Chapter 7 Property Acquisitions and Cost Recovery Deductions

Chapter 7 Property Acquisitions and Cost Recovery Deductions

Expense vs. Capitalize æDeduction permitted for all “ORDINARY AND NECESSARY” business expenses æDeduction prohibited for “PERMANENT improvements to increase the value of property” æSome types of capitalized costs can be recovered through amortization or depreciation

Expense vs. Capitalize æRepairs and maintenance? Source of IRS dispute due to facts. æCapitalize expenditures that increase the value or useful life of an asset. æEnvironment cleanup and prevention costs: TRA 1997 has a provision allowing firms to elect to deduct rather than capitalize expenditures to abate or control hazardous substances at contaminated areas.

Tax Basis æTax basis = unrecovered cost (cost - depreciation). æStarting basis generally equals COST basis: æoriginal purchase price regardless of whether acquired by debt, or æFMV of asset if cost more difficult to measure. æCost recovery of æInventory = cost of goods sold æTangible assets = depreciation æIntangible assets = amortization æNatural resources = depletion

Cost of Goods Sold æInventory Methods (must use accrual to account for COGS æ 1) FIFO æ 2) specific ID æ 3) LIFO - If use LIFO for tax, must also use LIFO for books. æIn times of inflation, LIFO decreases book and taxable income.

Depreciation æDepreciation applies to tangible assets (things you can touch versus intangibles like patents, goodwill) that: æLose value over time due to wear and tear, obsolescence æBuildings depreciate even though real estate often increases in value. æHave a reasonably ascertainable useful life æArtwork is not generally depreciable.

Depreciation æMACRS - Modified Accelerated Cost Recovery System æPersonalty: æDDB: 3, 5, 7, 10 æ 150% DB: 15, 20 æGeneral rule is half year convention æRealty: SL method: 27. 5 years residential, 39 years non-residential (specialty realty 20, 25, 50) æMid Month convention

Depreciation Conventions - Personalty æTable 7 -2 incorporates a half-year convention - provides only 1/2 of the regular rate in the year the property is put in service. æAnti-Abuse provision Mid-quarter convention æ: IF > 40% personalty is acquired during the last quarter of the year, THEN æCompute depreciation separately for EACH quarter’s acquisition using mid-quarter tables in appendix of chapter 7

Automobiles æMaximum annual depreciation limit per vehicle, indexed for inflation. æYear 1 $2, 960 (1 st yr) æYear 2 $4, 800 (2 nd yr) æYear 3 $2, 850 (3 rd yr) æYear 4 + $1, 775 (4 th +++ yrs). æCompute depreciation per MACRS, then limit above.

Expensing Election – Section 179 æApplies to tangible personalty. May expense $128, 000 of assets purchased after 2008 and $133, 000 in 2009. æExpense cannot create a business loss. æExpense reduced $ for $ by purchases > $800, 000. . æReduces recordkeeping, benefit for small businesses æPlanning - if buy a 3 -year, 5 -year and 7 -year asset, which one should you expense?

Amortization of Intangibles æGenerally requires a determinable useful life. æOrganizational costs & Start up costs æImmediately deduct up to $5, 000 æAmount over $5 K amortized over 180 months. æStart-up costs & Organization costs are defined on pg. 177. æExpansion costs may be currently deductible.

Leasehold Costs and Improvements æCost of acquiring lease is amortized over the period of lease. æImprovements to leased property are capitalized and depreciated according to type of property.

Purchased Intangibles æAllocate lump-sum price to assets by relative FMVs. æResidual = goodwill. æTax = 15 years SL æGAAP = 40 years pre-2002. No GAAP amortization post-2001 - evaluate for impairment annually. Book-tax difference is permanent post-2001.