Capital Recovery: Depreciation, Amortization and Depletion

1
Chapter 9

• Capital Recovery Depreciation, Amortization and
  Depletion

2
NOTE There are a LOT of changes to the tax code
in this chapter as a result of the May 6, 2003
Act!

• This chapter examines the various cost allocation
  methods allowed by the Code depreciation,
  amortization and depletion.
• Each of these methods relates to a process of
  allocating the cost of an asset over time.
• Depreciation concerns tangible property,
  amortization concerns intangible property and
  depletion concerns natural resources.

3
Tangible Property

• There are two types of tangible property real
  property and personal property.
• Real property (or realty) is land and anything
  attached to the land such as buildings, curbs,
  streets, fences and other improvements.
• Personal property is property that is not realty
  and is usually movable.
• The concept of personal property or personality
  should be distinguished from property that a
  person owns and uses for his or her benefit
  usually referred to as personal-use property.

4
Depreciation and Amortization for Tax Purposes

• The Code allows as a depreciation deduction a
  reasonable allowance for the exhaustion, wear and
  tear, and obsolescence of property that is either
  used in a trade or business or held for the
  production of income.
• Only property that wears out or becomes obsolete
  can be depreciated.
• This requirement means that depreciation is
  allowed only for property that has a determinable
  life.

5
Depreciation and Amortization for Tax Purposes
(contd)

• Property used for personal purposes cannot be
  depreciated.
• However, a single asset may be used for both
  personal purposes and profit-seeking activities.
  
• The taxpayer is permitted to deduct depreciation
  on the portion of the asset used for business or
  production of income.
• The basis for depreciation is the adjusted basis
  of the property as used for computing gain or
  loss on a sale or other disposition.
• Where property used is converted to use in
  business or the production of income, the basis
  for depreciation purposes is the lesser of the
  fair market value or the adjusted basis at the
  time of conversion.

6
Depreciation and Amortization for Tax Purposes
(contd)

• The basis for depreciation must be reduced by
  depreciation allowed or allowable.
• When a taxpayer fails or forgets to claim a
  depreciation to which he or she was entitled in
  prior years, future depreciation charges may not
  be increased to correct for the error.
• The taxpayer can file an amended return to claim
  the depreciation not taken in that year.
• Congress revised the method for computing
  depreciation by enacting Code section 168 and the
  Accelerated Cost Recovery System (ACRS).
• The current version of this system is known as
  the Modified Accelerated Cost Recovery System
  (MACRS).
• An alternative to MACRS, called the Alternative
  Depreciation System (ADS), is also available.

7
MACR System

• Taxpayers are required to calculate depreciation
  for most property using the Modified Accelerated
  Cost Recover System (MACRS).
• Under MACRS, useful lives for assets are termed
  recovery periods and are prescribed by statute.
• Each asset is deemed to have a particular useful
  life of 3,5,7,10,15, 20,27.5 or 39 years.
• Salvage value is ignored under MACRS.

8
Property Subject to MACRS

• Taxpayers must use MACRS to compute depreciation
  for all tangible property.
• MACRS is not used to amortize intangible assets.
  
• MACRS may not be used with respect to
• Property depreciated using a method that is not
  based on years (e.g., the units-of production
  method).
• Automobiles if the taxpayer has elected to use
  the standard mileage rate.
• Property for which special amortization is proved
  and elected by the taxpayer (e.g., amortization
  of pollution control facilities)
• Certain motion picture films, video tapes, sound
  recordings, and public utility property.
• Generally, any property that the taxpayer owned
  or used (e.g., leased) prior to 1987.

9
Property Subject to MACRS (contd)

• As a practical matter the taxpayer is allowed to
  elect out of MACRS and use the Alternative
  Depreciation System (ADS).
• In addition, in lieu of depreciation, the
  taxpayer may be allowed to expense up to 102,000
  annually of the aggregate costs of certain assets
  placed in service during the year.
• Exhibit 9-1 identifies the depreciation methods
  and accounting conventions available under the
  MACRS and ADS systems.

