Tax Planning: Cost Recovery Concepts (Module 6)

This year, Paul Green sells a business automobile to Ken Meyer on the following terms: - The price is $6,000, equal to the car's fair market value. - Paul's basis in the auto is zero; the cost of $14,000 had been fully recovered using straight-line depreciation. - Ken will pay in six annual installments of $1,000 plus accrued interest. - There is no down payment. Ken makes the first installment payment this year. Ignoring interest income, what amount of gain will Paul recognize for the current year?

$6,000 Paul must recover any gain as ordinary income first (depreciation recapture). He has fully depreciated the property (zero basis). Therefore, all gain ($6,000) is recovered in the current year as ordinary income.

a machine was purchased for $1,200 and estimated to have a salvage value of $200 and a useful life of ten years, what is the annual depreciation using the straight-line method?

(1,200-200) / 10 = $100

Real property

(often referred to as real estate or realty) is defined as land or any structure permanently attached to the land, such as buildings.

For luxury vehicles, if the taxpayer doesn't claim bonus depreciation, the greatest allowable depreciation deduction is what?

- $10,000 for the first year - $16,000 for the second year - $9,600 for the third year - $5,760 for each later taxable year in the recovery period

For luxury vehicles, if a taxpayer claims 100 percent bonus depreciation, the greatest allowable depreciation deduction is what?

- $18,000 for the first year -$16,000 for the second year -$9,600 for the third year -$5,760 for each later taxable year in the recovery period

What are the six classifications under the MACRS system?

- 3 year property - 5 year property - 7 year property - 10 year property - 15 year property - 20 year property

Section 179 Expense Deduction

- An election to treat the cost of certain qualified property as a currently deductible expense rather than as a capital expenditure. - In lieu of capitalizing the cost of new or used tangible personal business property, taxpayers may elect to expense up to $1,020,000 (2019) of the acquisition cost, as an ordinary deduction in the year of acquisition. The $1,020,000 deduction is reduced on a pro-rata basis for purchases over $2,550,000 (2019) in any year.

What are the alternatives for R&E expenditures?

- Expense R&E costs in the year paid or incurred. - Defer and amortize R&E costs as a ratable deduction over a period of 60 months or more. - Capitalize and write off R&E costs only when the research project is abandoned or worthless.

Intangible Property

- Property that does not have physical substance, such as goodwill, patents, and stocks and bonds. - The cost of intangible property is written off through amortization.

Tangible Property

- Property that has physical substance, such as land, buildings, natural resources, equipment, etc. - The cost of tangible property other than land is systematically written off through depreciation or depletion

Real properties are divided into two categories, what are they?

- Residential rental property - Non-residential real property

What are three times that you dont use MACRS?

- property that is depreciated using units of production method - Intangible assets - Films, videotapes or sound recordings

Examples of 1231 Property

- timber, coal or domestic iron ore - livestock - unharvested crops - all property used in a trade or business - all property held for the production of income

Which of the following is subject to MACRS? 1. Furniture 2. Plumbing Fixtures 3. Trademark 4. Goodwill 5. Automobile 6. Heavy Truck 7. Machinery

1, 2, 5, 6, 7

Which of the following is true about the MACRS system of depreciation? Why? 1. It is used to depreciate nonresidential real property. 2. It can't be used for fixed assets. 3. It requires the half-year convention for the year of acquisition. 4. It requires mid-quarter convention if > 40% of the depreciable property is put into service by the business during the fourth quarter of its tax year.

1, 3, 4 Fixed assets describe tangible property used in the operation of a business. Examples include a plant, machinery, and equipment. MACRS is used to recover costs of (depreciate) these fixed assets. Nonresidental real property can be recovered under MACRS. Land is not depreciable.

Jose owns a farm and land, farming equipment, stocks, bonds and a patent on a new farming tool. Which of these are considered intangible assets? 1. Bonds 2. Farming Equipment 3. Farm Land 4. Stocks 5. Patent on new farming tool

1, 4, 5 Intangible property is property that does not have physical substance, such as goodwill, patents, stocks and bonds

Property which qualifies for bonus depreciation must meet what four tests?

1. Must be acquired and placed in service after September 27, 2017 and prior to January 1, 2023. 2. Must be depreciable under the MACRS system, 3. Must have a useful life of 20 years or less (which eliminates real estate, except for certain leasehold improvements from qualifying); and, 4. The asset that is used first by the taxpayer must be new.

There are two basic situations for which the 1250 recapture rules will apply. In both cases, accelerated depreciation will have been used. What are they?

