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Maximizing Business Asset Tax Benefits

Understand cost recovery deductions for business assets, including depreciation methods and conventions for tangible property. Learn how to calculate deductible depreciation to optimize tax benefits over the asset's useful life.

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Maximizing Business Asset Tax Benefits

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  1. Chapter 10Property Acquisitions and Cost Recovery Deductions AKA: Tax Treatment of Business Assets

  2. Cost Recovery Businesses must capitalize the cost of assets with a useful life of more than one year on the balance sheet rather than expense the cost immediately Also known as depreciation, amortization, or depletion – depending upon the underlying nature of asset Businesses use these methods to recover cost of assets due to wear, tear and obsolescence of assets

  3. Tax deductible later … Tangible Assets Tangible Asset’s cost is deducted HOW: through depreciation (aka Cost Recovery) WHEN: as the asset is used Depreciation: Purpose: Provides a systematic way to “write-off” or expense the cost of assets over their useful lives.

  4. Basis Example Scrap-Happy Inc., a scrapbooking retail chain, purchased an old office building for $175,000 for use in expanding its current operations. An additional $15,000 was spent painting and remodeling the building in preparation for its opening. Two years later, a Scrap-Happy employee discovered that several leaks in the roof were causing serious water damage to the store’s inventory; the company spent $50,000 to re-roof the building. Every six months, Scrap-Happy pays $500 to have the carpet professionally cleaned.

  5. Basis Example (cont.) What is the original basis of the building? $175,000 initial cost + $15,000 painting and remodeling $190,000 Original Basis What effects do the other two transactions have on the original basis? $50,000 re-roofing expense: Added to basis (extends the useful life of the building) $500 biannual carpet cleaning: No effect on basis (Expensed immediately  routine maintenance)

  6. “Allowed or allowable” • For tax purposes, basis of asset MUST be reduced by cost recovery deductions allowed OR allowable. • That is, if business fails to claim allowable deduction for earlier year, it can’t currently deduct depreciation attributable to earlier year. • Must either file amended return for earlier year to claim deduction --- or lose it. • Example.

  7. MACRS (Modified Accelerated Cost Recovery System) • Provides systematic depreciation for tax purposes based on set property classes

  8. Categories of Depreciable Property Realty -- Assets firmly attached to land, but not land itself Personalty -- assets that are not realty

  9. Personal Property Depreciation

  10. Depreciation Methods • 200 percent declining balance (default position); 150 percent declining balance and straight line • Examples of each • Normally, business chooses 200 percent declining balance to accelerate depreciation

  11. Cost Recovery Period

  12. Depreciation Conventions Half-year Convention One–half year’s depreciation is allowed in first and last year of an asset’s life IRS depreciation tables automatically account for the half-year convention in year of purchase If an asset is disposed of before it is fully depreciated, only one-half of the table’s applicable depreciation percentage is allowed in the year of disposition

  13. Examples 10-3 and 10-4 on p.10-9

  14. Depreciation Example 1: Year of Acquisition Joseph Textiles, Inc. (rug producer) acquires new sewing machinery on June 4, 2014, for $100,000. Calculate deductible depreciation for 2014. Ignore IRC Sec 179 & Bonus Depreciation Calculate deductible depreciation for 2015.

  15. Alternative Depreciation Convention • Mid–Quarter Convention • Steps to determine whether the mid–quarter convention applies • Sum of the total basis of tangible personal property that was placed in service during the year • Sum of the total basis of tangible personal property that was placed in service during the fourth quarter • Divide step (2) by step (1), if the quotient is more than 40%, then the business must use this method

  16. Depreciation Example 2 • In 2014, Scrap-Happy purchased and placed in service the following assets: • What is the recovery period for each of the assets? • Computer = 5 years • Di-Cut Machine = 7 years • Which convention should Scrap-Happy use to determine depreciation for 2014? • Answer: Half-year •  $1,200 4th qtr. assets/$4,700 total assets = 25.53% < 40%