10
Classes of Property

• All property subject to MACRS is assigned to one
  of eight classes.
• Classification is important because the recovery
  periods, methods and accounting conventions to be
  used in calculating depreciation can vary among
  the different classes of property.
• Property is assigned to a particular class based
  on its class life as prescribed in Revenue
  Procedure 87-56.
• An excerpt of Revenue Procedure 87-56 is provided
  in Exhibit 9-2.

11
Calculating Depreciation

• Under MACRS, depreciation is a function of three
  factors the recovery period, the method, and the
  accounting convention.
• Recovery periods run various lengths of time
  based on the class of property (see Exhibit
  9-1).
• Certain property is assigned to a class without
  regard to its class life.
• Note also that the current structure provides
  different recovery periods for real property,
  depending on whether it is residential or
  nonresidential real estate.
• Realty qualifies as residential real estate if
  80 of the gross rents are for the dwelling units.

12
Calculating Depreciation (contd)

• The depreciation method to be used varies
  depending on the class of the property.
• The variation is actually between real and
  personal property.
• Real property is depreciated using the
  straight-line method
• Personal property is depreciated using either
  straight-line or a declining balance method.

13
Calculating Depreciation (contd)

• The final factor to be considered is computing
  depreciation is the accounting convention.
• The Code establishes three conventions the
  half-year, mid-month and mid-quarter conventions.
• The half-year convention applies to all property
  other than non-residential real property and
  residential rental property.
• Under the half-year convention, one-half year of
  depreciation is allowed regardless of when the
  asset is placed in service or sold during the
  year.
• The recovery period is effectively extended one
  year so that the remaining one-half may be
  claimed.

14
Calculating Depreciation (contd)

• To simplify the computation of depreciation, the
  IRS provides optional tables as shown in Exhibits
  9-4 to 9-7.
• The basic steps necessary to compute annual
  depreciation are as follows
• Identify the depreciable basis of the asset
• Determine the MACRS property class
• Identify the depreciation convention
• Determine the recovery period and method.
• Locate the appropriate table based on the
  depreciation convention, recovery period and
  method.
• Choose the table percentages relating to the
  recovery period of the asset.
• Multiply the table percentages by the depreciable
  (cost) basis of the asset to compute annual
  depreciation amounts.

15
Mid-Month Convention

• Applies only to real property (i.e.,
  non-residential real property and residential
  rental property).
• Under the mid-month convention, one-half month of
  depreciation is allowed for the month the asset
  is placed in service or sold and a full month of
  depreciation is allowed for each additional month
  of the year that the asset is in service.
• Due to the mid-month convention, the recovery
  period must be extended one month to claim the
  one-half month of depreciation that was not
  claimed in the first month.

16
Mid-Quarter Convention

• The mid-quarter convention applies only to
  personal property.
• However, it only applies if more than 40 percent
  of the aggregate bases of all personal property
  placed in service during the taxable year is
  placed in service during the last three months of
  the year.
• Property placed in service and disposed of during
  the same taxable year is not taken into account.
  
• Also not taken into account is any amount
  immediately expensed under section 179 or
  property used for personal purposes.
• If the 40 percent test is satisfied, the
  mid-quarter convention applies to all personal
  property placed in service during the year
  (regardless of the quarter in which it was
  actually placed in service).
• When applicable, the mid-quarter convention
  treats all personal property as being placed in
  service in the middle of the quarter of the
  taxable year in which it was actually placed in
  service.

17
Special Adjustment

• A special adjustment must be made if there is a
  disposition of the property before its cost is
  fully recovered.
• This adjustment is similar to that used for the
  half-year and mid-month convention.
• Ex The taxpayer is entitled to only one-half of
  a quarters depreciation for the quarter that the
  asset is sold.