1. Residential rental real estate placed in service prior to 1987. 2. Nonresidential real estate placed in service before 1981.

For assets placed into service after _________ , the Modified Accelerated Cost Recovery System (MACRS) system of depreciation is required.

1986

Which of the following is an example of an internally created intangible asset? 1. Land 2. Patent 3. Building 4. Copyright

2, 4 Examples of an internally created intangible asset would be a patent resulting from the taxpayer's research and development lab or a copyright

A __% tax credit does apply to certain incremental research expenditures, even if they are immediately expensed under Section 174.

20%

Depreciation on employee business property is reported on Form _______

2106

Which of the following is subject to SEC 197 Amortization? 1. Furniture 2. Plumbing Fixtures 3. Trademark 4. Goodwill 5. Automobile 6. Heavy Truck 7. Machinery

3, 4

You need to know that mid-quarter convention applies when __% or more of a firm's assets are placed in service in the fourth quarter.

40%

Individuals engaged in a trade or business as a sole proprietor, compute and report depreciation, cost recovery, depletion and amortization deductions on Form _________

4562

Sara purchases new office equipment for $9,500. Sara pays $500 in sales tax. Assuming she uses MACRS, what is the cost recovery deduction for the first year? a. $1,429.00 b. $2,000.00 c. $714.50 d. $1,000.00

A $10,000 x 14.29% (seven-year property)

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

Section 197 intangibles

An amortization deduction is permitted for certain acquired Section 197 intangible assets. This section applies to intangible assets that are acquired within the conduct of a trade or business, or an activity engaged in for the production of income.

A regular corporation buys new furniture worth $100,000. The corporation at year end has taxable income of $20,000. What is the maximum the corporation can expense under Section 179 at year end? Why? a. Zero, not enough information known to answer the question. b. $20,000 c. $100,000 d. $25,000 e. $139,000

B The limit is $1M, but the deduction is limited to the corporation's taxable income ($20,000).

Shelia purchased $100,000 of office furniture in June. She uses the straight-line option under MACRS. What is the cost recovery deduction for the first year? a. $14,290 b. $20,000 c. $7,145 d. $10,000

C $100,000 x 0.07145 = $7,145

Which of the following property is eligible for a 179 election? Why? a. Rental real estate purchased for $200,000 b. Commercial real estate purchased for $200,000 c. A computer purchased for $200,000 d. A franchise purchased for $200,000

C Section 1245 business personal property qualifies for the Section 179 election. Real estate is 1250 property. 1250 property is real, not personal, property. A franchise is intangible property.

Larry bought a light-duty truck for his business. The cost was $15,000. What cost recovery deductions can he take in the second year (MACRS)? a. $3,673.50 b. $2,143.50 c. $4,800.00 d. $3,000.00

C The truck is 5-year property ($15,000 x 32%).

WXYZ, a local business solutions company, purchased a computer, on January 1, 2012, for use by its administration division. For tax purposes, what MACRS recovery period will be assigned to the computer?

Correct Answer: 5 years Explanation: According the classification of assets based upon the determination of a class life from a listing of assets published by IRS, a recovery period of 5 years will be assigned to the computer. Under the MACRS system any property with a class life of more than 4 years but less than 10 years including automobiles, trucks, computers, research and experimental equipment will be assigned under the 5 year classification.

A 20% tax credit applies to certain incremental research expenditures, even if they are immediately expensed under Section 174. Why? A. True B. False

Correct Answer: A. True Explanation: A 20% tax credit does apply to certain incremental research expenditures, even if they are immediately expensed under Section 174.

If personal use property is either converted to business use or held for the production of income (e.g., a rental house), the property's basis for depreciation purposes is the lesser of its adjusted basis or the fair market value. Why? A. True B. False

Correct Answer: A. True Explanation: If personal-use property is either converted to business use or held for the production of income the property's basis for depreciation is the lesser of its adjusted basis or its fair market value (FMV) determined as of the conversion date. This lower of cost or market rule is intended to prevent taxpayers from depreciating the portion of the cost that represents a nondeductible loss on a personal-use asset.

In accounting for research and experimental expenditures, all of the following alternatives are available with the exception of? A. Expense R&E costs in the year paid or incurred. B. Expense R&E costs in the year in which a product or process becomes marketable. C. Defer and amortize R&E costs as a ratable deduction over a period of 60 months or more. D. Capitalize and write off R&E costs only when the research project is abandoned or worthless.

Correct Answer: B. Expense R&E costs in the year in which a product or process becomes marketable. Explanation: For income tax purposes the following alternatives are available for R&E expenditures: expense R&E costs in the year paid or incurred; defer and amortize R&E costs as a ratable deduction over a period of 60 months or more; or capitalize and write off R&E costs only when the research project is abandoned or worthless.

