Chapter 10: Cost Recovery Deductions

20 Year MACRS Recovery Period

Farm Buildings & Municipal Sewers HALF YEAR CONVENTION

5 Year MACRS Recovery Period

Automobiles & Computers Trucks, Computers, Copiers, Typewriters Solar & Wind Energy Equipment HALF YEAR CONVENTION

Accelerated Cost Recovery System (ACRS)

Between 1981-1986- Sec 168 of Code Generally provides faster cost recovery. Differences: 1. Automobiles- 3-Year period using 175% recovery rate 2. Office Furniture & heavy machinery- 5 year period and 175% recovery rate 3. Real Property- 15-, 18-, or 19- year recovery period depending on the date. 175% declining balance method

"Luxury" Automobiles

Firstyear bonus depreciation is $8,000 for property. Increased to a limitation of $18k for all cost recovery claimed for the auto. ' SUVs over 6k lbs but under 14k lbs subject to special $25k limitation on the first year expensing election. 1. $10k (plus bonus depreciation of $8k) 2/ $16k 3. $9.6l 4. $5.76k

Double Declining Balance

Typically 3-, 5-, 7-, 10-year classes. Switches to straight line once that value is more advantageous.

15 Year MACRS Recovery Period

Telephone Distribution Plants, Billboards, Roads/Sidewalks/Bridges Qualified Leasehold Improvements HALF YEAR CONVENTION

Basic Conditions for Cost Recovery Deductions

1. Asset must be either used in the taxpayer's business activity or held for the production of income 2. Taxpayer must generally have an ownership interest in the asset (not on leased property, but on improvements to leased property) 3. Taxpayer must have depreciable basis. Once basis is 0, no more depreciation 4. Asset must be considered to have a limited useful life (Patents, buildings, machinery,even goodwill etc Y, LAND--> NO)

MACRS Recovery Period Classes

1. Automobiles: 5 Years 2. Computers: 5 Years 3. Office Furniture: 7 Years 4. Most heavy machinery: 7 years 5. Residential Real Estate: 27.5 years 6. Nonresidential Real Estate: 39 years See 10.12

MACRS Recovery Methods

3-,5-,7- & 10- year classes are depreciated under the double-declining balance method, with a switch to straightline at the point where that offers a higher deduction 15-,20- is 150% declining balance method 27.5%-, 31.5%, 39% are depreciated under the straightline method. See. 10.13-10.15

150% Declining Balance

15-, 20- year classes. Switches to straight line once that value is more advantageous.

Alternative Depreciation System (ADS)

A cost recovery system that produces a smaller deduction than would be calculated under ACRS or MACRS. The alternative system must be used in certain instances and can be elected in other instances. § 168(g). IF eligible for double can elect straight line-- same time period. IF eligible for double and elect 150% or if eligible for 150% and elect straightline, property is generally depreciated over a longer period. (NOT IN EFFECT AFTER 1998)

Declining-Balance Method

A fixed percentage of the taxpayer's original basis in the depreciable property is allowed in the first year. The following year, the same percentage is applied to the new adjuste basis. Considered an accelerated method of depreciation because a percentage higher than that used under the straight-line method is allowable. Cannot be more than 2x straightline depreciation Recovery method for ACRS and MACRS property

Modified Accelerated Cost Recovery System (MACRS)

After 1986- Sec 168 of Code Public utility property, motion pictures, sound and intangibles are not depreciable

Mid-Quarter Convention

Applies is more than 40% of all property placed in service that year is placed in service during the last 3 months of the year. Property will be depreciated for the first year as if it had been placed in service in the middle of Q4. Preventing 6 months depreciation if bought at the end of the year (way less than 6 months)

"Listed" Property

Assets subject to special limitations on cost recovery deductions-- vans less than 6,000lbs, computers, or property generally used for entertainment, recreation or amusement. If not used for more than 50% for biz purposes, depreciation must be computed under MACRS alternative depreciation system (ADS) meaning that straight-line depreciation must be used.

Bonus Depreciation

Expense 100% of the cost of new or used qualifying property having MACRS recovery period of less than 20 year (non real estate). Subject to reccapture rules.

Qualified Leasehold Improvement Property (QLIP)

Improvement can be depreciated over a 15-year period using the straightline method. Typically an improvement to the interior.

Cost Recovery

allows taxpayers who invest capital in biz and income-producing property to recoup their investment through tax deductions for the capital investment.

