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Chapter 6Chapter 6

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Property Acquisitions and Property Acquisitions and Cost Recovery DeductionsCost Recovery Deductions

Chapter 6Chapter 6

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ObjectivesObjectives

Expense versus capitalize

Define tax basis and adjusted basis.

Show how leverage reduces the after-tax cost of assets.

Compute cost of goods sold.

Use recovery period, method and convention to compute MACRS depreciation.

Explain the Section 179 expensing election.

Understand role of depreciation in NPV of after-tax cash flows.

Amortize intangibles, deplete resources.

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Expense vs. CapitalizeExpense vs. Capitalize

Deduction permitted for all “ORDINARY AND NECESSARY” business expenses

Deduction prohibited for “PERMANENT improvements to increase the value of property”

Some types of capitalized costs can be recovered through amortization or depreciation

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Expense vs. CapitalizeExpense vs. Capitalize

Repairs and maintenance? Source of IRS dispute due to facts.

Capitalize expenditures that increase the value or useful life of an asset.

Environment cleanup and prevention costs: TRA1997 has a provision allowing firms to elect to deduct rather than capitalize expenditures to abate or control hazardous substances at contaminated areas.

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Tax Subsidies Permit ExpensingTax Subsidies Permit Expensing

R&D expenses. Allowing deduction for R&D is a tax subsidy.

What is the GAAP rationale for requiring expense under SFAS 2?

Various oil and gas: IDC, depletion

Advertising.

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Tax BasisTax Basis

Tax basis = unrecovered cost (cost - depreciation).

Starting basis generally equals COST basis: original purchase price, or FMV of asset if cost more difficult to measure.

When do you recover the cost? Depreciation or sale. Example: For depreciable equipment, adjusted basis is the original basis reduced by depreciation. Adjusted basis is like the tax equivalent of “net book value”

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Tax Basis and LeverageTax Basis and Leverage

Cost basis is the entire cost, even if asset purchased with debt.

Deductions for interest and cost recovery (depreciation) can improve NPV of after-tax cash flows. AP1, 2 Study example in text regarding After-Tax Cost of

Leveraged Purchase. Footnote describes the effect of borrowing rate versus internal discount rate.

Tax deductions made leveraged tax shelters in early 1980’s have positive NPV even when pre-tax flows were breakeven or negative. Chapters 9 and 15 discuss limits on tax shelter losses.

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Cost Recovery ofCost Recovery of

Inventory = cost of goods sold

Tangible assets = depreciation

Intangible assets = amortization

Natural resources = depletion

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Cost of Goods SoldCost of Goods Sold

Similar to GAAP1) Beginning inventory

2) PLUS purchases and cost of manufacture

3) = inventory available for sale

4) MINUS ending inventory

5) = CGS

Tax versus GAAP differences may occur in capitalization of indirect costs. Tax requires “uniform capitalization” under Section 263A. AP4

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Cost of Goods SoldCost of Goods Sold

Uniform capitalization rules (IRC Section 263A) Indirect costs that “benefit or are incurred by reason

of the performance of production or resale activities” Examples? Officers’ comp (VP Mfg.), employee

benefits, building rent, insurance, depreciation. Why might there be book-tax differences in indirect

costs being capitalized?

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Cost of Goods SoldCost of Goods Sold

What are permissible Inventory methods? Which one requires book-tax conformity? 1) FIFO 2) specific ID 3) LIFO - If use LIFO for tax, must also use LIFO

for books. In times of inflation, LIFO decreases book and

taxable income.

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DepreciationDepreciation

Depreciation applies to tangible assets (things you can touch versus intangibles like patents, goodwill) that: Lose value over time due to wear and tear, obsolescence

Buildings depreciate even though real estate often increases in value.

Have a reasonably ascertainable useful life Artwork is not generally depreciable.

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DepreciationDepreciation

MACRS - Modified Accelerated Cost Recovery System Personalty:

DDB: 3, 5, 7, 10 150% DB:15, 20

Realty: SL method: 27.5 years residential, 39 years non-residential (specialty realty 20, 25, 50)

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Depreciation Conventions - PersonaltyDepreciation Conventions - Personalty

Table 6-2 incorporates a half-year convention - provides only 1/2 of the regular rate in the year the property is put in service.

