CH 8: Depreciation, Cost Recovery, Amortization, and Depletion
Accelerated Cost Recovery System (ACRS)
A method in which the cost of tangible property is recovered (depreciated) over a prescribed period of time. This depreciation approach disregards salvage value, imposes a period of cost recovery that depends upon the classification of the asset into one of various recovery periods, and prescribes the applicable percentage of cost that can be deducted each year. A modified system is currently the default cost recovery method; it is referred to as MACRS. § 168.
Modified Accelerated Cost Recovery System (MACRS)
A method in which the cost of tangible property is recovered over a prescribed period of time. Enacted by the Economic Recovery Tax Act (ERTA) of 1981 and substantially modified by the Tax Reform Act (TRA) of 1986, the method disregards salvage value, imposes a period of cost recovery that depends upon the classification of the asset into one of various recovery periods, and prescribes the applicable percentage of cost that can be deducted each year. § 168.
Ceiling Amount.
A taxpayer can choose to use all, part, or none of the annual § 179 amount. If a business expects its marginal tax rate to increase in the future, it may decide not to use the § 179 deduction. In such a situation, it may be better to defer deductions to those later years. As discussed below, the business income limitation may also lead a business owner to choose not to expense assets.
Startup expenditures are partially amortizable by election.
A taxpayer must make this election no later than the due date of the return for the taxable year in which the trade or business begins. If no election is made, the startup expenditures are capitalized.
Section 179 (Election to Expense Certain Depreciable Business Assets) permits the taxpayer to deduct up to $1,040,000 in 2020 ($1,020,000 in 2019) of the acquisition cost of specific types of trade or business property.
Amounts that are expensed under § 179 reduce the asset's basis for additional first-year depreciation (see text Section 8-3b) and MACRS cost recovery (see text Section 8-2a).
Rather than determining depreciation under the regular MACRS method, taxpayers may elect straight-line under ADS. One reason for making this election is to defer cost recovery deductions to later years (presuming that marginal tax rates will be higher in those years).
Another reason is to simplify record keeping, since the cost recovery deduction will be the same as earnings and profits depreciation.
Any elected § 179 expense is taken before additional first-year depreciation is computed.
Any MACRS deduction is calculated on the basis of the asset net of the § 179 expense and any additional first-year depreciation.
Assets used in a trade or business or for the production of income are eligible for cost recovery if they are subject to wear and tear, decay or decline from natural causes, or obsolescence (e.g., equipment the taxpayer rents to third parties).
Assets that do not decline in value on a predictable basis or that do not have a determinable useful life (e.g., land, stock, and antiques) are not eligible for cost recovery.
Double declining balance is used for the 3-, 5-, 7-, and 10-year classes, with a switchover to straight-line depreciation when appropriate.
Cost recovery for the 15- and 20-year classes is based on the 150 percent declining-balance method, with an appropriate straight-line switchover. These methods and conventions are built into the IRS tables. As a result, it is generally not necessary to make these calculations.
The startup costs of creating a new active trade or business could include advertising; salaries and wages; travel and other expenses incurred in lining up prospective distributors, suppliers, or customers; and salaries and fees for executives, consultants, and professional services.
Costs that relate to either created or acquired businesses could include expenses incurred for the analysis or survey of potential markets, products, labor supply, transportation facilities, and the like. Startup expenditures do not include allowable deductions for interest, taxes, and research and experimental costs.