  17. Depreciation Example 3 • Now assume all the same facts, except that the computer was purchased in February and the machine in October, as shown: • What convention should be used in computing depreciation for the year? • Answer: Mid-quarter •  $3,500 4th qtr. assets/$4,700 total assets = 74.46% > 40% • How much depreciation can they take for each of the assets in 2014? • Computer: $1,200 x 35%* = $420 • Di-Cut Machine: 3,500 x 3.57%* = $125 *See respective mid-quarter MACRS tables for rates

  18. Depreciation incentives • Immediate Expensing • This incentive is commonly referred as §179 expense or immediate expensing election • Limits on immediate expensing • Choosing the assets to immediately expense • Bonus Depreciation • To stimulate the economy, policy makers occasionally implement bonus depreciation

  19. IRC §179–Election to Expense Assets Annual Limit(in 2015?) • Up to $500,000 of expenses for tangible personal property placed in service during 2014 (but only $25,000 in 2015 under current law) • Also, limited to business’ net income after deducting all expenses (including regular depreciation expense), except the §179 expense • Phased out for property purchased and put in service in 2014 in excess of $2,000,000 (but only $200,000 in 2015 under current law)

  20. Depreciation Example 4 JacksonPacking Company buys two $300,000 machines (7-year property) on April 15, 2014 and elects the maximum IRC §179 allowed. What is total cost recovery for 2013? Cost of machines $ 600,000 IRC § 179 deduction $ 500,000 Depreciable basis $ $100,000 MACRS rate .1429 Current depreciation ded $ 14,290 Total Deductions $514,290 How would answer change in 2015 if 2014 rules not extended to 2015?

  21. Bonus Depreciation (in 2015?) • Allows companies to take an additional 50% depreciation in first year. • The additional depreciation is taken after the §179 expense but before regular MACRS depreciation • Applies to most new tangible business property. (Does not include used property.) .

  22. Depreciation of Personal Property Recap Determine depreciable basis Determine §179 expense, if applicable Determine MACRS depreciation expense

  23. Depreciation of Real Property

  24. Depreciation Methods - Realty • Real Property • It uses mid–month convention and depreciated using straight line method

  25. REAL PROPERTY:Depreciation Example 5 • On July 12, Scrap-Happy purchases and places in service a warehouse and the land it resides on for $170,000 ($120,000 is allocated to the building and $50,000 to the land). • What is the amount of depreciation on the property for the first year? • Answer: $120,000 x 1.177% = $1,412 • 1.177% is the rate given in the nonresidential real property MACRS table under the column for the 7th month* • Land is not included in the calculation because it is not depreciable

  26. Depreciation Example 6 Year of Acquisition Wells Fargo Inc. acquires an office building for $1,000,000 on July 1, 2014. Calculate deductible depreciation expense for 2014 • Office bldg is non-residential realty => 39 year life • Middle of 7thmonth of year Table Rate is 1.177% (month 7, year 1) 1.177% x 1,000,000= $11,770 depreciation deductible for 2015.

  27. Depreciation Example 6 (cont.) Year of Disposition Wells Fargo sells the building for $1,250,000 in October 2015. • same 39 year life • Sold in middle of 10th month of year • Rate is 2.564% x 9½mo/12mo = 2.030% • 2.030% x $1,000,000= $20,300 depreciation deduction

  28. Depreciation of Realty Recap • Determine cost recovery period Residential -> 27½ years & Non-residential -> 39 years • Determine convention • Determine method (aka rate) • Table for Residential & Non-residential Realty • Determine depreciation expense • Multiply rate by depreciable basis

  29. Intangible Property • Section 197: Certain Types of Acquisition Goodwill Amortized over 15 years using the straight-line method. • Section 195: Taxpayer can elect to amortize startup costs over 15 years using the straight-line method.

  30. Depreciation (Chapter 10) Discussion Questions • Questions 1, 7, 9, 15, and 21

  31. Depreciation (Chapter 10) Problems • Problems 41, 46, 48, 49, 53, and 55 at the back of chapter 9 • .

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