18
Straight-Line Method

• There may be circumstances where the slower-paced
  straight-line method may be more beneficial.
• For example, if the taxpayer is currently in the
  10 or 15 tax bracket, he or she may want to
  defer depreciation deductions to years when he or
  she is in a higher tax bracket.
• The MACR System offers taxpayers a straight-line
  method of depreciation.
• The depreciation percentages to be used where the
  taxpayer elects the straight-line method are
  contained in Exhibit 9-8 (half-year convention
  property) for 3-, 5-, and 7-year property.
• Appendix C has straight-line depreciation tables
  for the half-year convention.
• The depreciation percentages for the mid-quarter
  convention are in Revenue Procedure 87-58.

19
Straight-Line Method (contd)

• The Alternative Depreciation System (ADS) is an
  option for taxpayers.
• The major differences between MACRS and ADS
  consist of different recovery periods (longer for
  most assets and slower for others).
• The recovery periods for ADS are summarized in
  Exhibit 9-9.
• Taxpayers electing ADS for real property are
  restricted to straight-line depreciation.
• The ADS depreciation percentages for real
  property are found in Exhibit 9-10.
• Except for real property, the taxpayer may elect
  to use ADS on property-by-property basis.
• The taxpayer must use ADS straight-line for
  depreciating
• Certain listed property property
• Foreign use property (i.e., property used outside
  the U.S. more than half of a taxable year),
• Property leased to a tax-exempt entity (and
  foreign persons unless more than 50 of the
  income is subject to U.S. tax), and
• Property that is financed either directly or
  indirectly by the issuance of tax-exempt bonds.

20
Limited Expensing Election Code Section 179

• When Congress introduced ACRS, it also enacted a
  provision allowing taxpayers (other than estates
  or trusts) to elect to treat the cost of
  qualifying property as a currently deductible
  expense rather than a capital expenditure subject
  to depreciation.
• The maximum amount that can be expensed by a
  taxpayer is 102,000 (for acquisitions made in
  2004).
• However, two limitations may restrict the amount
  that the taxpayer may otherwise expenses
• Acquisitions of Eligible Property Exceeding
  400,000.
• Where the aggregate cost of qualifying property
  placed in service during the year exceeds
  410,000 (2004), the 102,000 amount must be
  reduced 1 for each 1 for each 1 of cost in
  excess of 410,000.

21
Code Section 179 (contd)

• However, two limitations may restrict the amount
  that the taxpayer may otherwise expenses
  (contd)
• Taxable Income Limitation.
• The deduction under section 179 cannot exceed the
  amount of taxable income (prior to consideration
  of this deduction) derived from all of the
  taxpayers trades or businesses (including wage
  income).
• Any amount that cannot be deducted can be carried
  over indefinitely to following years to be used
  against future income.
• The 102,000 maximum amount that can be expensed
  in subsequent years is not increased by the
  carryover amount, however.
• Rather than carry over the amount that could not
  be expensed because of the taxable income
  limitation, the taxpayer has the option of not
  reducing the propertys basis by the carryover
  amount so it can be depreciated along with the
  rest of the propertys cost.

22
Code Section 179 (contd)

• The taxpayer may elect to expense all or a
  portion of an asset so long as the total amount
  expensed does not exceed the dollar limitation.
• Only certain property is eligible for expensing
• Recovery property
• Property that would have qualified for the
  investment credit (e.g., most property other than
  buildings and their components)
• Property used in a trade or business, as
  distinguished from property held for the
  production of income and
• Property acquired by purchase from someone who is
  generally not a related party under section 267
  (e.g., gifted or inherited property usually does
  not qualify nor would property acquired from a
  spouse or parent).

23
Code Section 179 (contd)

• Certain property is designated as ineligible for
  expensing includes
• Property used predominantly to furnish lodging or
  in connection with furnishing lodging unless the
  business is a hotel or motel that provides
  accommodations used (e.g., apartments, duplexes
  and the like)
• Property that is primarily used by a tax-exempt
  organizations
• Air conditioning and heating units and
• Property used outside the U.S.