Mrs. Abbott has a priceless painting she has inherited. Her friend advises her that she should claim depreciation on this. Has her friend advised her correctly? Why? A. True B. False

Correct Answer: B. False Explanation: Assets such as works of art have an indefinite life and are not depreciable. No depreciation is permitted on assets that have an indefinite life.

Roy Baxter owns a printing shop. Roy purchased and placed into service $100,000 worth of equipment in the current year (assume the mid-quarter convention does not apply). This equipment has a useful life of 7 years and will be depreciated using MACRS. To answer this question, consider both a Section 179 expense and MACRS depreciation and that Roy's business profit for the current year is $30,000. How much is Roy's maximum deduction in the current year? A. $0 B. $30,000 C. $40,003 D. $100,000

Correct Answer: C. $40,003 Explanation: By electing to expense under Section 179 an amount equal to the firm's profit ($30,000), Roy would then be able to depreciate the residual amount of $70,000 ($100,000 - $30,000). $70,000 X .1429 (year 1 using MACRS) = $10,003. This amount plus the elected expense of $30,000 = $40,003. Please note that this additional depreciation deduction would not be allowed if Roy had elected to expense the entire amount of $100,000.

Costs that qualify as research and experimental expenditures include all of the following EXCEPT? A. Attorney fees incurred in obtaining a patent B. Costs incurred in developing product improvements C. Marketing research D. Depreciation of laboratory equipment

Correct Answer: C. Marketing research Explanation: Marketing research and advertising etc. are items that do not qualify as research and experimental expenditures.

In January of this year, Adam, a sole proprietor, purchases equipment (5-year property) for $1,100,000 for use in his business. Assume he elects and qualifies for the maximum Section 179 deduction and uses MACRS. What is the maximum current-year deduction that Adam can claim with respect to the equipment? Why? a. $510,000 b. $1,100,000 c. $540,000 d. $1,020,000

D Equipment Cost $1,100,000 Section 179 deduction - $1,000,000 $100,000 20% of the remaining* x 20% $20,000 Plus Section 179 deduction + $1,000,000 Total deduction $1,020,000 *MACRS table 5-year property Starting in the year it was purchased, the buyer can deduct the remaining value (up to $2,500,000) over the designated lifetime of the property. For example, a 5 year property would be 1/5 or 20% a year and a 7 year property would be 1/7 or 14.28% a year.

In January of this year, Adam, a sole proprietor, purchases equipment (5-year property) for $1,600,000 for use in his business. Assume he elects and qualifies for the maximum Section 179 deduction and uses straight-line. What is the maximum current-year deduction that Adam can claim with respect to the equipment? Why? a. $1,520,000 b. $1,000,000 c. $1,600,000 d. $1,120,000

D $1,000,000 for the 179 deduction 20% of the remaining $600,000 equals $120,000 Total deduction is $1,120,000 NOTE: The concept of 179 has appeared on the CFP Exam. Section 179 is an election to expense.

The Section 179 expense election is available to which of the following properties? Why? a. A franchise b. 1250 property c. A strip shopping center d. 1245 property

D Only 1245 property qualifies under Section 179.

Which of the following business transactions will trigger an immediate tax deduction for a business? Why? a. Purchase of land b. Purchase of 1250 property c. Depreciation of 1245 property d. Repair to 1250 property

D Repairs are treated as expenses which are fully deductible in the current tax year. 1245 property is equipment and has a shorter depreciation schedule. But, it is not expensed immediately. 1245 property could be expensed immediately under Section 179.

Tom Jones owns TJ, Inc. The company typically sells unwanted inventory of other stores. TJ is very popular due to its low prices. Business profits should total $600,000 after all expenses. Tom feels the business computer cannot handle the increasing volume of transactions effectively. What should he do if he buys a new piece of computer equipment for $25,000? Why? a. Expense it under Section 197 rules. b. Depreciate it under MACRS rules. c. He cannot do anything because his business profits are $600,000. d. Expense it under Section 179 rules. e. Depreciate it under straight line rules.

D With a Section 179 election Tom, can now expense up to $600,000 the cost of the computer directly against the profits of the company this year. Under MACRS, he could depreciate it over 5+ years, but future depreciation is not as cost-effective as a current deduction.

DJM Inc. buys $625,000 of qualifying property in 2019. DJM Inc.had net income of $316,500. Can it use the section 179 election? If so, how much?

DJM's Section 179 deduction is limited to $316,500 for the year.

