6 - 1 ©2005 prentice hall, inc. property acquisitions and cost recovery deductions chapter 6

6 - 1©2005 Prentice Hall, Inc.

Property Acquisitionsand

Cost Recovery Deductions

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 Capitalized with the cost allocated to the years

the asset’s use benefits (cost recovery period)


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


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


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


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)


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


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 for the property surrendered


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:

FMV basis used for loss determination Donor’s basis used for gain determination No gain or loss between FMV and donor’s basis


Acquisition by Inheritance

Use date-of-death Fair Market Value as basis for inherited property (or alternate valuation date, if elected)

WillWill


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


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


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)


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


MACRS Tables

Year 5-Year 7-Year

1 20.00% 14.29%

2 32.00% 24.49%

3 19.20% 17.49%

4 11.52% 12.49%

5 11.52% 8.93%

6 5.76% 8.92%

7 8.93%

8 4.46%


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



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



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


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


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 Second quarter dispositions, 4.5/12months Third quarter dispositions, 7.5/12 months Fourth quarter dispositions, 10.5 /12 months


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


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


Special First-YearDepreciation

Two special provisions apply to tangible personalty that increase the first year’s depreciation Section 179 expensing election Bonus depreciation

If the asset is eligible for both provisions, Section 179 expensing applies first


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 $102,000 per taxpayer for

2004 Amounts not expensed may be eligible for

bonus depreciation and then regular MACRS depreciation


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

Limit is $410,000 for 2004 If more than $512,000 ($410,000 +

$102,000) of eligible assets placed in service, then no Sec. 179 expensing allowed


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


Section 179 Strategy

Expensing the assets with the longest class life generally maximizes the value of the Section 179 deduction

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


Bonus Depreciation

Permits additional first-year depreciation for new personalty

For assets acquired between 5/6/03 and 12/31/04, 50% is allowed For new assets acquired after 9/11/01, 30%

bonus depreciation allowed

Basis is reduced for this bonus depreciation before taking regular MACRS depreciation


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 allowed for the personal-use

If asset 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


Mixed-Use Assets

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


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


Limits for Passenger Vehicles

Depreciation is limited to the lesser of regular MACRS deductions (including any Section 179 expensing) or the ceiling limit

Limits for autos placed in service in 2003 $3,060 for first year without bonus and

$10,710 with 50% bonus depreciation $4,900 in the second year $2,950 in the third year $1,775 per year thereafter


Revised 2004 Auto Limits

Rev. Proc. 2004-20 revised the 2004 ceiling limits for auto by reducing the limits $100 for each year

New limits for autos placed in service in 2004 $2,960 for first year without bonus and



Truck and Van Limits

Rev. Proc. 2004-20 also revised the 2004 ceiling limits for trucks and vans

New 2004 limits for trucks and vans $3,260 for first year without bonus and



Ceiling Limits

When a vehicle 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


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


Revised Lease Inclusions

Rev. Proc 2004-20 also revised the 2004 lease inclusion amounts

Examples of inclusion amounts for a new auto leased in 2004 If FMV = $40,000 then $90 for year 1, $197

for year 2, $292 for year 3, $351 for year 4, and $405 for year 5 and later years

If FMV = $50,000 then $126 for year 1, $277 for year 2, $411 for year 3, $493 for year 4, and $570 for year 5 and later years


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


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


Research and Experimentation Expenses

Three alternatives for research and experimentation expenditures Expense them in full in the year paid or

incurred Amortize them over 60 months or more Capitalize them


Software

Off-the-shelf software can be deducted on a straight-line basis over 36 months beginning in the month placed in service

It is eligible for both Section 179 expensing and bonus depreciation


The End

6 - 1 ©2005 prentice hall, inc. property acquisitions and cost recovery deductions chapter 6

Documents

basis of property basis

fmv basis

assets basis

donors basis slide

adjusted basis slide

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basis of converted property

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