Cost Recovery Periods: MACRS Personalty (and Certain Realty): Property Class: 15-Year
Generally Includes Assets w/ the following ADR Lives: 20 years or more and less than 25 years Examples: Land improvements Qualified improvement property Assets used for industrial steam and electric generation and/or distribution systems Assets used in the manufacture of cement
Cost Recovery Periods: MACRS Personalty (and Certain Realty): Property Class: 20-Year
Generally Includes Assets w/ the following ADR Lives: 25 years or more Examples: Farm buildings except single-purpose agricultural and horticultural structures Water utilities
Cost Recovery Periods: MACRS Personalty (and Certain Realty): Property Class: 3-Year
Generally Includes Assets w/ the following ADR Lives: 4 years of Less. Examples: Tractor units for use over the road A racehorse that is more than 2 years old, or any other horse that is more than 12 years old, at the time it is placed in service Special tools used in the manufacturing of motor vehicles, such as dies, fixtures, molds, and patterns
Cost Recovery Periods: MACRS Personalty (and Certain Realty): Property Class: 5-Year
Generally Includes Assets w/ the following ADR Lives: More than 4 years and less than 10 years Examples: Automobiles and taxis Light and heavy general-purpose trucks Calculators and copiers Computers and peripheral equipment Rental appliances, furniture, carpets
In general, ADS depreciation is computed using the straight-line method.
However, for AMT, depreciation of personal property is computed using the 150 percent declining-balance method with a switch to the straight-line method when appropriate.
Some sport-utility vehicles (SUVs) are not considered passenger automobiles and, therefore, are not subject to the luxury automobile limitations.
However, in 2020, a $25,900 limit applies for the § 179 deduction when the luxury auto limits do not apply ($25,500 in 2019). The limit is in effect for SUVs with an unloaded GVW rating of more than 6,000 pounds and not more than 14,000 pounds.
The mid-quarter convention generally results in smaller depreciation deductions in the asset's acquisition year.
However, the basis of property used to determine whether the mid-quarter convention applies is derived after any § 179 immediate expense election. As a result, a taxpayer may be able to avoid the mid-quarter convention by designating § 179 treatment for assets placed in service during the last quarter of the taxable year.
To prevent the recovery of the same cost more than once (i.e., through periodic cost recovery during the asset's life and via its basis the sale of the asset), the basis of property is reduced by any cost recovery deducted on a tax return (this is the allowed cost recovery).
However, the property's basis is reduced by at least the amount of cost recovery that could have been taken using the appropriate cost recovery method (this is the allowable cost recovery). As a result, even if the taxpayer does not claim any cost recovery on property during a particular year, the basis of the property still is reduced by the amount of cost recovery that should have been deducted (the allowable cost recovery).
With 100 percent bonus depreciation available from 2018 through 2022, the majority of taxpayers will be able to completely deduct the cost of any MACRS personalty.
However, there may be times when the taxpayer will find it better to defer some of these deductions to future years. This might be the case if the taxpayer expects marginal tax rates to increase over time. In addition, the limitations on excess business losses (see text Section 7-5) or the 80 percent of taxable income limit on net operating losses (see text Section 7-6) might lead a taxpayer not to use § 179 and/or bonus depreciation. In addition, certain assets might not qualify for § 179 expensing or bonus depreciation. If any of these conditions applies, then other considerations come into play.
To determine an asset's cost recovery deduction for a year:
Identify the asset's MACRS class, find the cost recovery percentage for the year using the appropriate IRS table, and multiply this percentage by the asset's cost.
A taxpayer may elect to use the straight-line method for personal property.
If elected, the property is depreciated using the MACRS life of the asset with a half-year convention or a mid-quarter convention, whichever applies. The election is available on a class-by-class and year-by-year basis.
Limits exist on cost recovery deductions for automobiles and other listed property that are used for both personal and business purposes.
If listed property is not predominantly used for business purposes when placed in service, it is not eligible for the accelerated methods built into MACRS, the immediate expense election (§ 179), or bonus depreciation.
Taxpayers may find it better not to use § 179 expensing and/or bonus depreciation to completely write off asset acquisitions.
If taxpayers expect their marginal tax rates to increase over time (and in some instances, remain the same), it might be best, in present value terms, to defer some MACRS deductions to future years.
The top part of page 1 requests certain key information about the taxpayer (e.g., name, address, Social Security number, principal business activity, and accounting method used). Part I provides for the reporting of items of income.
If the business requires the use of inventories and the computation of cost of goods sold (see text Section 16-2 for when this is necessary), Part III must be completed and the cost of goods sold amount transferred to line 4 of Part I.
