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Chapter 6

Property Acquisitions and Cost Recovery Deductions T7-06-01-Ch6-Fixed Assets-2008.ppt Edited August 31, 2007. Chapter 6. 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

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Chapter 6

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  1. Property AcquisitionsandCost Recovery DeductionsT7-06-01-Ch6-Fixed Assets-2008.pptEdited August 31, 2007 Chapter 6

  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. HW-17. Basis for Depreciation Last year, Anne purchased a condo unit for $125,000. She used the condo as her personal residence. In the current year, when the condo unit appraises at $132,000, Anne moves out and converts the condo to rental property. What basis can Anne use when computing her depreciation on the rental condo unit?

  9. HWA-17. Basis for Depreciation $125,000. Anne uses the lower of her basis or fair market value at the date the condo is converted from personal to rental property.

  10. Acquisition in Taxable 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

  11. 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) Fraction for portion of gift tax: FMV at gift date – Donor’s Basis FMV at gift date

  12. Acquisition by Gift • 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

  13. HW-18. Gift Basis David received a gift of stock from Ted this year when the stock was worth $24,000. Ted purchased the stock for $18,000 five years ago and paid $2,000 of gift taxes on the gift. What is David’s basis for the stock?

  14. HWA-18. Gift Basis $18,500. David uses Ted’s basis increased by a portion of the gift tax related to the appreciation on the gift determined as follows: $2,000 gift tax x [($24,000 - $18,000)/$24,000] = $500 gift tax related to appreciation. $18,000 carryover basis from donor + $500 gift tax = $18,500.

  15. HW-19. Gift Basis Ellen received a gift of stock from Gisela this year when the stock was worth $50,000. Gisela purchased the stock for $60,000 four years ago. Calculate Ellen’s basis for the stock if she sells it: a. for $65,000? b. for $45,000? c. for $55,000?

  16. HWA-19. Gift Basis a. $60,000. The donor’s basis is always used to determine a gain. b. $50,000. Fair market value (when it is lower than the donor’s basis) is used to determine loss. c. $55,000. When the selling price is between the donor’s basis and the lower fair market value, there is no gain or loss. Effectively, basis equals the selling price.

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

  18. 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

  19. 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

  20. 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)

  21. 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

  22. HW-25. Depreciation of Realty Tatum Corp. (a calendar-year taxpayer) purchases a building on June 6 of the current year for $300,000, of which $60,000 is for the land. Depreciation for the first year if the building is: a. a warehouse? b. a rental apartment building?

  23. HWA-25. Depreciation of Realty a. $3,338 ($240,000 x 1.391%). This is 39 year property placed in service in month 6. b. $4,728 ($240,000 x 1.97%). This is 27½ year property placed in service in month 6.

  24. 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

  25. 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

  26. 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

  27. HW-20. MACRS Depreciation/Averaging Conventions Azona Corp. (a calendar-year taxpayer) purchased only one business asset during the current year, new 5-year property that cost $680,000. Compute Azona’s MACRS depreciation assuming that: a. the asset was purchased and placed in service on September 30, 2007. b. the asset was purchased and placed in service on October 1, 2007.

  28. HWA-20. MACRS Depreciation/Averaging Conventions a. Azona’s first-year depreciation is $97,172 ($680,000 x 14.29%) regular MACRS depreciation. (Note that Azona is not eligible to claim Section 179 expensing because it placed more than $562,000 property in service this year.) b. Azona’s first-year depreciation is $24,726 ($680,000 x 3.57% mid-quarter rate for a 4th quarter acquisition).

  29. HW-24. Depreciation/Averaging Conventions Kensington Corporation, Inc. (an October 31 fiscal year corporation) plans to purchase $600,000 of new office fixtures (7-year property) next year. This will be Kensington’s only personalty acquired during the year. Kensington’s management is willing to purchase and place the property in service anytime during the year to accelerate its depreciation deductions.

  30. HW-24. Depreciation/Averaging Conventions a. Compute the depreciation expense for the first year assuming all of the property is purchased and placed in service on June 19, 2007. b. Compute the depreciation expense for the first year, assuming all of the property is purchased and placed in service on September 19, 2007. c. What course of action do you recommend for Kensington?

  31. HWA-24. Depreciation/Averaging Conventions a. $92,885. The property is not eligible for the Section 179 expensing because the total investment exceeds $562,000. If placed in service in June, the half-year convention is used: $650,000 x 14.29% = $92,885. b. $23,205. The mid-quarter convention applies: $650,000 x 3.57% = $23,205 c. To maximize the first-year deduction the property should be place in service sometime prior to August 1 to avoid the mid-quarter convention.

  32. 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

  33. 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

  34. Dispositions • Second quarter dispositions, 4.5/12 months • Third quarter dispositions, 7.5/12 months • Fourth quarter dispositions, 10.5 /12 months

  35. 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

  36. HW-26. Depreciation in Disposal Year At the beginning of 2007, AB Corporation (a calendar year corporation) owned the following assets: Office Furn. Computer Equipment Date placed in service 11/15/04 4/15/05 Initial cost $20,000 $10,000 Accum. depreciation $10,160 $5,200 Recovery period 7-year 5-year Averaging convention Mid-qrter Half-year

  37. HW-26. Depreciation in Disposal Year On February 1, 2007, AB sold its office furniture. On March 15, 2007, AB sold its computer equipment. Compute AB Corporation’s depreciation deduction for 2007 for these two assets.

  38. HWA-26. Depreciation in Disposal Year Office Furniture: $352 ($20,000 x 14.06% x 1.5/12) Computer Equipment: $960 ($10,000 x 19.2% x ½)

  39. 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

  40. HW-29. Alternate Depreciation Craig Corporation (a calendar-ear corporation) purchased $655,000 of office furniture in April of the current year. It would like to know how much less the depreciation would be for the first three years if it elects to use ADS to compute its depreciation instead of regular MACRS accelerated deprecation.

  41. HWA-29. Alternate Depreciation Solution: The MACRS depreciation would be $368,568.50 [$655,000 x (14.29% + 24.49% + 17.49%)]. The ADS depreciation total is $233,966 [$655,000 x (7.14% + 14.29% + 14.29%)]. The difference is $134,602.50($368,568.50 - $ 233,966 ). The corporation is not eligible for Section 179 expensing because it placed equipment in excess of $562,000 in service this year.

  42. 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 $108,000per taxpayer for 2006

  43. Section 179 Limits. Pg. 242 • 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 $450,000 for 2007 • If more than $562,000 ($450,000 + $112,000) of eligible assets placed in service, then no Sec. 179 expensing allowed

  44. 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

  45. HW-21. Depreciation/Section 179 Expensing/Additional Bonus Depreciation In 2007, Lenux Corporation purchased $510,000 of new office furniture. Lenux wishes to take the maximum allowable depreciation deduction (including making any allowable elections). Calculate Lenux’s total depreciation deduction for 2007.

  46. HW-27. Section 179 Expensing Limitation In 2007, the Harry Corporation purchased and placed in service office furniture costing $150,000. What amount can Harry Corporation elect to expense under Section 179 if: a. this is the only asset placed in service this year by Harry Corporation. b. in addition to the $150,000 of office furniture, Harry Corporation also acquired and placed in service $300,000 of other factory equipment during the year. c. in addition to the $150,000 of office furniture, Harry Corporation also acquired and placed in service $450,000 of other factory equipment during the year.

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