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ACCT 308 - CHAP. 8 - DEPRECIATION, COST RECOVERY, AMORTIZATION, AND DEPLETION
Terms in this set (67)
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. True or false?
True. A write-off 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. True or false?
What is the difference between depreciation and cost recovery?
Depreciation refers to the allocation of costs to the appropriate period for financial reporting purposes, while cost recovery refers to an equivalent concept for tax purposes.
realty (real property)
land and buildings permanently affixed to the land
personalty (personal property)
any asset that is NOT realty (i.e. furniture, machinery, equipment, any other asset movable or not permanently affixed to land)
personal use property
any property held for personal use, rather than for use in a trade or business or income-producing activity
Cost recovery deductions are NOT allowed for personal use assets.
There is a distinction between the classification of an asset (realty or personalty) and the use to which the asset is put (business or personal). True or false?
Under what circumstances are assets eligible for cost recovery?
1. used in a trade or business or for production of income
2. subject to wear and tear, decay or decline from natural causes or obsolescence (i.e. automobile taxpayer rents to third parties)
3. decline in a value on a predictable basis
4. have determinable useful life
Land, stock, and antiques are NOT eligible for cost recovery. True or false?
When does cost recovery begin?
Cost recovery begins on the date an asset is placed in service (ready and available for use), NOT the date of purchase.
How does the basis reduction work for assets?
To prevent the recovery of the same cost more than once (i.e. through periodic cost recovery and on the sale of the asset), the basis of property is reduced by any cost recovery deductions taken 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 under the applicable 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).
What is the difference between the allowed cost recovery and the allowable cost recovery?
allowed cost recovery: any cost recovery deductions taken on a tax return
allowable cost recovery: the amount of cost recovery that could have been taken under the applicable cost recovery method
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. True or false?
True. This rule ensures that any decline in value that occurred while the property was personal use property cannot be deducted via cost recovery.
Modified Accelerated Cost Recovery System (MACRS) general rules
Under MACRS, the cost of an asset is recovered over a predetermined period that generally is shorter than the economic life of an asset.
MACRS provides separate cost recovery systems for realty and personalty.
What are the class lives of personalty?
3 to 20 years
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.
The "switchover" to straight-line depreciation is automatically done in the tables provided by the IRS.
What is the main difference between book and tax depreciation amounts reported for GAAP and Federal income tax purposes?
Typically, tax depreciation deductions are accelerated; that is, they are claimed in earlier reporting periods than is the case for financial accounting purposes.
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.
usually used for cost recovery for personalty
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.
This convention was added by Congress to inhibit taxpayers from placing large amounts of property in service toward the end of the taxable year, (and therefore receiving a half-year's depreciation).
Refer to Example 5 (Section 8-2a) for simple example.
When "mid-quarter" property is sold, the property is treated as though it were sold at the midpoint of the quarter. True or false?
True. So in the quarter when sold, cost recovery is allowed for one-half of the quarter.
Under MACRS, the cost of most realty is recovered using the straight-line method. True or false?
True. The recovery period for residential rental real estate is 27.5 years.
residential rental real estate
includes property where 80 percent or more of the gross rental revenues are from residential/dwelling units (i.e. an apartment building).
Low-income housing is classified as residential rental real estate.
nonresidential real estate
commercial or industrial buildings like hotels, motels, and similar establishments
recovered over 39 years
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
All eligible real estate is depreciated using this method.
If the property is sold before the end of the recovery period, one-half month's cost recovery is permitted for the month of sale (no matter when the property is sold).
Although MACRS requires straight-line depreciation for real estate, the taxpayer may elect to use the straight-line method for personal property. True or false?
True. If elected, the property is depreciated using the class life (recovery period) of the asset with a half-year convention or a mid-quarter convention, whichever applies.
§ 179 (Election to Expense Certain Depreciable Business Assets)
annual election that applies to the acquisition cost of property placed in service that year
It is the ability to deduct a capital expenditure in the year an asset is placed in service rather than over the asset's useful life or cost recovery period.
The immediate expense election generally is not available for real property or for property used for the production of income.
Any elected § 179 expense is taken before additional first-year depreciation is computed. And any MACRS deduction is calculated on the basis of the asset net of the § 179 expense and any additional first-year depreciation. True or false?
What are the three limitations the § 179 expense is subject to?
1. Ceiling Amount: A taxpayer's § 179 deduction cannot exceed an annual ceiling amount ($510,000 in 2017). A taxpayer can choose to use all, part, or none of the annual § 179 amount.
