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Module 10

Module 10. Cost Recovery Deductions. Cost Recovery Topics. Depreciation Accelerated Cost Recovery System Modified Accelerated Cost Recovery System Amortization Depletion. Economics of Cost Recovery. Expenditure benefits more than 1 tax year §263 denies a current deduction

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Module 10

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  1. Module 10 Cost Recovery Deductions

  2. Cost Recovery Topics • Depreciation • Accelerated Cost Recovery System • Modified Accelerated Cost Recovery System • Amortization • Depletion

  3. Economics of Cost Recovery • Expenditure benefits more than 1 tax year • §263 denies a current deduction • Cost recovery allows deduction over time • Tax policy issues • Marginal efficiency of capital affected by tax savings • Recovery periods • Recovery methods

  4. Cost Recovery Tax Savings • Assumptions • $10,000 asset • 35% marginal tax rate • 10% interest rate

  5. Cost Recovery Tax Savings • Assumptions • $10,000 asset • 35% marginal tax rate • 10% interest rate

  6. The Depreciation Allowance: Basic Requirements Key Learning Objective • Basic requirement • Qualifying property • Placed in service • Depreciable basis

  7. Qualifying Property • Limited (Exhaustible) Useful Life • Qualifying Use of Property • Trade or Business • Income-Producing Activity

  8. Placed in Service (PLIS) • PLIS when taxpayer can demonstrate • Readiness • Availability • Capacity to perform • Date PLIS can effect amount of cost recovery • Change in tax law • Affect modifying convention

  9. Cost Recovery Basis • Initial basis • Purchased property • Constructed property • Personal property converted to business use • Subsequent changes in basis • Capital improvements • Depreciation “allowed or allowable” • Return of capital

  10. Compliance Query: Conversion from Personal to Business Use • Purchased home for $125,000 • IF FMV = $112,000 at conversion • What is basis for depreciation? • IF FMV = $150,000 at conversion • What is basis for depreciation?

  11. Solution to Compliance Query: Conversion from Personal Use • Get lower of basis or FMV • Basis if converted when FMV = $112,000 • $112,000--lose decline in value during personal use • Basis if converted when FMV = $150,000 • $125,000--no step up for unrealized appreciation

  12. MACRS--The Basic Rules Key Learning Objectives • Class life • Depreciable basis • Recovery method • Modifying convention

  13. Equipment 5 & 7 year classes Most common Tangible equipment 3 year class Some animals & specialized equipment 10,15,20 Specialized uses Real Estate Residential--27.5 year Generally apartments & rental houses Non-residential 39 year In service after 8-9-93 31.5 year In service before 8-8-93 Class Life = Recovery Period

  14. Class Life Rev. Procs. 87-56 & 88-22 • IRS provides information as to class life • Assets used in all businesses • Classes 00.11 - 00.4 • Assets used in particular activities • Classes 01.1 - 80.0 • Equipment with no class life given • Use 7 years

  15. Research Query: MACRS Recovery Periods • This year Sea Drilling • Installed sidewalks around its office building • Purchased five floating drilling platforms for at-sea exploration. • See Rev. Proc. 87-56 in the OnPoint Service to determine recovery periods.

  16. Solution--Research Query • Sidewalks -- MACRS life of 15 years • used in all business activities • listed in Class 00.3 • Drilling platforms -- MACRS life of 5 years • used in specific activities • listed in Class 13.0

  17. TaxPoint: Class 57.0-- 7 Gets You 5 • Class 57.0 reads as follows: • Distributive Trades and Services: Includes assets used in wholesale and retail trade, and personal and professional services. Includes section 1245 assets used in marketing petroleum and petroleum products • If used in a “distributive trade or service,” an asset normally classified as 7-year property would get 5-year class life.