24
Code Section 179 (contd)

• If the property is converted to non-business use
  at any time, the taxpayer must be recapture the
  benefit derived from expensing.
• Recapture requires the taxpayer to include in
  income the differences between the amount
  expensed and the MACRS deductions that would have
  been allowed for the actual period of business
  use.

25
Bonus Depreciation

• The Act allows taxpayers to claim an additional
  first-year depreciation deduction equal to 50 of
  the adjusted basis of new qualified property
  (section 168(k)) for property placed in service
  on or after May 6, 2003 and before January 1,
  2005 .
• This bonus depreciation is in addition to any
  amount expensed under section 179 and regular
  depreciation.
• Observe that while the section 179 allowance
  phases out, taxpayers may still take advantage of
  the bonus depreciation.

26
Bonus Depreciation (contd)

• Qualified property is generally all newly
  acquired depreciable property other than
  buildings.
• Only new property qualifies.
• To qualify, the propertys first or original use
  must commence with the taxpayer on or after May
  6, 2003 (30 for property acquired and placed in
  after September 10, 2001 and before May 6, 2003).
  
• For this purpose, capital expenditures incurred
  to recondition or rebuild property meet this
  requirement.
• The cost of reconditioned or rebuilt property
  acquired by the taxpayer is considered used
  property and does not qualify.

27
Bonus Depreciation (contd)

• Qualified property includes the following
• Property eligible for MACRS depreciation with a
  recovery period of 20 years or less
• Certain water utility property
• Computer software (other than software that is
  acquired in connection with the acquisition of a
  business)
• Qualified leasehold improvement property.
• A qualified leasehold improvement is an interior
  improvement made under a lease of commercial
  property and placed in service more than three
  years after the building was first placed in
  service.

28
Bonus Depreciation (contd)

• Intangibles would not qualify for the additional
  allowance.
• Section 197 intangibles such as goodwill,
  covenants not to compete, and customer lists
  acquired in connection with the purchase of a
  business also would not be eligible.
• Property that must be depreciated using the ADS
  System does not qualify.
• However, if the taxpayer merely elects to use ADS
  for certain property, bonus depreciation can
  still be claimed.

29
Bonus Depreciation (contd)

• There is no limitation on the amount of bonus
  depreciation that may be claimed.
• Taxpayers may claim bonus depreciation for all
  qualified property.
• In addition, taxpayers may claim both bonus
  depreciation and section 179 expensing.
• When both amounts are claimed the bonus
  depreciation is equal to 50 of the adjusted
  basis of the property after the reduction for the
  amount expensed under section 179.
• Regular depreciation is computed after the basis
  of the property is reduced by both the section
  179 amount and the 50 additional allowance.

30
Bonus Depreciation (contd)

• The full amount of bonus depreciation may be
  claimed regardless of whether the mid-quarter
  convention applies.
• Note a taxpayer may elect not to claim the
  additional allowance.
• This may be done simply by computing depreciation
  in the normal fashion.

31
Bonus Depreciation and Section 179 Compared

• Although section 179 and bonus depreciation are
  similar, the same limitations do not apply.
• The expensing allowance of section 179 is subject
  to several special rules that limit its
  application.
• Differences include
• Bonus depreciation is not limited to the taxable
  income from the business.
• Bonus depreciation does not phase-out based on
  the amount of property placed in service during
  the year.
• Bonus depreciation can be claimed for purchases
  of investment property while section 179 applies
  only to business property.
• Bonus depreciation can be claimed on purchases
  from related parties while section 179 cannot.
• Estates and trusts are not allowed to elect
  section 179 but can use bonus depreciation.
• Section 179 can be claimed for used property
  while bonus depreciation cannot.