2. Property Placed in Service Maximum: The § 179 deduction ceiling amount ($510,000 in 2017) is reduced dollar for dollar when § 179 property placed in service during the taxable year exceeds a specified maximum amount ($2,030,000 in 2017). In 2017, a taxpayer who places in service $2,540,000 or more of qualifying property ($510,000 + $2,030,000) will NOT be able to claim a § 179 deduction, therefore this deduction is mainly for small businesses.
3. Business Income Limitation: The § 179 deduction allowed for a taxable year cannot exceed the taxpayer's business income for the year.
Look at Examples 18, 19, and 20 (Section 8-3a) for further explanation.
If an office building is placed in service during 2017, will it have an effect on a taxpayer's cost recovery deduction calculation for personal property placed in service?
No. The building is not tangible personal property (it is MACRS realty). Only tangible personal property is used to determine whether the § 179 ceiling amount ($510,000 in 2017) is reduced.
Business income is calculated by deducting all business expenses except the § 179 deduction. True or false?
True. As a result, a taxpayer's § 179 deduction cannot create (or increase) a net operating loss.
For this purpose, business income includes not just income from a sole proprietorship, but also from wages and any allocated business income from a partnership or an S corporation.
What is the tax treatment of any § 179 amount in excess of taxable income?
It is carried forward to future taxable years and added to other amounts eligible for expensing. Then the same limitations for that carryforward year are applied (i.e. the ceiling amount, the placed in service maximum amount, and the business income limitation).
What is the § 179 election effect on 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 ($2,030,000 for 2017). This adjusted amount does not reflect any business income limitation.
Conversion of the expensed property to personal use at any time results in recapture income. True or false?
True. A property is converted to personal use if it is not used predominantly in a trade or business.
additional first-year depreciation
This is also called "bonus depreciation."
allows taxpayers to deduct an additional 50 percent cost recovery in the year qualified property is placed in service
The term "qualified property" includes most new depreciable assets, other than buildings, with a recovery period of 20 years or less. The term "new" means the original or first use of the property. Property that is used but "new to the taxpayer" does not qualify.
When is any additional first-year depreciation computed?
computed after any § 179 immediate expense deduction is claimed, and taken in the year in which the qualifying property is placed in service
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. True or false?
A taxpayer may elect not to take additional first-year depreciation. True or false?
Using the § 179 expense election on the longest-lived asset accelerates overall cost recovery deductions to earlier years, gaining a time-value-of-money advantage for the taxpayer. True or false?
True. Refer to Example 24 in section 8-3c for further explanation.
In general, in 2017, a business that places in service $510,000 or less of qualifying § 179 property will exclusively use § 179 to immediately expense all of those assets, while a business placing in service $2,540,000 or more of qualifying assets (the point at which the § 179 amount is completely phased out; $510,000 + $2,030,000) will qualify only for bonus depreciation. True or false?
True. And any business placing in service between $510,000 and $2,540,000 of qualifying § 179 property will be able to use a combination of both § 179 and bonus depreciation.
If listed property is not predominantly (greater than 50%) 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. True or false?
True. If not predominantly used for business, the listed property's cost must be recovered using the straight-line method, and must continue to be recovered using the straight-line method, even if at a later date the property is predominantly used for business.
What is listed property?
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.
4. Any computer or peripheral equipment, with the exception of equipment used exclusively at a regular business establishment, including a qualifying home office.
5. Any other property specified in the Regulations.
How does an individual determine the percentage of business use of listed property?
Use a mileage-based percentage for automobiles. For other listed property, one employs the most appropriate unit of time (i.e. hours) for which the property ACTUALLY is used (rather than its availability for use).
What is considered a passenger automobile?
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, [i.e. taxicabs (including autos used for Uber or Lyft), ambulances, hearses, and trucks and vans].
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. True or false?
True. 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.
Luxury automobile limitations do not apply to some sport-utility vehicles (SUVs). True or false?
True. A $25,000 limit applies for the § 179 deduction when the luxury auto limits do not apply. This limit is in effect when the GVW is between 6,000 and 14,000 pounds.
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. True or false?
True. The amount required to be recaptured and included in the taxpayer's ordinary income is the excess cost recovery.
The excess cost recovery is the excess of the cost recovery deduction taken in prior years using the statutory percentage method OVER the amount that would have been allowed if the straight-line method had been used since the property was placed in service.
After the business use of the listed property drops below the more-than-50% level, the straight-line method is used for the remaining life of the property.
