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Basis rules, depreciation, and asset categorization.
Terms in this set (44)
What is amount realized?
To calculate gain or loss, the taxpayer's adjusted basis is subtracted from the amount realized.
Cost basis includes not only the cash paid by the taxpayer to purchase the investment, but also the amount of recourse debt that the investor incurs to purchase the investment. What is recourse debt?
debt that the taxpayer is personally liable to repay, regardless of whether or not the investment produces a return for the investor.
May recover from personal assets.
The taxpayer must earn money, pay tax on those earnings, and use the after-tax earnings to make debt payments.
Provide an example of recourse debt.
In our previous example, Nina purchased a Rolls-Royce for $400,000 in cash. Assume that instead of paying the full purchase price, she decides to obtain a recourse loan from Jarvis Savings Bank. Nina pays $80,000 in cash, and Jarvis Savings Bank gives her a promissory note for $320,000. Nina will have to pay back the $320,000 loan with after-tax dollars, so her initial basis in the car is still $400,000.
What is nonrecourse debt?
Nonrecourse debt is debt that is secured by the investment itself and/or collateral, often property, and is not an obligation of the investor (taxpayer).
Which 5 items are included in basis?
1. Purchase price.
2. Sales tax.
4. Installation and testing costs.
5. All costs to get the asset into operations.
An item that can cause an increase in basis is amortization of the discount on bonds purchased below face value. Explain.
Due to fluctuations in interest rates, a bond may sell for more or less than its face value. If the bond sells for less than its face value, the investor's return will consist of two components: (1) the periodic interest payments on the bond; and (2) the difference between the face amount (maturity value) of the bond and the bond's purchase price, or discount.
Why is the discount on bonds amortized over the life of the security?
The purchaser of a bond held to maturity expects to receive the full maturity value (usually $1,000 per bond) at the maturity date. The investor will periodically collect the coupon interest rate times the maturity value and then the full face value at maturity.
How do you calculate Phantom Income on a bond?
Two types of interest from discount bonds:
1. Annual or semi-annual coupon payments when received.
2. Amortization of the discount from par value.
The difference will be received at maturity. However, investors must recognize this difference each year the bond is held until it matures ; this refers to phantom income.
Taxpayers calculate the phantom income by using the yield to maturity (YTM) for the bond. Since the amount amortized each year passes through the tax toll booth and is subject to income tax, the investor's basis in the bond is increased by the amount of the annual discount subject to tax.
What are original issue discount bonds?
OID bonds. Bonds, other than US Savings bonds sold at a discount are called this.
What are the two most common ways of removing capital from an investment?
1. distributions from business entities that have pass-through tax treatment.
2. claiming depreciation deductions.
What is the difference between a premium purchased and a discount purchased bond?
If an investor pays a premium upon the purchase of a bond (most likely due to a decline in interest rates compared to the coupon rate since the bond was issued), the investor may elect to amortize the bond premium over the lifetime of the bond. One difference between a taxable bond premium and a discount is that the discount on a bond must be amortized (with a few rare exceptions, such as U.S. savings bonds), whereas the premium paid to acquire a bond is amortized only if the investor elects to do so.
If the investor elects to amortize the premium paid on a taxable bond, the amount amortized is treated as an interest deduction, which is used to offset interest income taxed at ordinary income tax rates.
Will reduce basis in bond.
What is one way that an individual may decrease their basis for a personal asset?
Using part of a personal residence for business purposes. May be able to deduct costs associated with the use of the property. Depreciation is one example.
What is Section 1014? (inheritance)
states that the basis in the hands of the recipient of inherited property is the value at which it was included in the gross estate.
What is the estate tax exception period of 2010?
Due to the temporary repeal of the estate tax in 2010, executors of estates of decedents who died in 2010 had the option to take a carry-over basis and not be subject to estate tax, or could opt out of this treatment subjecting the estate to a federal estate tax but qualifying for a step up in basis.
What did the Highway and Transportation Funding Act of 2015 impose?