Personalty includes furniture, machinery, equipment, and any other asset that is movable or not permanently affixed to land.
Personalty (or personal property) should not be confused with personal use property. Personal use property is any property (realty or personalty) that is held for personal use rather than for use in a trade or business or an income-producing activity. Cost recovery deductions are not allowed for personal use assets.
Listed Property
Property that includes (1) any passenger automobile; (2) any other property used as a means of transportation; (3) any property of a type generally used for purposes of entertainment, recreation, or amusement; and (4) any other property of a type specified in the Regulations. If listed property is predominantly used for business, the taxpayer is allowed to use the statutory percentage method of cost recovery. Otherwise, the straight-line cost recovery method must be used. § 280F.
The substantiation requirements of § 274 apply to listed property. A taxpayer must be able to prove for any business use the amount of expense or use, the time and place of use, the business purpose for the use, and the business relationship to the taxpayer of persons using the property.
Substantiation requires adequate records or sufficient evidence corroborating the taxpayer's statement. For example, to document business use of an automobile, it is expected that a taxpayer maintain a contemporaneous record of business miles driven (versus other miles), any expenses incurred (e.g., fuel, repairs, business tolls, parking), and the business reason for the auto's use.
Intangible Drilling and Development Costs (IDCs)
Taxpayers may elect to expense or capitalize (subject to amortization) intangible drilling and development costs. However, ordinary income recapture provisions apply to oil and gas properties on a sale or other disposition if the expense method is elected. §§ 263(c) and 1254(a).
The inclusion amount (determined from an IRS table) is based on the fair market value of the automobile. It must be computed for each taxable year the automobile is leased. Once determined, the inclusion amount is prorated for the number of days the auto is used during the taxable year.
The prorated dollar amount then is multiplied by the business and income-producing use percentage. The taxpayer deducts the lease payments, multiplied by the business and income-producing use percentage. In effect, the taxpayer's annual deduction for the lease payment is reduced by the inclusion amount.
Depreciation
The system by which a taxpayer allocates for financial reporting purposes the cost of an asset to periods benefited by the asset.
Cost Recovery
The system by which taxpayers are allowed to recover their investment in an asset by reducing their taxable income by the asset's cost or initial basis. Cost recovery methods include MACRS, § 179 expense, additional first-year deprecation, amortization, and depletion. §§ 168, 179, and 613.
Amortization
The tax deduction for the cost or other basis of an intangible asset over the asset's estimated useful life. Examples of amortizable intangibles include patents, copyrights, and leasehold interests. Most purchased intangible assets (e.g., goodwill) can be amortized for income tax purposes over a 15-year period.
For listed property to be predominantly used in business, its business use must exceed 50 percent.
The use of listed property for production of income does not qualify as business use for purposes of the more-than-50% test. However, both production of income and business use percentages are used to compute the cost recovery deduction.
Business Income Limitation.
The § 179 deduction allowed for a taxable year cannot exceed the taxpayer's business income for the year. For this purpose, business income is calculated by deducting all business expenses except the § 179 deduction. As a result, a taxpayer's § 179 deduction cannot create (or increase) a net operating loss. A taxpayer's "business income" includes income not only from a sole proprietorship but also from wages and any allocated business income from a partnership or an S corporation.
Any § 179 amount in excess of taxable income is carried forward to future taxable years and added to other amounts eligible for expensing.
Then the various limitations for that carryforward year are applied (i.e., the ceiling amount, the placed in service maximum amount, and the business income limitation).
Costs for tangible assets such as tools, pipes, and engines are capitalized and recovered through depreciation (cost recovery). Costs incurred after the well is producing are operating costs.
These costs include expenditures for such items as labor, fuel, and supplies. Operating costs are deductible as trade or business expenses. Depletable costs and intangible drilling and development costs receive different treatment.
The law places further limits on the annual cost recovery deductions for passenger automobiles.
These dollar limits were imposed because of the belief that the tax system was being used to underwrite automobiles whose cost and luxury far exceeded what was needed for the taxpayer's business use.