Taxpayers who lease, rather than purchase, a passenger automobile for business purposes are not subject to the luxury auto limits. True or false?
True. These taxpayers need to report an inclusion amount in gross income (in order to avoid getting around the luxury auto limits by deducting the full amount of the lease payments).
The inclusion amount is computed from an IRS table for each taxable year for which the taxpayer leases the automobile.
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.
alternative depreciation system (ADS)
a cost recovery system that produces a smaller deduction than would be calculated under ACRS or MACRS
When must the ADS be used?
1. To calculate the portion of depreciation treated as an alternative minimum tax (AMT) adjustment for purposes of the corporate and individual AMT (Chapter 15).
2. To compute depreciation allowances for earnings and profits purposes (Chapter 19).
In general, ADS depreciation is computed using the straight-line method. True or false?
True. 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.
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 is depreciated using the appropriate asset class life (e.g., 5- or 7-year) and the 150 percent declining-balance method.
Realty is depreciated over a 40-year life using straight-line depreciation.
True or false?
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). True or false?
True. If this election is made, there is no difference between the regular income tax and AMT cost recovery.
What type of schedule does a sole proprietor file?
Sole proprietors engaged in a business file a Schedule C, Profit or Loss from Business, to accompany Form 1040.
See Example 39 in Section 8-4 for further explanation.
amortization (§ 197)
the tax deduction for the cost or other basis of an intangible asset over the asset's estimated useful life (i.e. patents, copyrights, leasehold interests)
The amount of the deduction is determined by amortizing the adjusted basis of these intangibles ratably over a 15-year period beginning in the month in which the intangible is acquired.
Generally, self-created intangibles are NOT § 197 intangibles.
The 15-year amortization period applies regardless of the actual useful life of an amortizable § 197 intangible. True or false?
True. No other depreciation or amortization deduction is permitted for these intangibles.
How does one calculate their amortization deduction?
(cost of intangible asset / 15) * (remaining months left of the year / 12)
expenditures paid or incurred prior to the beginning of the business that would have been deductible as an ordinary and necessary business expense if business operations had begun
partially amortizable by using a § 195 election
examples: advertising; salaries and wages; travel and other expenses incurred in lining up prospective distributors, suppliers, or customers; and salaries and fees to executives, consultants, and professional service providers
What is the tax treatment of startup expenditures?
A taxpayer will immediately expense the first $5,000 (subject to phaseout) of startup expenditures and amortize the balance over a period of 180 months, unless the taxpayer elects to not do so.
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.
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. True or false?
True. 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.
What are the two requirements that must be met for an expense to be considered an amortizable startup expenditure?
1. The expenses must be paid or incurred in connection with:
(1) Creating a business, (2) Investigating the creation or acquisition of a business, (3) Anticipating an activity becoming a business.
2. The expenses must reflect those that could be deducted in an existing trade or business in the same field.
Startup expenditures do not include allowable deductions for interest, taxes, and research and experimental costs. True or false?
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
Land generally cannot be depleted.
Use cost method or percentage (statutory) method; the method that results in the larger deduction should be used.
intangible drilling and development costs (IDCS)
Taxpayers may elect to (1) expense or (2) capitalize (subject to amortization) intangible drilling and development costs.
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.
However, ordinary income recapture provisions apply to oil and gas properties on a sale or other disposition if the expense method is elected.
These costs generally have no salvage value and are a lost cost if the well is dry.
What is the tax treatment of costs incurred after a natural resource well is producing?
These costs are operating costs and include expenditures for such items as labor, fuel, and supplies.
Operating costs are deductible as trade or business expenses.
Why is it advantageous to expense IDSs?
1. the obvious immediate write-off
2. Because a taxpayer can use percentage depletion, which is calculated without reference to basis, the IDCs may be completely lost as a deduction if they are capitalized.
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.
Cost depletion resembles units-of-production depreciation.
percentage (statutory) depletion
Depletion based on a statutory percentage applied to the gross income from the property, but in no event may percentage depletion exceed 50 percent of the taxable income from the property before the allowance for depletion.
When a business is purchased, goodwill and covenants not to compete are both subject to an amortization period of 15 years. True or false?
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 (i.e. inventory, receivables, and personalty).
If the purchase price will be assigned to assets with longer recovery periods (i.e. realty) or to assets not eligible for cost recovery (i.e. land), the purchaser would likely prefer costs to be assigned to goodwill or a covenant.
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