Presentation:
Federal Income Taxation
Chapter 15 Capital Cost Recovery
Professors Wells
October 27, 2015
Antiques
Richard L. Simon
p.870
Simon acquired two Tourte bows for $30,000 and $21,000, respectively.
Simons claimed tax depreciation for the two bows, and the IRS
disallowed the deductions. Bows will be “played out” with continued
use, but evidence showed that the bows increased in value as antiques.
Second Circuit upheld deduction. Tourte bow was tangible property
that was placed in service in taxpayer’s business and were of a character
that is subject to depreciation because their frequent use subjects them
to wear and tear and eventually causes them to lose their ability to be
used in performances.
IRS argument that bows had appreciated in value was reason to not
allow deprecation was rejected. Why?
2 Land & Improvements
p.878
World Publishing Co. v. Commissioner
Taxpayer purchases land with building constructed by lessee for
$700,000. The taxpayer allocated $300,000 of the purchase price to the
lease and depreciated that $300,000 over the life of the lease. IRS
asserted that the taxpayer had no interest in the building as it would be
fully depreciated by the time the lease expired.
Court allowed taxpayer to claim a depreciation deduction. It was
irrelevant who built the building. In any event, the purchaser bought a
land with a building that provided rent, so the purchase price should be
allocated.
3 Amortization of Intangibles
Newark Morning Ledger
p.885
Allocation of part of the purchase price for
newspapers was allocated to the subscribers lists. How
demonstrate the useful lives? Apply a “mass asset” rule?
Treat as separate from goodwill?
Response: Code §197 (p.897) - permitting (or requiring) 15 year
amortization for intangibles (subject to certain exceptions).
4 Recovery of Capital Expenditures
p.902
Depreciation – Code §§167 & 168.
Adjusted Tax Basis = Original Tax Basis - Depreciation
Objective: allocate the cost of a depreciating item over its period
of productivity. Concept of matching income with the expenses
associated with that income over the asset’s “useful life” (as
prescribed in the Code). This assumes “useful life” is
determinable.
For federal income tax purposes how should the cost (i.e., tax
basis) for equipment, buildings, and intangibles (other than
financial instruments) be recovered (prior to disposition)?
5 Economic Depreciation
p.909
Value of property is equal to the present value of the remaining
cash flows expected over the assets remaining useful life. This is
called “economic depreciation.” Theoretically correct
depreciation would be to allow depreciation equal to amount asset
declines in value.
Example:
$34,441 $34,441 $34,441 $34,441 $34,441 $34,441
Yr 1
Yr 2
$130,559 $109,174
Yr 3
Yr 4
$85,649 $59,774
Yr 5
$31,310
Yr 6
$0
$150,000
Economic Depreciation
$19,441
$21,385
$23,525
$25,875
$28,464
$31,310
6 What Assets Are
Depreciable?
Code §167(a) prescribes the statutory allowance for depreciation:
1) property must be “used in the trade or business” or “held for
the production of income,” and
2) must be subject to “exhaustion, wear and tear” (including
obsolescence).
Raw land and corporate stock are not depreciable assets (cf.,
economic value).
7 Effect of The Depreciation Deduction
on Tax Basis
Depreciation reduces tax basis, but not if disallowed as a deduction.
Personal use property does not cause a reduction in tax basis.
Similar if a Code §280F(a) disallowance.
8 Code §168 – Depreciation
Deduction Issues
p.902
Tangible property depreciation rules.
What amount is deductible? Consider:
1)  Property classification - §168(e).
2) Recovery period - §168(c).
3) Depreciation method - §168(b).
4) Applicable convention - §168(d).
Note: no salvage value is required - §168(b)(4).
9 Tangible Personal Property
Depreciation Computation
See Code §168(b)(3) concerning the classification of property
for establishing depreciation lives.
Code §168(b)(1)(A) requires the use of the 200% declining
balance method (until switch-over to S.L. is preferable).
What is a “declining balance” method?
What is a “half-year convention”?
See Code volume preface (Rev. Proc. 87-57).
10 Example: $150,000 Cost
Industrial Machine
Entire $150,000 cost is deductible. Five year class life;
5 year property. No §179. Depreciated using 200 percent
declining balance method.
* 50%
*
* Note: In Year 5, the use of the straight line method provides a larger benefit of $17,280 (i.e., $17,280 x 1 year/1.5 years
remaining) compared to the depreciation benefit of $6,912 from using double declining (i.e., $17,280 x 20% x 200%).
11 Example: $150,000 Cost
Industrial Machine
Comparison of Economic Depreciation to Tax Depreciation
$60,000 $50,000 $40,000 Economic Deprecia-on $30,000 Tax Deprecia-on $20,000 $10,000 $0 1 2 3 4 5 6 12 Depreciation Recapture
§1245 - Personal Property
p.914
Asset’s tax basis is reduced (below FMV?) by tax
depreciation. Code §1016(a)(2).
Through depreciation the tax basis is recovered in
portions, not all at once.
All disposition gain equal to prior tax depreciation
deductions is ordinary.
§1221 > §1221(a)(2) > §1231 > §1245
Avoids tax arbitraging (except timing).
13 Depreciation Recapture Problem 1
(Sales Price Below Recomputed Basis)
p.914
Sale of office equipment:
Original Cost
Depreciation Claimed
Sales Price
30,000
8,000
25,000
Amount realized of 25,000 less 22,000 adjusted basis
(30-8=22); this 3,000 gain is recaptured as ordinary
income (up to the amount of prior depreciation) under
§1245.
14 Depreciation Recapture Problem 2
(Sales Price Above Recomputed Basis)
p.914
Sale of personal property acquired last year.
Cost
Depreciation
Sales Price
100,000
9,000
110,000
Amount realized of 110,000 less 91,000 adjusted basis provides gain
of $19,000; $9,000 of this gain is recaptured as ordinary income (up
to prior depreciation) under §1245. By taking the excess of the
recomputed basis over adjusted basis
($100,000 - $91,000).
15 Real Property Depreciation Computation
p.916
No depreciation is available for land (since not a wasting asset).
Residential real property or nonresidential property depreciation
27.5 years (residential), or 39 years (nonresidential) recovery
periods. Code §168(c) & (e)(2).
Straight line depreciation. §168(b)(3).
A mid-month convention is applicable for the year the asset is
placed into service.
16 Depletion
p.916
Do oil & gas deposits and hard minerals deposits get depleted?
Should cost recovery (of tax basis) be permitted for tax
purposes? Wasting asset?
How should such depletion be determined?
Cost Depletion?
Percentage Depletion?
Note: Code §611 permits a “reasonable allowance for depletion.” 17 Percentage Depletion -% of Revenue
p.917
This deduction is based on a percentage of the revenue
from the minerals extracted.
The deduction cannot exceed a specified portion of
taxable income.
Not available for oil and gas, except for small royalty
owners and independent producers (and certain others).
§613A.
Percentage depletion deduction continues after tax basis
has been reduced to zero.
18 IDCs & Hard Minerals Exploration Expenses p.918
IDCs for oil & gas wells are deductible. §263(c) & Reg.
§1.612-4. Cf., exploration.
§617 permits a current deduction of hard mineral
exploration expenses.
Deducted expenses must be “recaptured” when production
commences.
What is a development expense? Answer: The cost of
preparing the site for production or extraction. See §616.
19