpayers may still take advantage of the bonus depreciation.

26. Bonus Depreciation (cont�d) Qualified property is generally all newly acquired depreciable property � other than buildings. Only new property qualifies. To qualify, the property�s first or original use must commence with the taxpayer on or after May 6, 2003 (30% for property acquired and placed in after September 10, 2001 and before May 6, 2003). For this purpose, capital expenditures incurred to recondition or rebuild property meet this requirement. The cost of reconditioned or rebuilt property acquired by the taxpayer is considered used property and does not qualify.

27. Bonus Depreciation (cont�d) Qualified property includes the following: Property eligible for MACRS depreciation with a recovery period of 20 years or less; Certain water utility property; Computer software (other than software that is acquired in connection with the acquisition of a business); Qualified leasehold improvement property. A qualified leasehold improvement is an interior improvement made under a lease of commercial property and placed in service more than three years after the building was first placed in service.

28. Bonus Depreciation (cont�d) Intangibles would not qualify for the additional allowance. Section 197 intangibles such as goodwill, covenants not to compete, and customer lists acquired in connection with the purchase of a business also would not be eligible. Property that must be depreciated using the ADS System does not qualify. However, if the taxpayer merely elects to use ADS for certain property, bonus depreciation can still be claimed.

29. Bonus Depreciation (cont�d) There is no limitation on the amount of bonus depreciation that may be claimed. Taxpayers may claim bonus depreciation for all qualified property. In addition, taxpayers may claim both bonus depreciation and section 179 expensing. When both amounts are claimed the bonus depreciation is equal to 50% of the adjusted basis of the property after the reduction for the amount expensed under section 179. Regular depreciation is computed after the basis of the property is reduced by both the section 179 amount and the 50% additional allowance.

30. Bonus Depreciation (cont�d) The full amount of bonus depreciation may be claimed regardless of whether the mid-quarter convention applies. Note: a taxpayer may elect not to claim the additional allowance. This may be done simply by computing depreciation in the normal fashion.

31. Bonus Depreciation and Section 179 Compared Although section 179 and bonus depreciation are similar, the same limitations do not apply. The expensing allowance of section 179 is subject to several special rules that limit its application. Differences include: Bonus depreciation is not limited to the taxable income from the business. Bonus depreciation does not phase-out based on the amount of property placed in service during the year. Bonus depreciation can be claimed for purchases of investment property while section 179 applies only to business property. Bonus depreciation can be claimed on purchases from related parties while section 179 cannot. Estates and trusts are not allowed to elect section 179 but can use bonus depreciation. Section 179 can be claimed for used property while bonus depreciation cannot.

32. Limitations for Automobiles Section 280F carves out a special set of limitations for passenger automobiles: A passenger automobile is defined as any four-wheeled vehicle manufactured primarily for use on public streets, roads, and highways that weighs 6,000 pounds or less unloaded. The term passenger automobiles does not include vehicles for hire, such as taxi cabs, rental trucks, and rental cars. Ambulances and hearses directly used in a trade or business are also unaffected sport utility vehicles with gross weight ratings above 6,000 pounds are not affected by the auto depreciation limits. The maximum bonus depreciation and/or section 179 expense for autos is shown in Exhibit 9-11. The limits for a particular auto are determined by the year the auto is placed in service by the taxpayer.

33. Limitations for Autos (cont�d) The Act increases the first year limitation imposed by section 280F for automobiles by $7,650 from $4,060 to $10,710 if 50% bonus depreciation is elected. Exhibit 9-11 shows subsequent depreciation limits (assuming a 6 year recovery period) The Section 280F increase is allowed only for cars that qualify for bonus depreciation. Due to this change, only cars that cost more than $17,850 will be effected by the $10,710 limitations [($17,850 x 50% = $8,925) + (20% X {$17,850 � 8,925} = $1,785)].

34. Limitations for Autos (cont�d) Where the car is used less than 100% of the time for business � including the portion of time the car is used for production of income purposes � the maximum amounts must be reduced proportionately. If the property�s basis has not been fully deducted by the close of the normal recovery period, a deduction for the un-recovered basis is allowed in subsequent years. Deductions for the property�s un-recovered basis are limited to $1,775 annually until the entire basis is recovered.

35. Limitations for Autos (cont�d) The Act recognized that trucks and vans cost more than cars and created a separate set of limitations for these vehicles Total Section 280F depreciation limits for 2003 $11,010 See Exhibit 9-12 This does not apply to vehicles weighing over 6000 pounds

36. Limitations for Autos (cont�d) One effect of the new law is to make vehicles weighing over 6,000 pounds a very attractive purchase. Since the automobile limitations do not apply to such vehicles (certain sport utility vehicles) and taxpayers can now expense up to $102,000 (2004) under section 179 the entire cost (or at least the portion used for business) can be deducted of these vehicles.