Intangible drilling and development costs can be handled in one of two ways at the option of the taxpayer.
They can be either charged off as an expense in the year in which they are incurred or capitalized and written off through depletion. The taxpayer makes the election in the first year such expenditures are incurred, either by taking a deduction on the return or by adding them to the depletable basis.
The basis of the property for cost recovery purposes is reduced by the § 179 amount after accounting for the current-year amount of property placed in service in excess of the specified maximum amount ($2,590,000 for 2020).
This adjusted amount does not reflect any business income limitation.
A passenger automobile is any four-wheeled vehicle manufactured for use on public streets, roads, and highways with an unloaded gross vehicle weight (GVW) rating of 6,000 pounds or less.
This definition specifically excludes vehicles used directly in the business of transporting people or property for compensation [e.g., taxicabs (including autos used for Uber or Lyft), ambulances, hearses, and trucks and vans].
Property Placed in Service Maximum.
This rule effectively restricts the application of the § 179 deduction to smaller businesses. In 2020, a business that places in service more than $2,590,000 of qualifying property will have its § 179 deduction reduced. A business that places in service $3,630,000 or more of qualifying property will have its § 179 deduction eliminated.
If personal use assets are converted to business or income-producing use, the basis for cost recovery and for loss is the lower of the adjusted basis or the fair market value at the time the property was converted.
This rule ensures that any decline in value that occurred while the property was a personal use asset is not eligible for cost recovery.
Taxpayers who lease rather than purchase a passenger automobile for business purposes are not subject to the luxury auto limits.
To prevent taxpayers from circumventing the luxury auto limits by deducting the full amount of rental payments associated with a luxury automobile leased for business, the law requires these taxpayers to report an inclusion amount in gross income.
The § 179 deduction can be allocated to reduce the basis of qualifying assets in any manner the taxpayer chooses. This allows the deduction to be allocated proportionally across all assets acquired during the year or to specific assets identified by the taxpayer. This flexibility is important.
Two general rules might affect this choice. First, taxpayers generally should not use the § 179 election on automobiles. Automobiles are subject to special cost recovery rules (and annual limits), which we discuss later in this chapter. Second, given the time value of money, taxpayers should accelerate deductions to the earliest year possible. This is accomplished by expensing the assets with the longest MACRS lives first.
The taxpayer must use the half-year or the mid-quarter convention, whichever is applicable, for all property other than real estate. The mid-month convention is used for real estate. Under ADS, personal property (other than qualified improvement property) is depreciated using the appropriate asset class life (e.g., 5- or 7-year) and the 150 percent declining-balance method.
Under ADS, qualified improvement property has a 20-year life, residential rental real estate has a 30-year life, and nonresidential real estate has a 40-year life; all are depreciated using the straightline method.
For automobiles and other listed property not used predominantly in business in the year of acquisition (i.e., 50 percent or less), the straight-line method under the alternative depreciation system is required.
Under this system, the straight-line recovery period for automobiles is five years. However, the cost recovery deduction for any passenger automobile cannot exceed the luxury auto limit.
MACRS provides separate cost recovery systems for realty and personalty.
Based on cost recovery periods (called class lives), methods, and conventions specified in the Internal Revenue Code, the IRS provides tables that identify cost recovery allowances for personalty and for realty.
As a general rule, it is more advantageous to expense IDCs. The obvious benefit of an immediate write-off (as opposed to a deferred write-off through depletion) is not the only advantage.
Because a taxpayer can use percentage depletion, which is calculated without reference to basis (see Example 47), the IDCs may be completely lost as a deduction if they are capitalized.
Residential Rental Real Estate
Buildings for which at least 80 percent of the gross rents are from dwelling units (e.g., an apartment building). This type of building is distinguished from nonresidential (commercial or industrial) buildings in applying the recapture of depreciation provisions. The term also is relevant in distinguishing between buildings that are eligible for a 27.5-year life versus a 39-year life for MACRS purposes. Generally, residential buildings receive preferential treatment.