Modified Accelerated Cost Recovery System (MACRS)

Depreciation system required by federal income tax law.

Depreciation of rental properties are reported on Schedule _______

E

A company buys a light duty truck for $25,000. Under straight line method of depreciation, how much can the company take in cost-recovery deductions in the first year? a. $1,785 b. $2,500 c. $3,573 d. $25,000 e. $5,000

E Automobiles depreciated over the course of five years under straight line. $25,000 x 20% = $5,000

Cheryl purchases new office furniture. She pays $10,000 for the furniture. The sales tax is $700, and the shipping cost is $300. She spends $3,000 to improve her office. What is the cost recovery deduction she can claim for the new furniture in the first year? a. $1,429.00 b. $2,200.00 c. $2,000.60 d. $1,529.03 e. $1,571.90

E The office furniture is seven-year property. $11,000 x 14.29% = $1,571.90. The question asks only about the furniture - nothing else!

ABC builds a new building for research purposes. They can expense the entire cost of the building. True or False? Why?

False It is sometimes mistakenly believed that if a company constructs a new building to be used entirely as a research facility, the entire cost of the building can be expensed. However, the expenses election applies only to the depreciation allowances on the building

Section 1245 Recapture

Full recapture of depreciation or amortization allowed for tangible personalty or purchased intangibles

Election to expense property under Section 179 is made by claiming the deduction on Part __ of Form ____

I ; 4562

What happens if a listed property's business usage is greater than 50% of its total usage & what if its less then 50%?

If greater: he taxpayer may use the regular MACRS tables for the business-use portion of the asset's cost If less: the taxpayer must use the alternative depreciation system

Tom has $10,000 of 1231 gain in 2019. In 2014, he took a $4,000 ordinary loss on the sale of 1231 property. He had no 1231 sales in any other year. What amount will be treated as capital gain and what amount as ordinary income?

In 2019, Tom may take $6,000 of the gain as capital gain ($10,000 - $4,000), but the other $4,000 of gain will be treated as ordinary income. Five year look back period

DJM Inc. buys $625,000 of qualifying property in 2019. Can it use the section 179 election? If so, how much?

It can take the Section 179 election on $625,000. The $2,500,000 doesn't come into play.

Recovery Periods in MACRS vs ADS for Residential rental property?

MACRS = 27.5 years ADS = 40 years

Recovery Periods in MACRS vs ADS for nonresidential rental property?

MACRS = 31.5 or 39 years ADS = 40 years

Recovery Periods in MACRS vs ADS for Automobiles?

MACRS = 5 years ADS = 5 years

Recovery Periods in MACRS vs ADS for Computers?

MACRS = 5 years ADS = 5 years

Recovery Periods in MACRS vs ADS for Office Furniture and equipment?

MACRS = 7 years ADS = 10 years

What is most personal property classified as under MACRS?

Most depreciable personal property is classified as 7-year property under MACRS

MACRS: 7 Year Property

Property with a class life of 10 years or more but less than 16 years, including office furniture, equipment and most types of machinery.

MACRS: 20 Year Property

Property with a class life of 25 or more years, including utilities and sewers.

MACRS: 3-Year Property

Property with a class life of 4 years or less, including tractor units, race horses over 12 years old, and special tools.

MACRS: 10 Year Property

Property with a class life of more than 16 years, but less than 20 years, including barges, vessels, petroleum and food processing equipment.

MACRS: 15 Year Property

Property with a class life of more than 20 years, but less than 25 years, including billboards, service station buildings, and land improvements.

MACRS: 5-Year Property

Property with a class life of more than 4 years but less than 10 years including automobiles, trucks, computers and research and experimental equipment.

What are the MACRS recovery periods for residential rental property and non-residential real property?

Residential Rental Property = 27.5 years Non-Residential Real Property = 39 years

Late in 1986, a taxpayer purchased and placed into service a three-family house. The value of the building (excluding the land) was $250,000, and $250,000 of cost recovery was taken using the ACRS method. Had the straight-line method been used, only $227,300 would have been allowed. What is the nature and character of the gain if the net selling price is $100k?

Sale Price: $100k Realized Gain: $100k 1250 Recapture: $22700 Unrecaptured 1250 Gain: $77300 1231 Capital Gain: 0

Late in 1986, a taxpayer purchased and placed into service a three-family house. The value of the building (excluding the land) was $250,000, and $250,000 of cost recovery was taken using the ACRS method. Had the straight-line method been used, only $227,300 would have been allowed. What is the nature and character of the gain if the net selling price is $300k?