Consistent basis reporting standards for property that receives a Section 1014 step-to basis.
when an estate beneficiary sells an asset received through the estate of a decedent, the beneficiary's basis cannot exceed the final value that had been used for estate tax purposes.
What is an IRD and provide an example.
IRD (income in respect of a decedent) assets do not receive a step-to fair market value at the death of the transferor. IRD assets were not subject to ordinary income tax during the life of the transferor. To prevent these assets from escaping income taxation, they do not receive a step-to fair market value basis at death; rather the decedent's basis carries over to the beneficiary of the asset. Some examples of IRD assets are IRAs, annuities, installment notes, and back wages payable to the decedent.
What is a death bed gift?
Another exception to the step-to fair market value basis provision occurs when a donor (transferor) makes a gift of appreciated property to a donee, who later dies and leaves the property to the original transferor or the spouse of the transferor, and whose death occurs within one year of the gift.
The step-to-fair market value rule does not apply.
Provide an example of the death bed gift.
Clever Colin owns $1 million worth of highly appreciated AAPL stock with a basis of $45. Colin would like to donate the stock to his favorite Uncle Fred, have the stock receive an upward adjustment in its basis at the date of Fred's death, and then receive it back as an inheritance from Uncle Fred so that he avoids a large capital gain. However, this type of transaction will not receive an adjustment in basis if the decedent (Fred) dies within one year of the gift.
Provide the criteria for when the basis of a property in the hands of the donee will differ from the donor's basis.
1. The donor pays gift tax on the transfer.
2. when the donor gifts property that has a fair market value less than the donor's adjusted basis as of the date of the gift.
When a donor is required to pay gift tax, the portion of the gift tax paid that represents appreciation in the value of the property that occurred while in the hands of the donor may be added to the donor's original basis when determining the basis of the donee. What is the formula?
Appreciation in the property/ FMV of property at date of gift x gift tax paid = increase in basis for donee.
What happens when the basis of gifted property differs from the donor's basis, because the gifted property has a fair market value that is lower than the donor's basis?
Double basis rule. One for gain and another for loss.
What happens to the basis of property transferred between spouses or incident to divorce?
regardless of whether property is sold or given to a spouse, the basis of the original owner spouse will carry over to the new owner spouse.
Explain related party transactions.
When property is sold to a related party (other than the seller's spouse), and the sale will result in a gain to the selling party, the normal basis rules apply.
That is, the selling party will recognize gain and the purchasing party will acquire a basis in the property equal to the price he or she paid for the property.
Related parties include lineal ascendants, descendants, and brothers or sisters.
What happens if property is sold to a related party, other than the sellers spouse, at a loss?
The seller is not permitted to deduct the loss and the double basis rule applies.
The gain basis will equal the seller's original basis in the property.
Loss basis will equal the fair market value of the property at the time of the sale.
What is the significant difference between the double basis rule for sales and gifts?
For sales transactions, the holding period for determining the nature of the gain or loss starts anew on the date of sale. If loss property is gifted to a related party, the holding period starts anew if, on disposition of the property, the loss basis is used to determine the donee's loss.
What happens if property is held jointly (such as joint tenants with rights of survivorship, tenants in common, or community property)?
Each owners basis usually follows the actual contribution rule that each owner's basis equals their original contribution toward purchasing the property.
What happens if property is held by joint owners who are married, and titled in joint tenancy with rights of survivorship, tenancy by the entirety, or community property?
The basis of each spouse equals one half of the total basis regardless of their actual contribution.
What did the Economic Recovery Tax Act of 1981 do ?
Created the Accelerated Cost Recovery System (ACRS) which accelerated and simplified tax depreciation for assets placed in service after 1980.
What are the MACRS Asset Classes?
1. 3, 5, 7, 10, 15, and 20-year class life assets.
What is the double declining balance method?
