Cost Recovery and Depreciation

Assets and Cost Recovery

  • Businesses acquire assets like cash, accounts receivable, inventory, property, plant, equipment, machinery, and investments to generate revenue.

  • The goal is to understand how to acquire these assets and how the law allows for the recovery of their costs.

Deduction vs. Capitalization

  • From a tax perspective, it's generally more beneficial to fully deduct an expense rather than capitalizing it, due to the immediate cash flow benefit.

  • Accelerating expenses is a key tax strategy.

  • However, there are legal restrictions on immediate deductions, particularly if the benefit extends beyond twelve months, necessitating accrual.

Repairs vs. Refurbishing

  • Distinguishing between repairing and refurbishing an asset is crucial.

  • Repairs: Normal wear and tear on machinery are immediately deductible.

  • Refurbishing: If work alters the machine's nature or output, it's considered a new asset and must be capitalized.

De Minimis Expenses

  • A safe harbor exists for de minimis expenses (below a certain materiality threshold), allowing for immediate deduction.

Research and Development (R&D) Expenditures

  • R&D expenditures were previously immediately deductible but now are amortizable over five years (domestic) or fifteen years (foreign) following the 2017 tax law.

  • There's ongoing discussion to revert to immediate deductions.

Advertising Costs

  • Despite providing long-term benefits, advertising costs can be fully deducted when expended, as permitted by law.

Cost Recovery Methods

  • Capitalized assets can have their costs recovered over time.

  • Financial accounting uses the straight-line method, often considering salvage value and usage years.

  • Tax rules offer different, potentially more accelerated, methods.

Initial Basis and Adjusted Basis

  • Initial Basis: The cost to acquire an asset (e.g., 5,000).

  • Adjusted Basis: The remaining basis after accounting for cost recovery (how much remains to be recovered).

  • Example: If an asset costs 5,000 and 1,000 is deducted each year for five years, the adjusted basis decreases by 1,000 each year.

Cash Flow Perspective

  • Capitalizing expenditures means not fully deducting the expense in year zero.

  • Cost recovery (depreciation) is a tax deduction but not a cash deduction.

  • Tax deductions generate tax savings by shielding income.

  • Present value calculations are used to determine after-tax costs, considering discount factors.

Asset Acquisition

  • Initial basis is usually the cost paid to acquire an asset.

  • If an asset is traded, the fair value of the traded asset equals the acquired asset's value.

  • Borrowing funds doesn't change the ability to depreciate fully.

  • Interest paid on borrowed funds is a deductible expense, generating tax savings.

Leveraged Purchase

  • Leveraging the purchase changes timing of payments but not cost recovery.

  • Interest is paid in arrears (year after it's due), creating a deductible expense and tax savings.

Specific Assets and Cost Recovery

  • Cash: Recovered by spending it to acquire other assets.

  • Accounts Receivable: Recovered by collecting it; if uncollectible, it's written off.

Inventory and Cost of Goods Sold (COGS)

  • Inventory is recovered through Cost of Goods Sold (COGS).

  • COGS calculation depends on the inventory costing method.

  • Viable inventory costing methods include:

    • FIFO (First In, First Out): First inventory in is the first one sold; good for getting rid of older assets.

      • Older assets have the lowest cost of goods sold, which is beneficial in times of inflation.

    • LIFO (Last In, First Out): The Last inventory item in is the first one sold; newer assets are sold first.

      • Newer assets have a higher cost of goods sold, which is beneficial to maximize expenses in times of inflation.

    • Specific Identification: Identifying the actual purchase price of each asset sold (used for unique goods).

    • Weighted Average: Reconfigure the cost with each purchase or sale; calculate the weighted average cost for all inventory items.

  • FIFO (First-In, First-Out): Older assets have the lowest cost of goods sold, which is beneficial in times of inflation.

  • LIFO (Last-In, First-Out): Newer assets have the higher cost of goods sold, which is beneficial to maximize expenses in times of inflation.

  • Specific Identification: Each item has a unique cost associated with it (like Lamborghinis).

  • Weighted Average: Calculate the cost based on a weighted average when it comes to continually buying and selling (tons of sand).

Tangible Assets

  • Assets you can touch and feel. Can be real property or non-real property (personality).

  • Take two types:

    • Real Property

    • Personality (non-real property business assets)

Tax vs GAAP

  • Tax accounting and GAAP accounting calculated cost recovery differently.

  • Congress created expenses that can be deducted faster for taxes than for GAAP, which occurred in 1986.

Modified Accelerated Cost Recovery System (MACRS)

  • Tax uses MACRS to accelerate the timing of cost recovery.

  • Total depreciation is limited to the asset's cost.

  • MACRS assigns a class life to every asset, unrelated to its actual useful life.

Tangible Assets Time Periods (Class Life)

  • Congress assigned different time periods to different tangible assets.

  • Tangible Personalty Property - 3, 5, or 7 year tables

  • Real Property - 27.5 or 39 year tables

  • If you sum every column, you'll get to 100%.

Rules for Personalty Property:

Half-Year Convention

  • The general rule is to take half a year's cost recovery in the first year, regardless of when acquired.

  • If you're still depreciating an asset, then when you get to that last half year, you take the last half year.

  • If property is disposed of, you can take half a year's cost recovery in the year of disposition.

Mid-Year Rules

  • Mid-Year Rules = half a year when you acquire it, half a year when you dispose of it.

  • You manually adjust the table so that you're only taking 50% cost recovery in that year to comply with the rules.

Mid-Quarter Rule

  • If > 40% of assets are acquired in the fourth quarter, then you must use the Mid-Quarter tables for ALL assets acquired that year.

  • There are 4 tables representing assets acquired in the first, second, third, or fourth quarter.

  • The table stays with that asset for its entire life.

  • There are special tax rules for cars used in business, due to Congress giving the tax world accelerated cost recovery.

Section 179 Deduction

  • You can acquire tangible personalities and fully recover it without having to go through MACERS.

  • In 2024, you can take 1,220,000 of assets every year without going to the makers.

  • The amount is per year, not multiple assets.

  • Threshold is 3,050,000

    • As long as all tangible personalty is less, can take full amount.

  • For every dollar above, you reduce the amount.

Bonus Depreciation

  • After the Section 179 deduction, it applies per asset, allowing a certain percentage of the remaining value to be deducted as additional first-year cost recovery before MACERS.

  • For 2024, it is currently at 60% bonus depreciation.

Tangible Real Property

  • Only talking about the 27.5 year (residential) or 39 year (non-residential) properties.

  • No Section 179 or Bonus Depreciation

  • Tangible real property only uses MACERS.

Mid-Month Rule

  • ½ month cost recovery → how many months of that year

Intangible Asset Recovery

  • 180 months amortized

  • Two types of costs

    • Organization Expenses: help from the business

    • Startup Expenses: legitimate expenses of the business before it opened

  • If the business NEVER opened, NO DEDUCTION

  • NO DEDUCTION if you have already started a business in that business

  • Recovery Rules

    • 1st 5000 of expenses → immeditate deduction

    • Remainder → amortized over 180 months

    • Threshold 50,000

  • Goodwill

    • 180 month amortized