Sale Price: $300k Realized Gain: $300k 1250 Recapture: $22700 Unrecaptured 1250 Gain: $227,300 1231 Capital Gain: 50000*** *** Will only occur to the extent that the sales price exceeds the original purchase price. This amount is taxed at the 15% capital gain rate.

Amortization: What section does Pollution Control Facilities fall in?

Section 169

Amortization: What section does Research and Experimental Expenditures fall in?

Section 174

Amortization: What section does Start-Up Expenditures fall in?

Section 195

Amortization: What section does goodwill and other purchased intangibles fall in?

Section 197

Amortization: What section does Organizational Expenditures fall in?

Section 248

Depreciation must be calculated for real property using what method?

Straigh-Line Method

Property placed into service after December 31, 1980 and before January 1, 1987, must follow what depreciation and cost recovery systems?

Taxpayers must follow the Accelerated Cost Recovery System (ACRS) as provided in Section 168.

Property placed into service after December 31, 1986, must follow what depreciation and cost recovery systems?

Taxpayers must follow the Modified Accelerated Cost Recovery System (MACRS) as provided in Section 168.

Property placed into service prior to 1981, must follow what depreciation and cost recovery systems?

Taxpayers must use the rules contained in Section 167 and these rules basically follow financial accounting principles.

Has the depreciable life of an automobile changed under MACRS?

The depreciable life of an automobile has been extended from 3 to 5 years under MACRS rules

BAM Inc. buys $2,575,000 of qualifying property in 2019. Can it use the section 179 election? If so, how much?

The maximum Section 179 election is $925,000 ($1,000,000 less $75,000, the excess over the $2,500,000 limitation

half-year convention

The practice of taking six months' depreciation in the year of acquisition and in the year of disposition, rather than computing depreciation for partial periods to the nearest month. This method is widely used and is acceptable for both income tax reporting and financial reports, as long as it is applied to all assets of a particular type acquired during the year.

Why were the restrictions enacted on automobiles?

The restrictions on automobiles were enacted in 1984 because of a concern that the tax system was underwriting the acquisition of automobiles whose cost and luxury far exceeded what was required for business needs

assume that a taxpayer uses a machine in her business that is required to be classified as 7-year property under MACRS. However, the machine is operated 24 hours a day, seven days a week, and will completely wear out in two years. The use of the 7-year recovery period substantially understates the depreciation for the machine. What can be done?

Under Section 168(f), taxpayers may exclude property from the MACRS system, if the property is depreciated under the unit-of-production method or any other method not expressed in terms of years. Therefore, if a taxpayer can express the useful life of the machine in terms of some base other than years such as machine hours, units produced and so on, it may be possible for the taxpayer to depreciate the machine over a much shorter period than the seven years required under MACRS.

Unrecaptured 1250 Gain Rule

a gain from the sale of real estate held by a noncorporate taxpayer for more than one year in a trade or business or as rental property attributable to tax depreciation deducted at ordinary tax rates. This gain is taxable at a maximum 25% capital gains rate.

Amortization: Research and Experimental Expenditures

as defined in Section 174 include experimental and laboratory costs incidental to the development of a product. Section 174 was enacted to clarify the income tax treatment of research and experimental expenditures.

If you own a duplex and life in half of it, can you depreciate the business?

if a taxpayer owns a duplex and uses one unit as a personal residence, only the portion of the unit that is rented to tenants qualifies for depreciation.

Listed property

includes automobiles, computers and peripheral equipment, cellular telephones, and property generally used for purposes of entertainment, recreation, or amusement, like a video recorder.

Personal-use property

is any property, tangible or intangible, real or personal, that is used by the taxpayer for his own personal use rather than in a trade or business or for the production of income.

Non-residential real property

is any real property other than residential rental property.

Personal property

is any tangible property that is not real property, and includes items such as equipment, vehicles, and furniture.

Residential rental property

is the property from which at least 80% of the gross rental income is the rental income from dwelling units.

recapture of depreciation

part or all of the gains on the sale of depreciable property may be taxed as ordinary income. The amount of gain taxed as ordinary income, depends on the type of property and the depreciation method used to depreciate it. five year look back period

inventory

property which is held to be sold to customers in the ordinary course of business is inventory. Inventory is not depreciable.

Amortization

the process of allocating to expense the cost of an intangible asset

If personal-use property is either converted to business use or held for the production of income, what is the basis?

the property's basis for depreciation purposes is the lesser of its adjusted basis or its fair market value (FMV) determined as of the conversion date

Section 1231 Property

trade or business held for more than one year, as classified in Section 1231 of the Internal Revenue Code