Read the narrative below and then indicate the best answer to each question by darkening the letter of the answer on the answer sheet. When you are finished, proceed to the next page. Do not refer back to this page to change answer.
Mr. and Mrs. Wagner purchased a building and five acres of land. They operate a flower shop on the lower level of the building, and the family has its living quarters on the upper level. Both levels are equal in floor space. The land is used to grow some types of flowers and greenery that are used in floral bouquets, but most flowers are purchased from a vendor. The Wagners purchased a used van (8 years old) to deliver flowers, a new car for personal use, and two new identical computers. One computer will be used in the office at the flower shop to keep records of inventory, accounts receivable, accounts payable and other business information. The second computer will be kept at home so the children can play games and use it for homework. The
Wagners paid for the computers, car, and the van when purchased, but they make installment payments on the land and building.
1. Which of the following can be depreciated for tax purposes?
A.
Land and the entire building
B.
The entire building
C.
Lower level of the building
D.
Land and the lower level of the building
2. Which of the following statements is true?
A.
The land is depreciable because it is used to grow flowers and greenery used in
a trade or business.
B.
More than 50% of the building must be used for business purposes for any part
of it to be depreciable.
C.
The flowers and greenery grown on the land are depreciable since they are used
in a trade or business.
D.
Flowers purchased from a vendor are inventory and are not depreciable.
3. Which of the following assets are depreciable?
A.
Used van, new car, and both new computers
B.
Used van and new car
C.
Used van and new computer used in flower shop office
D.
New car and both new computers
4. The Wagners want to deduct as much depreciation as possible. Which of the following would accomplish their purpose?
A.
Move their living quarters to another location and rent the upper level to an
unrelated individual.
B.
Purchase all flowers and greenery from vendors.
C.
Sell on computer and use the other computer for both business and personal
purposes.
D.
Borrow money and pay the debt on the land and building

Depreciation is an allowance for recovery of capital investment in a wasting asset; it is not the reflection of a drop in the value of an asset. The right to deduct depreciation is not predicated upon ownership of the legal title to property but upon investment in the property.
Depreciation does not depend on income or lack of income.
Section 167(a) of the Internal Revenue Code (1986) states that, in general, there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property if it (1) is used for a trade or business or held for the production of income, (2) has a determinable useful life exceeding one year, and (3) wears out, decays, becomes obsolete, or loses value from natural causes.
An activity is considered to be a trade or business for the production of income if it is carried on with the objective of making a profit. In order to establish the right to depreciation, it is necessary to show that the property, whether tangible or intangible, will become exhausted within a definite period (useful life) and which can be ascertained from specific terms such as a contract or can be determined from available facts. The estimated useful life over which an asset is depreciable is not necessarily the useful life inherent in the asset but is the period over which the asset may reasonably be expected to be useful to the taxpayer in a trade or business or in the production of income.
The use rather than the character of property determines whether a depreciation deduction is allowed. The principal kind of property subject to depreciation allowance is permanent, tangible property, such as buildings, office equipment, machinery, and devices and other equipment of a relatively permanent nature. Assets that are not depreciable include those that have no determinable life (land), stock in trade (inventory) or assets held for personal use
(jewelry). Generally, a depreciable intangible asset must have an ascertainable value and a limited useful life that can be determined with reasonable accuracy. If part of one’s home is used regularly and exclusively for business purposes, depreciation may be deducted only if this is the principal place of business for any trade or business in which the taxpayer engages or it is a place to meet or deal with patients, clients, or customers in the normal course of the trade or business.
Depreciation is allowed in order that taxpayers may treat as an expense in determining taxable income, an allocable part of the cost of business assets that have a limited life. In some instances, the IRS may deny a deduction for depreciation, and the taxpayer may choose to litigate the issue in court.
YOU MAY READ THE GENERAL INFORMATION AS MANY TIMES AS YOU WISH TO
THOROUGHLY UNDERSTAND THE MATERIAL. WHEN YOU ARE READY TO
PROCEED, TURN THE PAGE AND CONTINUE WITH THE EXPERIMENT. ONCE YOU
TURN THIS PAGE, YOU MAY NOT REFER TO THE GENERAL INFORMATION TO
ANSWER QUESTIONS.