When dispose of asset, multiply table amount by 1/2 in the year of sale.

Buy $10,000 of 7-year property in 2002. Sell the property in 2004. What is 2002, 2003, 2004 depreciation?

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Depreciation Conventions – Personalty - MidquarterDepreciation Conventions – Personalty - Midquarter

IF > 40% personalty is acquired during the last quarter of the year, THEN

Compute depreciation separately for EACH quarter’s acquisition using mid-quarter tables.

Adjust table amounts in year of disposition: multiply table amount by X.5 / 4, where X = # of full quarters held.

Example – dispose in May, which is the second quarter. Multiply table amount by 1.5/4

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Depreciation Conventions – PersonaltyDepreciation Conventions – PersonaltyDepreciation Conventions – PersonaltyDepreciation Conventions – Personalty

New law 2003 Tax ActElect 50% extra first-year depreciation for assets

purchased after 5/5/03 and before 1/1/05: MACRS personalty <= 20 yr life Software w/ 3yr amortization life Certain leasehold improvements.

Compute 50% extra depreciation AFTER expense election under Section 179.

Apply regular MACRS depreciation to basis remaining after Sec. 179 expense and 50% extra depreciation.

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Depreciation Conventions - RealtyDepreciation Conventions - Realty

Mid-month convention. Get 1/2 of a month in month acquired. Built into Table 6-3. Choose column for month put in service. Use this same column throughout the asset life. AP10.

Like personalty, you have to adjust table amount in year of disposition. Get 1/2 of a month for the month of disposition.

Buy apartment building for $1,000,000 in August 2003. Sell in March 2008. What is depreciation in 2001- 2008?

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Depreciation ConventionsDepreciation Conventions

What is the purpose of the half-year, midquarter and midmonth conventions? Balance 1) prevent taxpayer from claiming a full

year of depreciation if held only for a portion of the year

2) Easier rules than computing actual days held.

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AutomobilesAutomobiles

Maximum annual depreciation limit per vehicle, indexed for inflation. 2003 $3,060 (1st yr) + $4,600 (extra under 2002

Tax Act). 2004 $4,900 (2nd yr) 2005 $2,950 (3rd yr) 2006+ $1,775 (4th +++ yrs).

Compute depreciation per MACRS, then limit above.

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Expensing ElectionExpensing Election

Applies to tangible personalty. May expense $100,000 of assets purchased in 2003, 2004, 2005. The amount will revert back to $25,000 in 2006.

Expense cannot create a business loss.

Expense reduced $ for $ by purchases > $400,000. AP9.

Reduces recordkeeping, benefit for small businesses

Planning - if buying a 3-year, 5-year and 7-year asset, which one should you expense?

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Other Depreciation Details Not in TextOther Depreciation Details Not in Text

Combination business and personal use property - “listed property” - such as computers, phones, cars.

Only use accelerated depreciation if business use > 50%.

Different depreciation methods apply for Alternative Minimum Tax purposes (Chapter 10, 14).

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Lease versus BuyLease versus Buy

Text compares purchasing for cash up-front to an operating lease.

A capital lease is treated like a purchase by the lessee.

A lessee who obtains assets through an operating lease has rent expense but no interest and depreciation deductions (because lessor still owns the asset), but doesn’t have deemed debt on financial balance sheet.

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Amortization of IntangiblesAmortization of Intangibles

Generally requires a determinable useful life.

Organizational costs are amortizable straight line method over 60 months.

Start-up costs are also amortizable straight line method over 60 months - some exceptions.

Expansion costs may be currently deductible.

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Leasehold Costs and ImprovementsLeasehold Costs and Improvements

Cost of acquiring lease is amortized over the period of lease.

Improvements to leased property are capitalized and depreciated according to type of property.

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Purchased IntangiblesPurchased Intangibles

Allocate lump-sum price to assets by relative FMVs.

Residual = goodwill.

Tax = 15 years SL

GAAP = 40 years pre-2002. No GAAP amortization post-2001 - evaluate for impairment annually. Book-tax difference is permanent post-2001.

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DepletionDepletion

Cost depletion = unrecovered basis * units sold / estimated beginning units.

Percentage depletion statutory % of gross income. See Q18.

Deduct the greater of cost or percentage depletion.