Assets that have a 3, 5, 7, or 10 year class life are depreciated under a depreciation method known as the double declining balance (or "200 percent declining balance") method, with a switch to straight-line depreciation when the straight-line method produces a larger deduction than the double declining balance method.
If used in farming, depreciated under 150% method.
What is the 150% declining balance method?
Property in the 15 and 20 year class lives are depreciated under the 150 percent declining balance method, but also switch to straight-line depreciation when the straight-line method would produce a greater deduction for the current tax year.
How is software depreciated?
Straight line basis over three years.
As an alternative to the 150% and 200% depreciation method, what might be used?
1. Elect straight line depreciation for property.
2. Elect the alternative depreciation system (ADS).
a. 200% -> 150%.
b. 150% -> straight line.
c. Real estate will be depreciated over a 40 year period on a straight-line basis, with the exception of residential rental property, for which the recovery was reduced to 30 years.
What are depreciation conventions?
When depreciable assets are placed in service, certain conventions govern the amount of the depreciation deduction available for the first year.
For personality (assets with a class life of 20 years or less), which depreciation convention is used?
The half-year convention assumes that the asset was placed in service half-way through the year, regardless of the date it was actually employed; and therefore a half-year of depreciation is allowed in the year in which the asset is placed in service.
When would the mid-quarter convention be used?
for a year in which more than 40 percent of all depreciable personalty (based on cost) is placed in service in the last three months of the taxable year. When this occurs, a "mid-quarter" convention is used, which states that the first-year depreciation deduction for the property will be calculated as if each asset purchased during that year was placed in service in the middle of the quarter in which it was actually placed in service.
What is bonus depreciation?
Bonus depreciation is a method of accelerated depreciation that allows businesses to take an immediate first-year deduction on the purchase of qualifying business property, in addition to other depreciation.
Explain bonus recapture after September 27th, 2017.
Sept. 28th, 2017 - Dec 31st, 2022, 100% depreciation.
Once 100 percent bonus depreciation is taken, there is no additional cost recovery available.
Taxpayers can also make an election to apply a 50 percent bonus deprecation rate in lieu of the 100 percent rate.
Which properties are eligible for the bonus depreciation?
• be tangible personal property with a regular depreciation life of 20 years or less
• be computer software
• be water utility property
• be qualified film or television production
• be qualified live theatrical productive.
Whom is bonus depreciation not available to?
• vehicle dealers and other businesses that have floor-plan financing • electrical energy, water, or sewage disposal services
• gas or steam through a local distribution system
• transportation of gas or steam by pipelin
Explain the depletion of natural resources.
The cost of many natural resources, such as oil, coal, gas, and precious metals can be recovered through depletion deductions. A method called cost depletion is normally used for financial accounting. Two different methods, cost depletion and statutory or percentage depletion, are available for federal income tax purposes.
What is listed property?
Listed property includes automobiles weighing less than 6,000 pounds, as well as property generally used for entertainment, recreation, or amusement such as photographic equipment and electronic devices.5 Listed property is considered suspect because it is easily used for both business and personal purposes, and taxpayers will be tempted to take a deduction for their personal use of the asset. Since only the business use of the asset qualifies for depreciation deductions, those taking deductions for such property will merit special review.
How does listed property relate to the given depreciation systems?
If listed property is used more than 50 percent for business purposes, the normal MACRS rules will apply, and the deduction will equal the allowable depreciation for the asset multiplied by its percentage of business use. If listed property is not used more than 50 percent for business purposes, depreciation must be computed under the alternative depreciation system (ADS) of MACRS and a straight-line depreciation method must be used.
if use of listed property that was being depreciated under MACRS falls to 50 percent or less for any year, excess depreciation is recaptured (included in income). Excess depreciation, for this purpose, equals the depreciation actually claimed in prior years, less the amount of depreciation that would have been allowed under ADS.
How do Section 179 influence depreciation?
Section 179 provides business owners with an option to elect to expense property placed in service during the year instead of capitalizing the assets and depreciating them over their MACRS class life, provided that certain requirements are met.
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