The examples on this page illustrate various situations where depreciation is or is not deductible for tax purposes. You may read the examples as many times as you wish. When you have finished reading and studying the examples, proceed to the next page. Do not refer to these examples for information when answering questions in the posttest scenarios.
Example 1
During a five-year period, Associated Obstetricians and Gynecologists (AOG) purchased over 70 works of art to be displayed in its medical offices. The artwork consisted of paintings, sculpture, pottery and batik prints ranging in price from $40 to $7,000. The total cost of artwork acquired over the five-year period was $75,410.32. None of the works was purchased for investment or was used for any personal or non-business purposes. AOG’s accountant determined the useful life of the artworks was 10 years, the same period selected for the interior design scheme, office furnishings, and medical equipment. Deduction for depreciation of the art objects was claimed accordingly. The Court denied the depreciation deduction claiming that AOG failed to establish that the art objects had a determinable useful life or that any amount is otherwise allowable under
Section 167. The taxpayer has the burden of proof that the assets have determinable useful lives and what those lives are.
Example 2
Charles V. Doyle was engaged in accepting wagers on horse races (bookmaking or operating a handbook) in Illinois, although this business was illegal. Doyle rented a room in Chicago where he accepted, recorded and paid the wagers. Doyle claimed deductions for salaries, rent, lights, depreciation, claims forms, and other business expenses. Deductions for expenses that are incurred in the normal course of a trade or business are deductible.
Example 3
Keith Nickisch was employed as a certified public accountant by Leaverton Accounting, an accounting firm. Nickisch agreed to purchase the accounting firm from Leaverton in 19x7. A written purchase agreement stated that Nickisch would pay $25,000 for the firm’s equipment,
$9,978 for the accounts receivable, and $5,000 for Leaverton’s covenant not to compete. No part of the purchase price was allocated to the accounting firm’s goodwill. An oral agreement was made on the same date to purchase the use of the customer list of Leaverton Accounting for
$65,000, payable at a monthly rate. After the sale, the accounting firm continued to occupy the same office space, retained the same employees, and continued to service many of the same customers. Nickisch deducted the payments for the customer list as rental expenses, but the court ruled that the customer list is a capital asset and should be depreciated over its useful life.

The posttest consists of a series of four scenarios, each of which describes two situations. Read the narrative and answer the questions by darkening the letter of the answer you believe is correct on the answer sheet. Do not refer to the pretest, information on general depreciation, or the examples to answer questions in the scenarios.

SCENARIO 1
Dr. Johnson, an obstetrician and gynecologist, opened a medical clinic in Midland, Texas. She purchased office furniture, x-ray equipment, medical supplies, medical equipment, and approximately 5,000 patient charts from Dr. Roden when he retired. The purchase price of $30,323.24 included an allocation of
$25,000 to the patient charts and $5,323.24 to the remaining property. Payment for the property will be made in installments. Dr. Johnson estimated the patient charts to be of value for five years because of the transient nature of the population in Midland and the limited type of medical practice. Dr. Johnson keeps her books on a cash basis.
1. Which of the following assets may be depreciated for tax purposes for Dr. Johnson’s medical practice?
A.
Office furniture, x-ray equipment, medical supplies, medical equipment, and patient
charts.
B.
Office furniture, x-ray equipment, medical equipment, and patient charts.
C.
Office furniture, x-ray equipment, and medical equipment.
D.
Office furniture, x-ray equipment, medical equipment, and medical supplies.
2. Which of the following statements is true?
A.
Depreciation is not allowed on any of the assets because Dr. Johnson keeps her
books on a cash basis rather than on an accrual basis.
B.
Dr. Johnson cannot take depreciation on any of the assets purchased from Dr.
Roden because he already fully depreciated the depreciable assets during the time
he owned them.
C.
The patient charts are depreciable if their useful life can be estimated with
reasonable accuracy and the life exceeds one year.
D.
The patient charts are not depreciable because their useful life cannot be accurately
estimated.
Dr. Johnson also purchased a German Shepherd dog for $125. The dog was kenneled at the medical clinic and was used as a guard dog.
3. Which of the following statements is true?
A.
Depreciation may be deducted for the dog because the dog is a capital asset used in
a trade or business and it has a limited useful life.
B.
No depreciation may be taken on the dog because its useful life cannot be estimated
with reasonable accuracy.
C.
No depreciation may be taken on the dog because it is not used directly in the actual
conduct of the trade or business.
D.
No depreciation may be taken on the dog because animals cannot be depreciated.

SCENARIO 2
Sam Smith spent four years in medical school but never obtained his medical license because he did not pass the state examinations. Sam “bought” a medical degree and license from a broker who specializes in fake documents and Sam holds himself out to the community as a medical doctor. Sam purchased an eight-room house just outside the city limits where he maintains living quarters in five rooms of the house. He uses three rooms exclusively for medical purposes to treat patients. Treating patients without an official medical degree and medical license is clearly illegal in the state where he lives. Mr. Smith has not obtained a license to operate a business in his home which is a violation of local ordinances. Mr.
Smith purchased new living quarters’ furniture for $10,000, used office furniture (15 years old) for $1,000 and new medical equipment for $30,000.
1. Which of the following can be depreciated for tax purposes?
A.
Used office furniture, medical equipment, living quarters’ furniture, and eight-room
house.
B.
Used office furniture, medical equipment, and three rooms of the house.
C.
Medical equipment and used office furniture.
D.
None of the assets can be depreciated.
2. Which of the following is true for Mr. Smith?
A.
No depreciation will be allowed on any assets used in the medical practice because
he is not legally a medical doctor.
B.
Depreciation is deductible on the assets used in the medical practice even though
Mr. Smith is illegally conducting a trade or business.
C.
No depreciation will be allowed because Mr. Smith does not have a business license
to conduct a trade or business in his home.
D.
Depreciation can be claimed only on the living quarters’ furniture.
Sam Smith purchased a used boat for $55,000 to use as a charter boat. He expected to make a huge profit in the charter-boat business, and Mr. Davis was hired to operate the charters. Expenses were incurred for advertising, repairs, maintenance, salaries, etc. and some income was generated. Ten months later the boat was sold for $36,000 because the venture was unprofitable.
3. Which of the following statements is true?
A.
Depreciation will be allowed on the boat because the value of the charter boat
declined considerably in a short period of time.
B.
Depreciation on the boat is not allowed because the charter boat was owned by Mr.
Smith less than one year.
C.
Depreciation on the boat will not be allowed because Mr. Smith’s profit
expectations were unreasonable.
D.
Depreciation on the boat will be allowed because the boat was used in a business
entered into for the purpose of making a profit.

