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 is: • Deducted currently or • 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 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. Basis of Property • 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 • 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 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. Acquisition in aTaxable 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 and the basis of the property acquired is its FMV

9. 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) • FMV at gift date – Donor’s Basis FMV at gift date • If FMV at gift date is less than donor’s basis and property is sold for a loss, donee uses lower FMV as basis

10. Acquisition by Inheritance • Use Fair Market Value as basis for inherited property Will Will

11. After-Tax Cost • Tax savings from depreciation deductions reduces the effective after-tax cost of an asset • The annual tax savings equals the 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

12. 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

13. 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)

14. MACRS • Depreciation for personalty can use: • 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 • Original basis is multiplied by % from table

15. MACRS Tables

16. 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

17. Averaging Conventions • Mid-quarter convention is required if more than 40% of the personalty (not buildings) was placed in service during the last quarter of the 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

18. 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

19. Mixed-Use Assets • If an asset is used for both business and personal purposes, depreciation is only permitted for the business-use portion • No depreciation is allowed for the personal-use portion

20. Dispositions • When an asset is disposed of before it is fully depreciated, the same averaging convention will apply • An asset that was depreciated under the half-year convention will be allowed one-half year’s depreciation in the year of disposal

21. 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, 1½ /12 months • Fourth quarter dispositions, 10½ /12 months • For realty, depreciation is taken from the beginning of the year until the midpoint of the month in which the disposition takes place

22. 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

23. Section 179 Election • Taxpayers may elect to expense a portion of the cost of depreciable personalty in the year of acquisition • Pre-2003 Tax Act annual limit was $25,000 per taxpayer • 2003 Tax Act raises limit to $100,000 for 2003, 2004, and 2005 • Excess cost is subject to regular MACRS depreciation

24. 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 • Pre-2003 Tax Act limit was $200,000 • 2003 Tax Act increased limit to $400,000 for 2003, 2004, and 2005

25. Section 179 Limits • The expense deduction cannot exceed taxable income from the trade or business using the asset • The unused cost (due to this income limitation only) is carried forward to the next year and added to the qualifying amounts for the expense deduction in that year

26. Section 179 Strategy • Expensing the assets with the longest class life will generally maximizes the value of the Section 179 deduction • The use of 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

27. Additional First-Year Depreciation • Permits additional first-year depreciation for new personalty • Before 2003 Tax Act, 30% was allowed for assets acquired 9/11/01 - 9/10/04 • 2003 Tax Act increases this to 50% for assets acquired 5/6/03 – 12/31/04 • Basis is reduced for this additional depreciation before taking regular MACRS depreciation

28. Additional First-Year Depreciation • When Section 179 has been elected, the amount expensed is deducted before the additional first-year depreciation is computed • Then the regular MACRS depreciation is taken on the balance

29. Listed Property • Properties that can be used for both business and personal use (automobiles, computers, cell phones) are subject to limits unless: • Owned or leased by the business and • Used exclusively at the business • If 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

30. Listed Property • 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 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

31. 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

32. Ceiling Limits for Automobiles • Depreciation is limited to the lesser of regular MACRS deductions (including any Section 179 expensing) or the ceiling limit • $3,060 in the year the auto is placed in service (if additional first-year depreciation not claimed) • $4,900 in the second year • $2,950 in the third year • $1,775 per year thereafter

33. Ceiling Limits for Automobiles • When a car 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

34. Additional First-Year Depreciation for Autos • The first-year ceiling limit for new business-use autos is increased • Before 2003 Tax Act, an additional $4,600 ($3,060 + $4,600 = $7,660 total first year) • 2003 Tax Act increases additional amount to $7,650 for cars acquired 5/6/03 – 12/31/04 • Additional first-year amount only available if car used more than 50% for business

35. 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

36. 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

37. 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

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