39 Year MACRS Recovery Period

Nonresidential Rental Property (Office Buildings, Factories, Warehouses) 31.5 if before 1993 MID MONTH RECOVERY PERIOD-- deduction amount depends on the beginning month of service

Sum-of-the-years-digits method

Not a standard under ACRS or MACRS A changing percentage is applied to the ORIGINAL basis of the property. The fraction is determined as followed: 1. Numerator = number of years remaining in the cost recovery period as of the year the depreciation is being claimed (changes) 2. Denominator= sequential sum of the numbers representing each year in the total recovery period (doesn't change)

Obsolescence

Occurs when an asset become economically useless to the taxpayer who owns it. Can occur as a result of technological or scientific advances in a given business or industry. Loss of usefulness resulting from abnoraml condditions. A deduction is available for the undepreciated basis the taxpayer has left in the obsolete asset.

7 Year MACRS Recovery Period

Office Furniture & Heavy Machinery HALF YEAR CONVENTION

10 Year MACRS Recovery Period

Property for petroleum refining, Fruit bearning trees & vines, water transport vessels (boats) HALF YEAR CONVENTION

Section 1245 Property

Property that is subject to the recapture of depreciation under § 1245. Gain from the sale of the property will be taxable as ORDINARY INCOME to the extent of the cumulative depreciation deductions claimed for the property. Respect to tangible personal property

Property NOT Depreciable under MACRS

Public Utility Property, Motion Pictures, SOund Recordings, Intangible Property, Property for which a depreciation method not determined by annual recovery period has been elected by taxpayer (choosing an old method).

3 Year MACRS Recovery Period

Racehorses, Tractors, Breeding Hogs, Manufacturing TOols, Software, Rent-to-Own Property HALF YEAR CONVENTION

Section 1250 Property

Real estate that is subject to the recapture of depreciation under § 1250. For real property placed in service after 1986, a SEPCIAL long-term maximum CAPITAL GAINS tax rate of 25% applies to the portion of capital gain that is attributable to depreciation upon the sale of real property by an individual taxpayer (HIGHER THAN REGULAR CG RATES) Unrecaptured Sec 1250 gain is defined as the amount of long-term capital gain which would be taxed as ordinary income if Sec 1250 provided for the recapture of depreciation

27.5 Year MACRS Recovery Period

Residential Real Estate MID MONTH RECOVERY PERIOD-- deduction amount depends on the beginning month of service

Straight-Line Method

Still used for real estate currently placed in service. Taxpayer simply divides the depreciable basis in the property by the number of years of the property's applicable recovery period to arrive at an annual deduction that remains the same over the course of the recovery period.

Half Year Convention

Tax rule that requires recognizing six months of depreciation expense on an asset both in the year of purchase and in the year of disposal regardless of the actual purchase date. Since there is half-year's depreciation in Y1, actual depreciation period is one year longer than the class suggests

Sec 179 Expensing

Taxpayers other than trusts, estates may elect to deduct the full cost of certain depreciable property in the year it is placed in service. Typically for biz. dollar amount limit on the property-- Most that can be expensed is $1M. However, only $25k for taxpayers buying an SUV weighing btwn 6,000 &14,000 lbs $1M maximum must be reduced dollar for dollar by the amount that assets acquired are greater than $2.5M (if put $2.6M of Sec 179 assets in place, max expensible amount is $900k ($2.6M-$2.5M= $100k, $1M-$100k)) WHEN SOLD, GAIN TAXED AS ORDINARY INCOME

Depreciation

The most common type of cost recovery deduction Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value.

Recovery Period

The period of time over which the cost is recovered Generally a fixed number of years over which the cost is recovered. May or may not be based on the actual economic useful life of the asset.

Recovery Method

The rate at which the asset's cost is recovered. A mathematical formula that determines how much of an asset's cost can be deducted in a given year. Does not represent a loss in the actual value. Assets could actually be appreciating in value

Amortization

the process of allocating to expense the cost of an intangible asset- 180 MONTHS. No conventionface because depreciation is monthly. Unrelated to physical wear and tear over an assets useful life. Eligible: 1. Goodwill of biz 2. Going concern value of biz 3. Company's workforce in place 4. Biz books and records, operating systems 5. Copyrights and patents 6. Formulas, processes 7. Licenses & permits To qualify assets must be used in a trade or biz or held for the production of income.