MACRS Conventions (by Property Type): Personal Property
Convention: Half-year or mid-quarter. Cost recovery deduction in the year of disposition: Half-year for year of sale or half-quarter for quarter of sale.
MACRS Conventions (by Property Type): Real Property (Straight-Line method must be used)
Convention: Mid-month Cost recovery deduction in the year of disposition: Half-month for month of sale.
Amortizable startup expenditures generally must satisfy two requirements.
First, the expenses must be paid or incurred in connection with: -Creating a business, -Investigating the creation or acquisition of a business, or -Anticipating an activity becoming a business. Second, the expenses must reflect those that could be deducted in an existing trade or business in the same field.
In determining the percentage of business use of listed property, a mileage-based percentage is used for automobiles.
For other listed property, one employs the most appropriate unit of time (e.g., hours) for which the property actually is used (rather than its availability for use).
If not predominantly used for business when placed in service, the listed property's cost must be recovered using the straight-line method.
Further, the straight-line method must continue to be used even if, at some later date, the property is predominantly used for business.
Cost Recovery Periods: MACRS Personalty (and Certain Realty): Property Class: 7-Year
Generally Includes Assets w/ the following ADR Lives: 10 years or more and less than 16 years. Examples: Office furniture, fixtures, and equipment Agricultural machinery and equipment
Cost Recovery Periods: MACRS Personalty (and Certain Realty): Property Class: 10-Year
Generally Includes Assets w/ the following ADR Lives: 16 years or more and less than 20 years Examples: Vessels, barges, tugs, and similar water transportation equipment Assets used for petroleum refining or for the manufacture of grain and grain mill products, sugar and sugar products, or vegetable oils and vegetable oil products Single-purpose agricultural or horticultural structures
The amortization election for startup expenditures allows the taxpayer to deduct the smaller of:
(1) the startup expenditures related to the trade or business or (2) $5,000. The $5,000 maximum is reduced dollar for dollar by the amount of startup expenditures in excess of $50,000. As a result, if startup expenditures equal or exceed $55,000, no immediate deduction is allowed. Any startup expenditures not deducted are amortized ratably over a 180-month period, beginning in the month in which the trade or business begins.
In summary, both realty and personalty can be either business use/income-producing property or personal use property. Examples include:
-A residence (realty that is personal use), -An office building (realty that is business use), -A dump truck (personalty that is business use), and -Common clothing (personalty that is personal use).
Listed property includes:
-Any passenger automobile. -Any other property used as a means of transportation. -Any property of a type generally used for purposes of entertainment, recreation, or amusement. -Any other property specified in the Regulations. A computer or peripheral equipment placed in service after 2017 is not listed property.
In developing an oil or gas well, the producer typically makes four types of expenditures.
-Natural resource costs. -Intangible drilling and development costs. -Tangible asset costs. -Operating costs.
The alternative depreciation system (ADS) must be used:
-To calculate the portion of depreciation treated as an alternative minimum tax (AMT) adjustment for purposes of the individual AMT (see text Section 12-5d). -For residential and nonresidential real estate and any qualified improvement property placed in service after 2017 by a "real property trade or business" that opts out of the interest expense limitations of § 163(j). In general, these interest expense limitation rules only apply to businesses with annual gross receipts in excess of $26 million (in 2019 and 2020). -To compute depreciation allowances for earnings and profits purposes.
The § 179 expense deduction is subject to three limitations, applied in this order.
1. Ceiling Amount. A taxpayer's § 179 deduction cannot exceed an annual ceiling amount ($1,040,000 in 2020; $1,020,000 in 2019). 2. Property Placed in Service Maximum. The § 179 deduction ceiling amount ($1,040,000 in 2020) is reduced dollar for dollar when § 179 property placed in service during the taxable year exceeds a specified maximum amount ($2,590,000 in 2020; $2,550,000 in 2019). In 2020, a taxpayer who places in service $3,630,000 or more of qualifying property ($1,040,000 + $2,590,000) cannot claim a § 179 deduction. 3. Business Income Limitation. The § 179 deduction allowed for a taxable year cannot exceed the taxpayer's business income for the year.
