Chapter 7 - Property Acquisitions and Cost Recovery Deductions

What is deduction allowed for? What section allows this?

Section 162 - Deduction is allowed for all ordinary and necessary business expenses

What is deduction prohibited for? What occurs instead of deduction?

Deduction is prohibited for permanent improvements to increase the value of property

The cost of the improvement is capitalized

A expenditure must be capitalized if...?

The expenditure creates or enhances an identifiable asset with a useful life substantially beyond the current year

How are capitalized costs recovered (2)?

1. Through depreciation, amortization, or depletion deductions

2. If not depreciable, amortizable, or depletable, it is recovered only on disposition (i.e. land)

How do tax subsidies permit expensing of research and experimental expenditures?

1. 2021-2024 - such costs must be capitalized and amortized over 5 years (domestic) or 15 years (outside of U.S.)

2. After 2024, domestic R&E is once again immediately deductible

What are other examples of tax subsidies that permit expensing (3)?

1. Advertising

2. Farmers can deduct soil & water conservation expenditures and fertilizing expenditures

3.

Oil and Gas producers can deduct intangible drilling and development costs of wells

What is Tax Basis?

The amount of a taxpayer's unrecovered dollars represented by an asset

What is, in most cases, the initial tax basis of an asset?

Cost (including sales tax and incidental costs related to placing the asset in service)

What is Adjusted Tax Basis?

Initial Basis reduced by depreciation, amortization, or depletion deductions

Can an asset's adjusted tax basis be different than the asset's adjusted book basis? Why or why not?

Yes, because book and tax recovery deductions may be different

What is leverage? How does leverage affect tax basis?

The use of borrowed funds to purchase assets

Cost (tax) basis includes the amount of borrowed funds

Is interest paid on borrowed funds deductible? What does this result in?

Interest paid on borrowed funds is deductible

Increases tax savings

What are the cost recovery methods for Inventory, Tangible Assets, Intangible Assets, and Natural Resources?

1. Inventory = Cost of Goods Sold

2. Tangible Assets = Depreciation

3. Intangible Assets = Amortization

4. Natural Resources = Depletion

How do you calculate COGS?

Beginning inventory

+ Capitalized Costs (Purchases)

= Inventory available for sale

-Ending inventory

= Cost of Goods Sold

What section is UNICAP? What does this state?

263A - Must capitalize indirect costs (overhead) as part of inventory for tax purposes

What does UNICAP result in?

Creates an Unfavorable Temporary Difference (DIT Asset)

What are the two types of inventory valuation methods?

1. FIFO

2. LIFO

What is the LIFO conformity rule?

If a company uses LIFO for tax purposes, it must also use LIFO for financial reporting purposes

What does depreciation apply to?

Tangible assets that lose value over time due to wear and tear, or obsolescence

Have a reasonably ascertainable useful life

Is artwork depreciable?

No

What section outlines MACRS depreication?

Section 168

What is MACRS depreication?

Every depreciable asset is assigned to 1 of 10 recovery periods; this recovery period is usually shorter than the asset's estimated useful life

What method is used for assets with 3, 5, 7, and 10-year recovery periods? What type of property is used for these periods?

The 200% declining balance method

Personal Property

What method is used for assets with 15 and 20-year recovery periods? What type of property is used for these periods?

The 150% declining balance method

Personal Property

What method is used for assets with 25, 27.5, 39, and 50-year recovery periods? What type of property is used for these periods?

Straight-line method

Real Estate Property

27.5 - Residential Properties

39 - Nonresidential Properties

What are the depreciation conventions for personalty? What are the recovery periods for personalty?

1. Half-year Convention

2. Midquarter Convention

What if the half-year convention? What is factored into the IRS Tables and what is not?

One-half year of depreciation is allowed for the year in which the property is placed in service and the year in which the property is disposed of

First half-year of depreciation is built into IRS Tables

Last half-year of depreciation not built into IRS Tables

What is the mid-quarter convention? When does it apply?