37. Limitations for Autos (cont�d) The depreciation ceilings for automobiles are tripled for electric vehicles is tripled to $22,950. Thus the first year ceiling amount for electric cars is $26,040 for vehicles placed in service on or after May 6, 2003 ($9,090 + $22,880 = $32,030) Exhibit 9-13 shows the Section 280F depreciation limits for electric cars

38. Leasing The amount that the taxpayer must include in income is generally based on the automobile�s fair market value and is determined in the following manner: Using the value of the automobile for the taxable year in which the auto is first used under the lease, identify the annual inclusion amount from the table found in Exhibit 9-14. Note: for the last year of the lease, the dollar amount of the preceding year is used Prorate the dollar amount for the number of days of the lease term included in the taxable year. Multiply the prorated dollar amount by the business and investment use for the taxable year. Note: without these rules a taxpayer could circumvent the depreciation rules

39. Limitations For Personal Use Section 280F also restricts the amount of depreciation that may be claimed for so-called �listed property� that is not used predominantly � more than 50% � for business. If the property is not used more than 50% for business in the year it is placed in service, the following restrictions are imposed: Limited expensing under section 179 is not allowed. MACRS may not be used in computing depreciation. Note that these restrictions are imposed if the property is not used primarily for business in the first year. Subsequent usage in excess of 50% does not permit the taxpayer to amend the earlier return or later use accelerated depreciation or limited expensing. On the other hand, if qualified usage initially exceeds 50% but subsequently drops to 50% or less, benefits previously secured must be relinquished. Exhibit 9-13 identifies the depreciation methods available for listed property.

40. Limitations For Personal Use (cont�d) The restrictions apply only to listed property: Passenger automobiles Any other property used as a means for transportation (e.g., motorcycles and trucks) Any property generally used for purposes of entertainment, recreation, or amusement unless used exclusively at a regular business establishment (e.g., at the office) Any computer or peripheral equipment unless used exclusively at a regular business establishment Any cellular telephones and similar communications equipment Bonus depreciation may be claimed for listed property as long as such property is eligible for MACRS. If qualified business use does not exceed 50%, ADS must be used and, in such case, the property would not be eligible for bonus depreciation

41. Limitations For Personal Use (cont�d) In determining whether the property is used more than 50% for business, only qualified business use is considered. An employee�s use of his or her own property in connection with employment is not considered business use unless it is for the convenience of the employer and is required as a condition of employment. The qualified business use rules directly address the problems of the company-owned car and other company-owned property used by employees.

42. Limitations For Personal Use (cont�d) Where an employee use an automobile, an employer is able to secure 100% qualified business use � and thus depreciate the entire cost of the automobile � in one of four ways: The employee�s actual business usage is disregarded and the entire value of using the vehicle is included in the employee�s income; The employee�s actual business usage is combined with inclusion of the value of any personal use by the employee as income; The employee�s actual business usage is combined with a reimbursement arrangement where the employee reimburses the employer for any personal use (i.e., a fair rent is paid); or, The use falls under one of four exceptions. Conditions 2 and 3 cannot be applied to qualify the use of a person owning greater than a 5% interest in the business. The car is depreciated based on actual business usage.

43. Limitations For Personal Use (cont�d) Each requires a valuation of the vehicle�s use by the employee: The value can be determined using a facts-and-circumstances approach or one of several safe harbors provided by Temporary Regulations. The Regulations provide a table based on the car�s total value which provides values for personal use. Another alternative is the standard mileage allowance. Bonus depreciation is considered to be depreciation for purposes of these recapture rules. Thus, if business use falls below 50% within 2 years after the asset is placed in service, recapture occurs.

44. Limitations For Personal Use (cont�d) For listed property, the taxpayer is required to substantiate the following: The amount of each expenditure related to the property, including the cost of acquisition, maintenance and repairs; The date of the use of the property; The amount of each business or investment use as well as total use (the number of miles � in the case of a car or other means of transportation � or the amount of time that the property was used for other listed property (e.g., a computer); The purpose of the use of the property.

45. Anti-Churning Rules Sales, exchanges, and other dispositions of assets are referred to as �churning� transactions � exchanges of used property solely to obtain the benefits of MACRS. The thrust of the anti-churning rules is to preclude the use of MACRS for property placed in service prior to the enactment of either version of MACRS, unless the property is transferred in a transaction where not only the owner changes but also the user. There are three sets of rules designed to police churning. A taxpayer would typically be subject to the anti-churning rules in the following situations: Sale followed by immediate leaseback Like-kind exchange Formation and liquidation of a corporation or partnership, including transfers of property to and distributions from these entities.

46. Special Note Mid-term 2 and Final Exam Note: you will not be responsible for studying/knowing the sections on: Amortization (page 9-36) Depletion (page 9-38) Research and expenditures (page 9-40) or Expenses of farmers or ranchers (page 9-43)