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Property Acquisitionsand

Cost Recovery Deductions

Chapter 6

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Capital Expenditures

The cost of a business asset with a useful life extending beyond the current year may be

1) Deducted currently2) Capitalized until disposal or3) Capitalized with the cost allocated to the

years the asset’s use benefits the taxpayer (cost recovery period)

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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

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Basis of Property

The original basis of an asset includes:1) Cash plus fair market value of property given

up by the purchaser2) Money borrowed and used to pay for the

property acquired3) Liabilities of the seller assumed by the

purchaser4) Expenses of making the purchase, such as

attorney fees or brokerage commissions

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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)

Original basis of specific asset =Total purchase price x (FMV of specific asset /

FMV of all assets) If the purchase price exceeds the value of the

assets, the excess is goodwill Alternatively, buyer and seller can agree to a

written allocation of the purchase price to individual assets

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Adjusted Basis

The original basis of an asset isIncreased 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)

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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

any decline in value while used for personal purposes

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Acquisition Through aTaxable Exchange

Basis of acquired asset equals the FMV of the property given up or the services performed

Gain or loss is recognized on any property surrendered as if cash had been received in the exchange

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Acquisition by Gift

Donee’s basis = donor’s basis + portion of gift taxes due to appreciation (but total cannot exceed FMV at date of gift)

This addition is gift tax paid multiplied by FMV at gift date – Donor’s Basis

FMV at gift date If FMV is less than donor’s basis, basis may

be limited to lower FMV on subsequent sale

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If FMV at gift date is less than donor’s basis FMV used as basis only for loss

determination (if sold at less than FMV)Donor’s basis used for gain determination

(if sold for more than donor’s basis)No gain or loss if sold for price between

FMV at gift date and donor’s basis Holding period determined by basis used for

gain or loss

Acquisition by Gift

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Acquisition by Inheritance

Use date-of-death fair market value as basis for inherited property (or alternate valuation date, if elected)

Inherited property always has a long-term holding period

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After-Tax Cost

Tax savings from depreciation deductions reduce the effective after-tax cost of an asset

The annual tax savings equal 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

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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

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MACRS

Modified Accelerated Cost Recovery System assigns assets to a class with a pre-determined recovery period (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)

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MACRS

Depreciation for personalty uses200% declining-balance method (with a switch

to straight-line to maximize deductions) orStraight-line method

Realty must use the straight-line method IRS provides tables with annual allowable

depreciation expressed as a percentageAnnual deduction equals the asset’s original

basis multiplied by % from table

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MACRS Tables

Year 5-Year 7-Year1 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%

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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

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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 yearThis 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

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Mid-Quarter Rates

Year 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.1 35.00% 25.00% 15.00% 5.00%

2 26.00% 30.00% 34.00% 38.00%

3 15.60% 18.00% 20.40% 22.80%

5-year property

7-year propertyYear 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.

1 25.00% 17.85% 10.71% 3.57%

2 21.43% 23.47% 25.51% 27.55%

3 15.31% 16.76% 18.22% 19.68%

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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

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39-Year Nonresidential Realty

Month Year 1 Years 2-39 Year 401 2.461% 2.564% 0.107%

2 2.247% 2.564% 0.321%

3 2.033% 2.564% 0.535%

4 1.819% 2.564% 0.749%

5 1.605% 2.564% 0.963%

6 1.391% 2.564% 1.177%

7 1.177% 2.564% 1.391%

8 0.963% 2.564% 1.605%

9 0.749% 2.564% 1.819%

10 0.535% 2.564% 2.033%

11 0.321% 2.564% 2.247%

12 0.107% 2.564% 2.461%

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Dispositions

When an asset is disposed of before it is fully depreciated, the same averaging convention applies in the year of dispositionAn 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

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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

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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

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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 usedFor certain listed propertyTo compute earnings and profitsTo compute AMT adjustment

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ADS Tables

Year 5-Year 7-Year1 10.00% 7.14%2 20.00% 14.29%3 20.00% 14.29%4 20.00% 14.28%5 20.00% 14.29%6 10.00% 14.28%7 14.29%8 7.14%