Applies if more than 40% of personalty acquired in a year is placed in service in the 4th quarter

Assets placed in service during any quarter of the year are assumed to be placed in service midway (1.5 months) through the quarter

What are the depreciation conventions for realty?

Midmonth Convention

What is the Midmonth Convention? What is factored into the IRS Tables and what is not?

One-half month of depreciation is allowed for the month in which the property is placed in service and in the month in which the property is disposed of

First half-month built into IRS tables

Last half-month not built into IRS tables

What is the rule for Limited Depreciation for Passenger Automobiles? How is this rule used?

2024: 12,400

2025: 19,800

2026: 11,900

2027 and beyond: 7,160

Compute the depreciation under MARCS, then apply the limit

What is the Section 179 Expensing Election?

Taxpayer may expense a limited amount of cost of qualifying property placed in service in a year

Limited to $2,500,000 in 2025

Reduced $ for $ for amount over $4,000,000 threshold

What happens to the cost of an asset Under Section 179 Expensing that cannot be expensed?

The remaining cost (unexpense) is capitalized and recovered through MACRS

What is the Section 179 Taxable Income Limitation?

The deduction for a Section 179 Expense is limited to taxable business income before the deduction

Under the Section 179 Taxable Income Limitation, what happens to any non deductible expense?

It is carried forward into future years

What is Bonus Depreciation?

Immediate expensing of the cost of qualifying property based on the following:

2017-2022: 100%

2023: 80%

2024: 60%

1/1/2025-1/19/2025: 40%

After 1/19/2025: 100%

What is qualifying property for Section 179 Expensing?

Depreciable personalty and off-the-shelf software

What is qualifying property for Bonus Depreciation?

Depreciable Personalty, computer software, and certain leasehold improvements

How are Section 179 Expensing and Bonus Depreciation Different?

Section 179 - Allows taxpayers to elect to immediately expense the cost of qualifying property, subject to annual dollar limits and taxable income limitations (cannot create a loss)

Bonus Depreciation - Allows taxpayers to automatically deduct a percentage of the cost of qualifying property in the year placed in service, with no dollar limit and no taxable income limitation (unless the taxpayer elects out) (can create a loss)

What are intangible assets? What are examples?

Assets with no physical substance

Leases, Patents, and other contractual rights

How is the basis of an intangible asset amortized?

On a straight-line method over the determinable life (no determinable life = no amortization)

What are organizational and start-up costs?

Organizational - legal, accounting, and filing fees attributable to the formation of an entity

Start-up - the cost of investigating a new business and expenses incurred before the business is operational

How are organizational and start-up costs recovered?

1. The first $5,000 is deductible

2. Deduction reduced $ for $ by amount exceeding $50,000

How are nondeductible organizational and start-up costs treated?

Capitalized and amortized over 15 years

How are leasehold costs amortized?

The costs of acquiring a lease is amortized over the term of the lease

How are physical improvements to leased property treated?

Physical improvements to leased property are capitalized and depreciated over the appropriate MACRS recovery period

Even if the recovery period is longer than the term of the lease

How are assets treated when an entire business is purchased for a lump-sum price?

1. Cost allocation based on FMV of identifiable assets

2. Any residual cost allocable to purchased goodwill

How are acquisition intangibles treated once their cost has been allocated?

Capitalized cost of acquisition intangibles is amortized over 15 years

How does tax treatment of goodwill differ from book treatment of goodwill?

For book purposes, goodwill is not amortized, but instead tested for impairment

Often results in Book > Tax (Favorable DIT Liability)

Is a write-down of goodwill under book purposes deductible for tax purposes?

No

How do you calculate depletion deduction?

GREATER of Cost Depletion or Percentage Depletion

How do you calculate cost depletion?

Unrecovered basis x (units of production/estimated total units in ground)

How do you calculate percentage depletion?

Statutory % of gross income from the mine or well

Can percentage depletion be deducted even after the mine/well tax basis has been reduced to zero?

Yes