If depreciation is claimed, it should be supported by completing Form 4562.
A 2019 Form 4562 is illustrated; the 2020 Form 4562 was not available when this text was published. The amount listed on line 22 of Form 4562 is transferred to line 13 of Part II of Schedule C.
Sole proprietors engaged in a business file a Schedule C, Profit or Loss from Business, to accompany Form 1040.
A 2019 Schedule C is illustrated; the 2020 Schedule C was not available when this text was printed.
Half-Year Convention
A cost recovery convention that assumes that property is placed in service at mid-year and thus provides for a half-year's cost recovery for that year.
Mid-month Convention
A cost recovery convention that assumes that property is placed in service in the middle of the month that it is actually placed in service.
Mid-Quarter Convention
A cost recovery convention that assumes that property placed in service during the year is placed in service at the middle of the quarter in which it is actually placed in service. The mid-quarter convention applies if more than 40 percent of the value of property (other than eligible real estate) is placed in service during the last quarter of the year.
Alternative Depreciation System
A cost recovery system in which the cost or other initial basis of an asset is recovered using the straight-line method over recovery periods similar to those used in MACRS. The alternative system must be used in certain instances and can be elected in other instances. § 168(g).
Conversion of the expensed property to personal use at any time results in recapture income.
A property is converted to personal use if it is not used predominantly in a trade or business.
In general, in 2020, a business that places in service $1,040,000 or less of qualifying § 179 property will exclusively use § 179 to immediately expense all of those assets, while a business placing in service $3,630,000 or more of qualifying assets (the point at which the § 179 amount is completely phased out; $1,040,000 + $2,590,000) will qualify only for bonus depreciation.
Any business placing in service between $1,040,000 and $3,630,000 of qualifying § 179 property will be able to use a combination of both § 179 and bonus depreciation (see Concept Summary 8.4).
Qualified Improvement Property
Any improvement to an interior portion of nonresidential real property made after the property is placed in service, including leasehold improvements.
In the event a passenger automobile used predominantly for business qualifies for additional first-year depreciation, the first-year recovery limitation is increased by $8,000 for automobiles placed in service before 2027.
As a result, for acquisitions made in 2019, the initial-year cost recovery limitation increases from $10,100 to $18,100 ($10,100 + $8,000).
Placed in Service Requirement
Cost recovery begins on the date an asset is placed in service (ready and available for use), not the date of purchase. This distinction is particularly important for an asset that is purchased near the end of the tax year, but not placed in service until the following tax year.
Percentage Depletion
Depletion based on a statutory percentage applied to the gross income from the property. The taxpayer deducts the greater of cost depletion or percentage depletion. § 613.
Cost Depletion
Depletion that is calculated based on the adjusted basis of the asset. The adjusted basis is divided by the expected recoverable units to determine the depletion per unit. The depletion per unit is multiplied by the units sold during the tax year to calculate cost depletion. If the taxpayer later discovers that the original estimate was incorrect, the depletion per unit for future calculations is redetermined using the revised estimate.
Section 197 covers the amortization of most intangibles. Amortizable § 197 intangibles include most intangibles acquired after August 10, 1993, and acquired in connection with the acquisition of a business, including goodwill, going-concern value, franchises, trademarks, copyrights, patents, and covenants not to compete.
Generally, self-created intangibles are not § 197 intangibles.
The half-year convention is based on the simplifying presumption that assets generally are acquired at an even pace throughout the tax year.
However, Congress was concerned that taxpayers might defeat that presumption by placing large amounts of property in service toward the end of the taxable year (and by doing so, receive a half-year's depreciation on those large end-of-year acquisitions).
The luxury auto limits must be reduced proportionally for any personal use of the auto. In addition, the limitation in the first year includes any amount the taxpayer elects to expense under § 179.
If the passenger automobile is used partly for personal use, the personal use percentage is ignored for the purpose of determining the unrecovered cost available for deduction in later years.