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Section 179 Election

Taxpayers may elect to expense a portion of the cost of depreciable personalty in the year of acquisition (realty is not eligible)

Applies to both new and used property Annual limit is $250,000 per taxpayer for

2009 and 2010

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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 $800,000 for 2009 and 2010If more than $1,050,000 ($800,000 +

$250,000) of eligible assets placed in service, then no Sec. 179 expensing allowed

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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

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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

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Bonus Depreciation

For assets acquired in 2009 50% additional first-year depreciation for new

personalty (used personalty and all realty ineligible)

Section 179 expensing claimed before bonus depreciation

Unlike Section 179 expensing, there were no phaseout or income limits for bonus depreciation

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Bonus Depreciation

Basis was first reduced for Section 179 expensing before computing bonus depreciation

Basis was then reduced for bonus depreciation

Regular MACRS depreciation could be claimed on any basis remaining after reduction for both Section 179 expensing & bonus depreciation

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Mixed-Use Assets

If an asset is used for both business and personal purposes, depreciation is only permitted for the business-use portion

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

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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 to 50% or less in a future year, a change to ADS must be madeAny excess depreciation claimed in earlier

years must be recaptured as income in the year of change to ADS

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Employee-Owned Property

Two additional tests must be met to depreciate employee-owned property

1) The use of the property must be for the convenience of the employer and

2) The use of the property must be required as a condition of employment

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Limits for Passenger Vehicles

Depreciation is limited to the lesser of: Regular MACRS deductions (including

any Section 179 expensing) or Ceiling limit

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Auto Ceiling Limits

Limits for autos placed in service in 2010 $3,060 for the first year $4,900 for the second year $2,950 for the third year $1,775 per year thereafter

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Auto Ceiling Limits

Limits for autos placed in service in 2009 $2,960 without bonus depreciation or

$10,960 with bonus depreciation $4,800 for the second year $2,850 for the third year $1,775 per year thereafter

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Truck and Van Limits

Limits for trucks and vans placed in service in 2010 $3,160 for the first year $5,100 for the second year $3,050 for the third year $1,875 per year thereafter

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Truck and Van Limits

Limits for trucks and vans placed in service in 2009 $3,060 without bonus depreciation or

$11,060 with bonus depreciation $4,900 for the second year $2,950 for the third year $1,775 per year thereafter

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Vehicle 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 useSpecial rules apply to cars used by a more-than-

5% owner or someone related to the employer

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Heavy SUVs

Heavy SUVs (gross vehicle weight over 6,000 pounds) are not subject to the vehicle depreciation ceiling limits

But the 2004 Jobs Creation Act reduced to $25,000 the cost of heavy SUVs (weighing up to 14,000 pounds) that can be expensed under Section 179

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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

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Lease Inclusions

Examples of inclusion amounts for a new auto leased in 2010 If FMV = $40,000 then $48 for year 1, $105

for year 2, $155 for year 3, $186 for year 4, and $215 for year 5 and later years

If FMV = $100,000 then $162 for year 1, $356 for year 2, $528 for year 3, $634 for year 4, and $731 for year 5 and later years

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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 deductions1) Cost depletion – depletion per unit

calculated by dividing adjusted basis by estimated recoverable units

2) Percentage depletion – calculated as a percentage of gross income

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Intangibles

Intangible assets are grouped into 3 categories

1) Intangibles with perpetual life that cannot be amortized

2) 15-year intangibles (including goodwill) acquired as part of a business purchase (Section 197 assets)

3) Intangibles amortizable over a life other than 15 years

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Research and Experimentation

Research and experimentation expenditures are costs incident to obtaining a patent and costs for development of an experiment or pilot model, formula or invention

Choice of three alternatives1) Expense them in full in the year paid or

incurred2) Amortize them over 60 months or more 3) Capitalize them

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Software

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

It is eligible for Section 179 expensing

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The End