Chapter 10 Depreciation Cost Recovery Amortization and Depletion

Chapter 10 • Depreciation, Cost Recovery, Amortization and Depletion

Learning Objectives • Understand the general concepts of tax depreciation • Classify property and calculate cost recovery under the MACRS rules • Calculate amortization for intangible assets and understand the difference between amortizable and non-amortizable assets • Apply cost and percentage methods and understand the treatment of intangible drilling costs

Introduction • Allows taxpayers to deduct a reasonable allowance for the exhaustion, wear and tear, and obsolescence. • Taxpayers must use specific depreciation methods depending on when an asset is placed into service.

Depreciation and Cost Recovery • Property placed into service prior to 1981 • Property placed into after December 30, 1980 and before January 1, 1987 (ACRS) • Property placed into service after December 31, 1986 (MACRS)

Common Rules of All Systems • No depreciation may be claimed on land or other assets that have an indefinite life (works of art). • Depreciation is permitted in the year the asset is placed into service • Consistency is required, no matter which system is used • Basis of property being depreciated must be reduced by the amount of depreciation that is allowable for each taxable year

Types of Property • Tangible Property (physical) • Intangible Property (nonphysical) • Real Property • Personal Property vs. Personal. Use Property

Depreciation Methods 1986 and later years • MACRS – Personal property • Use 3, 5, 7, 10, 15, 20 year useful life • 200% declining balance with a conversion to straight-line • Half-year convention(no matter when asset is placed into service, the first year can only take a half years depreciation) • Mid-Quarter convention is used when the aggregate basis of all personal property placed into service during the last three months of the year exceed 40% • No salvage value

Depreciation Methods • Real Property – Residential rental property: 27. 5 years – Nonresidential rental property: 39 years – Depreciation is calculated using the straight -line method – Mid-month convention –year of acquisition and year of disposition – Straight-line or Alternate Depreciation System(ADS)

Section 179 Expensing Election • • • May elect to expense up to $105, 000 in 2005 Placed into service during the year Not applicable to real estate, only applicable personal property.

Section 179 Expense

Bonus Depreciation • Additional first year depreciation deduction for certain qualified property. – Be acquired after September 10, 2001 and before September 11, 2004. • Non real estate • Recovery period of 20 years or less • Computer software • Qualified leasehold improvement property • Depreciation deduction is 30% of the adjusted basis of the property. • Increased to 50% for qualified property placed in service after May 5, 2003 and before January 1, 2005

MACRS Restrictions • • • Portion of asset used for personal use is not depreciable Listed property rules Recapture of excess cost-recovery Luxury automobile limitation (see page P 10 -14) Vehicle over 6, 000 lbs GVWR

Depreciation Example • Luxury Automobile Limitations 2003 a 2003 b 2004 c 2004 d 2005 1 st year 7, 660 10, 710 10, 610 2, 960 2 nd year 4, 900 4, 800 4, 700 3 rd year 2, 950 2, 850 4 th and later years 1, 775 1, 675

Amortization Intangible Assets • Definition of Section 197 – Goodwill and going concern value, covenants not to compete, franchise fees, trademarks, and trade names etc. • Classification and disposition of intangibles – A Sec. 197 asset is treated as depreciable property so that Sec. 1231 treatment is accorded the disposition if held more than one year • Research and experimental expenditures – Include experimental and laboratory costs incidental to the development of a product. • Computer software

Depletion and Intangible Drilling and Development Costs • Treatment of intangible drilling and development costs (IDCs) – Capitalized or deducted currently – Decision to expense or capitalize depends on taxpayer’s current position (profit or loss)

Depletion and Intangible Drilling and Development Costs • Depletion methods – Cost depletion method is calculated by dividing the adjusted basis of natural resource by expected quantity to be extracted – Percentage depletion method is calculated by multiplying the statutory depletion percentage times the gross income generated

Tax Planning Considerations • Alternative depreciation under MACRS • IDCs: CAPITALIZATION VS. EXPENSING • Units of Production Depreciation • Structuring a business combination

Compliance And Procedural Considerations • IDCs Election • Form 4562 is used to report depreciation, depletion, and amortization deductions. • Research and Experimental Expenditures