SCENARIO 3
John J. Sexton is a garbage collector. He acquires dumpsites by rental or purchase and charges his customers for dumping at a price per cubic yard. He purchased 88 acres of land for $150,000 which contained excavations (from 35-60 feet deep) made by the extraction of clay. The value of level land in that vicinity was $500 per acre. A survey was performed that showed approximately 2,500,000 cubic yards available for dumping. After the excavated space has been completely filled with garbage and a six-foot overfill of dirt, the land is of no further use in this business. An estimate of the value of the land when ultimately filled is $44,000. Mr. Sexton complied with the landfill rules and kept daily records of the number of truckloads dumping at the site. He had the property surveyed periodically to determine the amount of space remaining and the amount of space filled.
1. Which of the following statements is true?
A.
No depreciation will be allowed on the garbage dump space because it is land and land is not depreciable.
B.
No depreciation will be allowed because Mr. Sexton will recover the cost of the property from customer charges.
C.
Depreciation will be allowed on the garbage dump because the excavated space has a determinable life and it is used in a trade or business.
D.
Depreciation will be allowed on the dump because the value of the land when filled is considerably less than the value when it was purchased.
2. Which of the following arguments would be most relevant in determining whether Mr.
Sexton can claim depreciation?
A.
The dump space is a property right separate and apart from the land.
B.
The dump space is simply air and air is not depreciable.
C.
The dump space is a manmade depression, not a natural deposit, so it is not depreciable.
D.
Sexton purchased land, not air, and land is not depreciable.
Mr. Ekberg was a rancher in South Dakota. He had an earthen dam constructed on his property to create a pond so the cattle would have access to water at all times. The cost of the dam was less than $2,000.
As a result of a normal erosion process, silt will eventually fill in the pond, and there is no practical means for removing the silt that accumulates. Depreciation on the dam was claimed over ten years as determined by an expert appraiser. The IRS refused to allow a depreciation deduction.
3. Which of the following statements is most crucial to the judge’s decision regarding depreciation?
A.
The dam is simply dirt that has been moved from one place to another and land is not depreciable.
B.
The watering hole will gradually fill in with silt and eventually the pond will be useless so it does have a determinable useful life.
C.
An earthen dam does not have a determinable useful life since there is no accurate means of knowing how long the fill-in process takes.
D.
The $2,000 cost is minimal and should be expensed when incurred rather than depreciated.

SCENARIO 4
On June 1, 19x3, Westinghouse Broadcasting Company, Inc. purchased all of the assets of television station WPTZ for $8,500,000 including its network affiliation contract valued at $5,000,000 with NBC which was to expire on January 1, 19x4. The network affiliation contract was renewable automatically for indefinite successive two-year terms unless, 90 days prior to the expiration of any two-year term, either party sent the other written notice of its intention not to renew. At the time of purchase,
Westinghouse expected to renew the contract for two (two-year) terms until January 1, 19x8 (55 months).
The contract was automatically renewed on January 1, 19x4, for a two-year term expiring January 1,
19x6. On October 1, 19x5, NBC notified Westinghouse that the contract would not be renewed beyond
January 1, 19x6.
1. Which of the following statements is true regarding depreciation on the network affiliation contract?
A.
Depreciation will be allowed on the contract because there is no way of reasonably determining its useful life
B.
Depreciation on the contract will be allowed for a period of 7 months (June 1, 19x3 to
January 1, 19x4).
C.
Depreciation on the contract will be allowed for a period of 31 months (June 1, 19x3 to
January 1, 19x6).
D.
Depreciation on the contract will be allowed for a period of 55 months (June 1, 19x3 to
January 1, 19x8).
2. The key issue in determining whether depreciation is or is not allowed on the contract is:
A. The value assigned to the network affiliation contract (5,000,000).
B. The number of renewal periods expected to be exercised.
C.
If the useful life can be determined with reasonable accuracy.
D.
If a contract is a depreciable asset.
Alexis Hawkins, a lawyer, purchased for approximately $126,450, various works of art including mosaics, paintings, and statues. These items are displayed in his law office. Hawkins believes that the artworks have a useful life and are depreciable. He cannot use his artworks after he dies, and he contends the life of the artworks is based on his life expectancy (according to standard mortality tables).
3. Which of the assets can be depreciated for the law practice?
A.
Mosaics, paintings, and statues
B.
Mosaics and statues
C.
Paintings only
D.
None of the items is depreciable