  18. Depreciable (Recovery) Basis • Salvage value always ignored • Equipment (equipment) • Reduction for §179 Election • Reduction for 50% of certain business credits • Realty • Exclusion of any land costs • Reduction for rehabilitation credits

  19. MACRS Recovery Methods • 200% declining balance • 3,5,7,10 year classes of equipment • 150% declining balance • 15 and 20 year classes of equipment • Conversion to straight-line allowed • Straight-line • All realty

  20. Modifying ConventionYear of Acquisition Equipment • General rule--half-year convention • Exception--mid-quarter convention IF • More than 40% • In service in last quarter Realty • Mid-month convention

  21. The Four Quarters of Mid-Quarter • Applies to all assets according to quarter placed in service

  22. Compliance Query: Modifying Convention • A calendar year taxpayer places in service:

  23. Solution to Compliance Query: Modifying Convention • First test for mid-quarter • The warehouse is ignored for the 40% test • 4th quarter divided by all Equipment acquisitions • 10,000 ÷ 260,000 = 3.8% • This is less than 40% • The half-year convention applies

  24. Solution--Compliance Query Appropriate MACRS Deduction Machine ($250,000 x .1429) . . . . . $35,725 Computer ($10,000 x .20) . . . . . . 2,000 Warehouse ($100,000 x .00535) . . 535 The mid-month convention applies to buildings. Note that the tables other than five -year are on the TaxPoint disk.

  25. Compliance Query: Modifying Convention • If we reverse the month of acquisition for the equipment that our calendar year taxpayer places in service, we get a different answer for the computer and equipment but not the building.

  26. Solution to Compliance Query: Modifying Convention • First test for mid-quarter • The warehouse is ignored for the 40% test • 4th quarter divided by all equipment acquisitions • 250,000 ÷ 260,000 = 96.2% • This is more than 40% • The mid-quarter convention applies

  27. The Four Quarters of Mid-Quarter • The computer was placed in service in March, so it is first quarter mid quarter 5-year property--35%. • The equipment is fourth quarter, mid quarter 7 year, so this table doesn’t apply.You will find 3.57% in the 7 year 4th quarter mid-quarter table on the disk.

  28. Solution--Compliance Query Appropriate MACRS Deduction Machine ($250,000 x .0357) . . . . . $8,925 Computer ($10,000 x .35) . . . . . . . . 3,500 Warehouse ($100,000 x .00535) . . . . 535 The mid-month convention applies to buildings. Note that the tables other than five -year are on the TaxPoint disk.

  29. Compliance Query: MACRS Deduction in Year 2, (no disposition) • Do not leave the column you started in! Machine ($250,000 x .2755) . . . . . $ 68,875 Computer ($10,000 x .26) . . . . . . . .$ 2,600 Warehouse ($100,000 x .02564) . . $ 2,564 • Note that the tables other than five -year are on the TaxPoint disk.

  30. Modifying ConventionYear of Disposition • Applies to both equipment & realty • Use same convention as in year acquired • If mid-month, count the months, subtract 1/2 month, divide by 12 • If mid-year, use 1/2 • If mid-quarter, count the quarters, subtract 1/2 quarter, divide by 4

  31. Compliance Query MACRS Deduction in Year 3, (sell in July) • Do not leave the column you started in! Machine ($250,000 x .1968 x 2.5 ÷ 4) . . . . $30,750 Computer ($10,000 x .1560 x 2.5 ÷ 4) . . . . . .$975 Warehouse ($100,000 x .02564 x 6.5÷12) . . . . $1,389

  32. Compliance Query: Once More, on Your Own • Mac Co. a calendar-year corporation • Placed in service in October • $250,000 of computers • only assets acquired that year • What is the recovery deduction for Year 1? • If Mac sells the computer in June, of Year 3 what is the year 3 recovery deduction?

  33. Solution--Compliance Query: Once More, on Your Own. Solution Year 1: 5 year/ mid-quarter property $250,000 x .05 = $12,500 Solution Year 3: still 5 year/mid-quarter $250,000 x .2280 x (1.5/4) = $21,375 • Mid-quarter, count the quarters, subtract 1/2 quarter, divide by 4

  34. MACRS - Special Elections Key Learning Objectives • The requirements for the §179 election • The two straight-line recovery methods available under MACRS

  35. §179 Immediate Expensing Election • Qualifying personal property equipment used in an active trade or business Year of acquisition only • $20,000 maximum annual election -- 2000 • $ for $ phaseout of $ 20,000 for acquisitions over $200,000 • Can’t create a loss with §179 deduction

  36. Tax Planning QueryMake a §179 Election? • Minor Co. a calendar-year corporation • PLIS a $15,000 computer in April • (the only asset acquired that year). • Taxable income for the current year is $500 before considering MACRS recovery • Minor had profits of $120,000 in each of the preceding five years. • What factors should Minor consider in evaluating a §179 election?