32
Limitations for Automobiles

• Section 280F carves out a special set of
  limitations for passenger automobiles
• A passenger automobile is defined as any
  four-wheeled vehicle manufactured primarily for
  use on public streets, roads, and highways that
  weighs 6,000 pounds or less unloaded.
• The term passenger automobiles does not include
  vehicles for hire, such as taxi cabs, rental
  trucks, and rental cars.
• Ambulances and hearses directly used in a trade
  or business are also unaffected sport utility
  vehicles with gross weight ratings above 6,000
  pounds are not affected by the auto depreciation
  limits.
• The maximum bonus depreciation and/or section 179
  expense for autos is shown in Exhibit 9-11.
• The limits for a particular auto are determined
  by the year the auto is placed in service by the
  taxpayer.

33
Limitations for Autos (contd)

• The Act increases the first year limitation
  imposed by section 280F for automobiles by 7,650
  from 4,060 to 10,710 if 50 bonus depreciation
  is elected.
• Exhibit 9-11 shows subsequent depreciation limits
  (assuming a 6 year recovery period)
• The Section 280F increase is allowed only for
  cars that qualify for bonus depreciation.
• Due to this change, only cars that cost more than
  17,850 will be effected by the 10,710
  limitations (17,850 x 50 8,925) (20 X
  17,850 8,925 1,785).

34
Limitations for Autos (contd)

• Where the car is used less than 100 of the time
  for business including the portion of time the
  car is used for production of income purposes
  the maximum amounts must be reduced
  proportionately.
• If the propertys basis has not been fully
  deducted by the close of the normal recovery
  period, a deduction for the un-recovered basis is
  allowed in subsequent years.
• Deductions for the propertys un-recovered basis
  are limited to 1,775 annually until the entire
  basis is recovered.

35
Limitations for Autos (contd)

• The Act recognized that trucks and vans cost more
  than cars and created a separate set of
  limitations for these vehicles
• Total Section 280F depreciation limits for 2003
  11,010
• See Exhibit 9-12
• This does not apply to vehicles weighing over
  6000 pounds

36
Limitations for Autos (contd)

• One effect of the new law is to make vehicles
  weighing over 6,000 pounds a very attractive
  purchase.
• Since the automobile limitations do not apply to
  such vehicles (certain sport utility vehicles)
  and taxpayers can now expense up to 102,000
  (2004) under section 179 the entire cost (or at
  least the portion used for business) can be
  deducted of these vehicles.

37
Limitations for Autos (contd)

• The depreciation ceilings for automobiles are
  tripled for electric vehicles is tripled to
  22,950.
• Thus the first year ceiling amount for electric
  cars is 26,040 for vehicles placed in service on
  or after May 6, 2003 (9,090 22,880 32,030)
• Exhibit 9-13 shows the Section 280F depreciation
  limits for electric cars

38
Leasing

• The amount that the taxpayer must include in
  income is generally based on the automobiles
  fair market value and is determined in the
  following manner
• Using the value of the automobile for the taxable
  year in which the auto is first used under the
  lease, identify the annual inclusion amount from
  the table found in Exhibit 9-14.
• Note for the last year of the lease, the dollar
  amount of the preceding year is used
• Prorate the dollar amount for the number of days
  of the lease term included in the taxable year.
• Multiply the prorated dollar amount by the
  business and investment use for the taxable year.
• Note without these rules a taxpayer could
  circumvent the depreciation rules

39
Limitations For Personal Use

• Section 280F also restricts the amount of
  depreciation that may be claimed for so-called
  listed property that is not used predominantly
  more than 50 for business.
• If the property is not used more than 50 for
  business in the year it is placed in service, the
  following restrictions are imposed
• Limited expensing under section 179 is not
  allowed.
• MACRS may not be used in computing depreciation.
• Note that these restrictions are imposed if the
  property is not used primarily for business in
  the first year.
• Subsequent usage in excess of 50 does not permit
  the taxpayer to amend the earlier return or later
  use accelerated depreciation or limited
  expensing.
• On the other hand, if qualified usage initially
  exceeds 50 but subsequently drops to 50 or
  less, benefits previously secured must be
  relinquished.
• Exhibit 9-13 identifies the depreciation methods
  available for listed property.