Once made, the election is binding on both the taxpayer and the IRS for all such expenditures in the future.
If the taxpayer fails to elect to expense IDCs on the original timely filed return for the first year in which such expenditures are incurred, an irrevocable election to capitalize them has been made.
To simplify reporting, taxpayers may elect to use the 150 percent declining-balance method to compute cost recovery for the regular income tax (rather than the 200 percent declining-balance method that is available for personal property).
If this election is made, there is no difference between the regular income tax and AMT cost recovery.
If the taxpayer's goal is to recover the cost of fixed assets as quickly as possible, then using § 179 or additional first-year depreciation is preferable.
If, however, a taxpayer has a new business with little income or a business with a net operating loss carryover, the taxpayer's goal may be to slow down cost recovery. In this situation, the taxpayer generally should do the following. -Elect not to take additional first-year depreciation, if available. -Choose the straight-line cost recovery method. -Not elect to expense assets under § 179. -Defer placing assets in service in the current tax year or postpone capital outlays until future tax years.
Because the amortization period for both goodwill and a covenant is 15 years, the purchaser may want to assign purchase costs to assets with shorter lives (e.g., inventory, receivables, and personalty).
If, however, the purchase price will be assigned to assets with longer recovery periods (e.g., realty) or to assets not eligible for cost recovery (e.g., land), the purchaser would likely prefer costs to be assigned to goodwill or a covenant.
Additional First-Year Depreciation
In general, this provision provides for an additional cost recovery deduction of 100 percent for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2027. (The bonus depreciation percentage is reduced by 20 percent for each tax year after 2022.) Qualified property includes most types of new and used property other than buildings. The taxpayer can elect to forgo this bonus depreciation. Different rules applied between 2008 and September 28, 2017.
MACRS Personalty; Half-Year Convention
Kareem acquires a 5-year class asset on April 10, 2020, for $30,000. Kareem's cost recovery deduction for 2020 is computed as follows. MACRS cost recovery ($30,000 x 0.20 = $6,000)
The 15-year amortization period applies regardless of the actual useful life of an amortizable § 197 intangible.
No other depreciation or amortization deduction is permitted for these intangibles.
Part II allows for the reporting of deductions. Some of the deductions discussed in this chapter and their location on the form are depletion (line 12) and depreciation (line 13).
Other expenses (line 27) include those items not already covered (see lines 8-26). An example is research and experimental expenditures.
There are two methods of calculating depletion. Cost depletion can be used on any wasting asset (and is the only method allowed for timber).
Percentage depletion is subject to a number of limitations, particularly for oil and gas deposits. Depletion should be calculated both ways, and the method that results in the larger deduction should be used. The choice between cost depletion and percentage depletion is an annual decision; the taxpayer can use cost depletion in one year and percentage depletion in the following year.
Additional first-year (bonus) depreciation is not limited by a taxpayer's taxable income.
Taxpayers who make large capital investments with limited taxable income may choose not to make a § 179 election and only take bonus depreciation on these items.
Property includes both realty (real property) and personalty (personal property).
Realty generally includes land and buildings permanently affixed to the land. Personalty is defined as any asset that is not realty.
Property to which § 179 applies includes:
Tangible personal property, computer software, qualified improvement property, and certain real property (roofs; heating, ventilation, and air conditioning units; fire protection and alarm systems; security systems). In general, the immediate expense election is not available for real property or for property used for the production of income.
Under the modified accelerated cost recovery system (MACRS), the cost of an asset is recovered over a time period that generally is shorter than the economic life of an asset.
The MACRS rules were designed to encourage investment, improve productivity, and simplify the tax law and its administration.
§ 179 expensing
The ability to deduct the cost of qualified property in the year the property is placed in service rather than over the asset's useful life or cost recovery period. The annual ceiling on the deduction is $1,040,000 in 2020 ($1,020,000 in 2019). However, the deduction is reduced dollar for dollar when § 179 property placed in service during the taxable year exceeds $2,590,000 ($2,550,000 in 2019). In addition, the amount expensed under § 179 cannot exceed the aggregate amount of taxable income derived from the conduct of any trade or business by the taxpayer.