  37. Electing §179 Expense $15,000 Deduction limited to $500 (limited to taxable income) $14,500 may be carried to the next year Not Electing §179 MACRS deduction = $3,000 ($15,000 x .05) creating an NOL NOL may be carried back to the third prior tax year Refund = $975 ($2,500 x .39) Solution--Tax Planning Query Make a §179 Election?Key Factor--Expected profitability in future

  38. Tax Planning Query:Place In Service This Year or Next? • Meta Co. a calendar-year corporation • Put in service in February • $120,000 equipment (only acquisition to date) • Meta wants to acquire $83,000 of furniture • Should Meta placed the furniture in service • in December or January of the next tax year? • What factors should Meta consider in deciding when to buy the furniture?

  39. Solution--Tax Planning Query Place In Service This Year or Next? If placed in service in December • Total acquisitions = $203,000 • Maximum §179 = 17,000. (20,000- 3000) • Expensed property not used in test for mid-quarter • Could expense either equipment or furniture • If equipment, then mid-quarter • 83,000 ÷ (203,000-17,000) = 44.6% • If furniture, then half year • (83,000-17,000) ÷ (203,000-17,000) = 35.5%

  40. Solution--Tax Planning Query Place In Service This Year or Next? If placed in service in January of next year • Then for the current year • Maximum §179 is $ 20,000 (assumes 2000) • The half-year convention will apply • no acquisitions in fourth quarter

  41. MACRS Straight-Line Options • Acquisition year conventions apply • Must make election by class by year • Straight-line over the MACRS life • Straight-line over the class life Alternative depreciation system (ADS) • Major exceptions to the class life rule: • Autos and computers (5 years) • equipment with no class life (12 years) • Realty (40 years)

  42. Compliance Query:Which MACRS Elections? • Melon Corp. a calendar-year corporation • PLIS a $29,000 machine in March 2000 (the only asset acquired this year) • The machine does not have a class live • Melon elects §179 • What is the TOTAL cost recovery under • Regular MACRS recovery • Straight-line MACRS recovery • Alternative Depreciation System (ADS)

  43. Solution--Compliance Query Which MACRS Elections? §179 deduction = $20,000 Remaining basis = $ 9,000 No class live so MACRS = 7 and ADS = 12 MACRS = $1,286 ($9,000 x .1429) MACRS SL = $ 643 ($9,000 x 1/7 x .5) ADS SL = $ 375 ($9,000 x 1/12 x .5) TOTAL deduction increased by $ 20,000 in each case

  44. MACRS--Special Restrictions Key Learning Objectives • The anti-churning rules • Restrictions applicable to listed properties • Including special limits on automobiles • MACRS computations for alternative minimum tax (AMT) purposes

  45. Anti-churning RulesPrevent Perceived Abuse • Prevents using sales between related parties to change depreciation methods when tax law changes • If related party sale occurs, the transaction is ignored, old recovery method continues

  46. Listed Property Rules: Personal Use Can Limit Recovery • Applies only to equipment • Subject to restriction if Qualified Business Use (QBU) < 50% • QBU generally limited to non-employee trade/business use

  47. Listed Property Rules: Personal Use Can Limit Recovery • Straight line over CLASS LIFE used in any year QBU < 50% • Test must be applied each year • Recapture applies if MACRS used prior to failing the business usage test

  48. Compliance Query:Change in QBU • Sue Adams , a calendar-year taxpayer • Placed in service in March • $10,000 computer • the only asset acquired this year • §179 NOT elected • For Year 1 QBU = 90%. • For Year 2 QBU = 40%. • What are Sue’s recovery deductions?

  49. Year 1 MACRS recovery = $1,800 ($10,000 x .2 x .9) ($10000 ÷ 5 x 2 x .9) Note ADS would have been $900 ($10,000 ÷ 5 x .9) Year 2 ADS straight-line recovery = $800 ($10,000 x 1/5 x .40). $900 recaptured as additional income This is the difference between MACRS Yr 1 (1800) & ADS Yr 1 (900) Solution--Compliance Query Change in QBU

  50. Luxury Auto Rules--Everyone Bought a $15,300 Car in 1999 • Limits for autos placed into service in 2000 • First year $3,060 (15,300 x .20) • Second year $5,000 (15,300 x .32) • Third year $2,950 • Remaining years $1,775

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