40
Limitations For Personal Use (contd)

• The restrictions apply only to listed property
• Passenger automobiles
• Any other property used as a means for
  transportation (e.g., motorcycles and trucks)
• Any property generally used for purposes of
  entertainment, recreation, or amusement unless
  used exclusively at a regular business
  establishment (e.g., at the office)
• Any computer or peripheral equipment unless used
  exclusively at a regular business establishment
• Any cellular telephones and similar
  communications equipment
• Bonus depreciation may be claimed for listed
  property as long as such property is eligible for
  MACRS.
• If qualified business use does not exceed 50,
  ADS must be used and, in such case, the property
  would not be eligible for bonus depreciation

41
Limitations For Personal Use (contd)

• In determining whether the property is used more
  than 50 for business, only qualified business
  use is considered.
• An employees use of his or her own property in
  connection with employment is not considered
  business use unless it is for the convenience of
  the employer and is required as a condition of
  employment.
• The qualified business use rules directly address
  the problems of the company-owned car and other
  company-owned property used by employees.

42
Limitations For Personal Use (contd)

• Where an employee use an automobile, an employer
  is able to secure 100 qualified business use
  and thus depreciate the entire cost of the
  automobile in one of four ways
• The employees actual business usage is
  disregarded and the entire value of using the
  vehicle is included in the employees income
• The employees actual business usage is combined
  with inclusion of the value of any personal use
  by the employee as income
• The employees actual business usage is combined
  with a reimbursement arrangement where the
  employee reimburses the employer for any personal
  use (i.e., a fair rent is paid) or,
• The use falls under one of four exceptions.
• Conditions 2 and 3 cannot be applied to qualify
  the use of a person owning greater than a 5
  interest in the business.
• The car is depreciated based on actual business
  usage.

43
Limitations For Personal Use (contd)

• Each requires a valuation of the vehicles use by
  the employee
• The value can be determined using a
  facts-and-circumstances approach or one of
  several safe harbors provided by Temporary
  Regulations.
• The Regulations provide a table based on the
  cars total value which provides values for
  personal use.
• Another alternative is the standard mileage
  allowance.
• Bonus depreciation is considered to be
  depreciation for purposes of these recapture
  rules.
• Thus, if business use falls below 50 within 2
  years after the asset is placed in service,
  recapture occurs.

44
Limitations For Personal Use (contd)

• For listed property, the taxpayer is required to
  substantiate the following
• The amount of each expenditure related to the
  property, including the cost of acquisition,
  maintenance and repairs
• The date of the use of the property
• The amount of each business or investment use as
  well as total use (the number of miles in the
  case of a car or other means of transportation
  or the amount of time that the property was used
  for other listed property (e.g., a computer)
• The purpose of the use of the property.

45
Anti-Churning Rules

• Sales, exchanges, and other dispositions of
  assets are referred to as churning transactions
  exchanges of used property solely to obtain the
  benefits of MACRS.
• The thrust of the anti-churning rules is to
  preclude the use of MACRS for property placed in
  service prior to the enactment of either version
  of MACRS, unless the property is transferred in a
  transaction where not only the owner changes but
  also the user.
• There are three sets of rules designed to police
  churning. A taxpayer would typically be subject
  to the anti-churning rules in the following
  situations
• Sale followed by immediate leaseback
• Like-kind exchange
• Formation and liquidation of a corporation or
  partnership, including transfers of property to
  and distributions from these entities.

46
Special Note

• Mid-term 2 and Final Exam Note you will not be
  responsible for studying/knowing the sections on
• Amortization (page 9-36)
• Depletion (page 9-38)
• Research and expenditures (page 9-40) or
• Expenses of farmers or ranchers (page 9-43)