If the business use percentage of listed property falls to 50 percent or less after the year the property is placed in service, the property is subject to cost recovery recapture.
The amount required to be recaptured and included in the taxpayer's ordinary income is the excess cost recovery. Excess cost recovery is the excess of the cost recovery deduction taken in prior years using the regular MACRS method over the amount that would have been allowed if the straight-line method had been used since the property was placed in service.
On July 27, 2020, Fred places in service an automobile that cost $20,000. The auto is used 40% for business and 60% for personal use.
The cost recovery allowance for 2020 is $800 [$20,000 × 0.10 (Exhibit 8.7) × 40%].
Taxpayers may "write off" (deduct) the cost of certain assets that are used in a trade or business or held for the production of income.
The deduction may take the form of depreciation (or cost recovery), depletion, or amortization. Tangible assets, other than natural resources, are depreciated. Natural resources, such as oil, gas, coal, and timber, are depleted. Intangible assets, such as copyrights and patents, are amortized. Generally, a deduction is allowed for an asset only if it has a determinable useful life.
Depletion
The process by which the cost or other basis of a natural resource (e.g., an oil or gas interest) is recovered upon extraction and sale of the resource. The two ways to determine the depletion allowance are the cost and percentage (or statutory) methods. Under cost depletion, each unit of production sold is assigned a portion of the cost or other basis of the interest. This is determined by dividing the cost or other basis by the total units expected to be recovered. Under percentage (or statutory) depletion, the tax law provides a special percentage factor for different types of minerals and other natural resources. This percentage is multiplied by the gross income from the interest to arrive at the depletion allowance. §§ 613 and 613A.
Note that percentage depletion is based on a percentage of the gross income from the property and makes no reference to cost. All other deductions detailed in this chapter are a function of the adjusted basis (cost) of the property.
Thus, when percentage depletion is used, it is possible to claim aggregate depletion deductions that exceed the original cost of the property. If percentage depletion is used, however, the adjusted basis of the property (for computing cost depletion in a future tax year) is reduced by any depletion deducted until the basis reaches zero.
All MACRS real estate is depreciated using the mid-month convention.
Under this convention, one-half month's cost recovery is allowed for the month the property is placed in service. So if a calendar year taxpayer places MACRS real estate in service on June 2 of the current tax year, it will be able to deduct six and one-half months of cost recovery (June 15 to December 31). If the property is sold before the end of the recovery period, one-half month's cost recovery is allowed for the month of sale (no matter when the property is sold).
A number of special rules apply under MACRS. To encourage investment in capital assets and reduce the related compliance costs, Congress has implemented two rules:
immediate expensing (§ 179) and additional first-year depreciation (also called bonus depreciation). To curb potential taxpayer abuses of certain assets—particularly when the assets are used for both business and personal purposes—Congress established specific rules for "listed property." Finally, Congress also created an alternative depreciation system (ADS) that taxpayers can use instead of MACRS. The ADS must be used in certain settings (e.g., for the alternative minimum tax).
The additional first-year depreciation is taken in the year in which the qualifying property is placed in service;
it is computed after any immediate expense (§ 179) deduction is claimed. After the additional first-year depreciation is determined, the regular MACRS cost recovery deduction is calculated by multiplying the remaining cost recovery basis (original cost recovery basis less § 179 expense and additional first-year depreciation) by the appropriate MACRS percentage. A taxpayer may elect not to take additional first-year depreciation.
Nonresidential realty has a 39-year life, and any improvements made to this property would normally have a 39-year life.
n exception to this general rule is provided for qualified improvement property. Qualified improvement property is recovered over a 15-year life using the half-year convention and the straight-line method.
Cost recovery for personalty generally incorporates the half-year convention;
that is, cost recovery in the year the asset is placed in service, as well as the year it is removed from service, is based on the assumption that the asset was used for exactly one half of the year, allowing a half-year of cost recovery.