Chapter 15
p.869
Capital Cost Recovery
Code §167(a) allows a depreciation deduction
for a reasonable allowance for the exhaustion,
wear and tear (including for obsolecence) of
property (1) used in a trade or business or (2)
held for the production of income. The
depreciation amount is based on the cost basis
(§1012) for the asset. Basis adjustment - §1016.
Similar “cost recovery” treatment upon the
depletion of hard minerals & oil and gas.
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What property is
depreciable?
P. 870
No tax depreciation deduction is available for an
asset that has an indefinite life. Examples: land
and corporate stock and bonds.
Tax depreciation is available for buildings and
improvements to real estate; machinery &
equipment; and other tangible wasting assets.
Amortization (§197, 15 year straight line cost
recovery) is available for certain intangible
property (e.g., a patent, but not a bond, since
full repayment is anticipated at maturity).
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Simon case
p. 870
Musician buys antique violin bow used in his
profession and seeks to depreciate it for tax.
Bow actually appreciating in fair market value.
Holding: Bow is “recovery property” under
§168 for which depreciation may be claimed.
It is “of a character subject to the allowance for
depreciation.” This property will suffer
exhaustion, wear and tear or obsolescence.
Bow is not to be treated as a non-depreciable
collectible asset.
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Simon case, continued
p. 870
What if valuable antiques are acquired as
“office furniture”? Or an oriental rug for the
floor? Is depreciation available?
What if Old Masters paintings acquired as
“decoration” on the wall of the office?
Was the Simon violin both (1) trade or business
property and (2) non-wasting antique? If so,
should only part of the tax basis be depreciable?
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World Publishing
P.878
P purchases for 700x improved real estate with
the building subject to a lease to tenant (who
built the building on the property). Allocation
of 300x to the building and 400x to the land.
Life of building was shorter than the lease term.
Is P entitled to depreciate the 300x building?
Did P have a depreciable interest in building?
Held: P could depreciate excess cost over land
value (over the remaining term of the lease).
What actually was the “depreciable asset”?
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World Publishing, cont.
P.878
What is a premium lease? How does it arise?
Can property be acquired subject to a premium
lease?
Can this premium be amortized for tax
purposes (over its useful life)?
Cf., § 171 re amortization of bond premium
(noted on p. 884). What is the “premium”?
Excess of purchase price over bond maturity
value.
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Newark Morning Ledger
P.885
NML purchases assets of other newspapers and
seeks to allocate purchase price, including to a
“paid subscribers” list (& exclusive of any
allocation to “goodwill”). Statistical info is
provided re the useful life of these lists.
IRS says no asset separate from goodwill & an
indeterminate life for goodwill.
Sup.Ct. says fact burden satisfied by taxpayer &
an intangible asset exists with (1) ascertainable
value and (2) limited useful life.
continued
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Newark Morning Ledger
P.885, continued
Dissent (p.893): Failure of proof by taxpayer.
Confusion of subscription duration with
goodwill on the date of the assets acquisition.
Continued support for the concept that goodwill
is not depreciable.
Note: Houston Chronicle – acquisition of a
customer list from a defunct business (the prior
Houston Press) & depreciation for the list.
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Intangibles & Cost
Recovery
p.897
§167 enable straight line amortization of
intangibles – e.g., patents, trademarks.
§197 provides special 15 year amortization rules
for goodwill and purchased intangibles,
including customer lists, skilled work force, &
non-compete covenant, etc.
Does the value of these items actually decline?
§197 is the response to the Newark Morning
Ledger case (p. 885). Did the enactment of Code
§197 produce a tax increase?
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Non-compete Agreement
P.900
What is a non-compete agreement?
In making a noncompete deal the actual term is
often five years (or shorter). When/why is a
non-compete deal made?
Code §197 mandates a 15 year amortization of
the payor’s cost of this noncompete agreement
(even though gross income inclusion over the
shorter period to the recipient of payment).
Why?
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Residual Valuation
P.901
How allocate the purchase price when
acquisition of a going concern (assuming asset
rather than stock purchase).
See Williams v. McGowan case, p. 1116.
Allocation on basis of the residual method –
easiest assets to value are first in order in the
valuation process, with the remaining value to
the (residual) goodwill.
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Depreciation Deductions
p.901
Cost for “wasting assets” should be recovered
over time – associating the cost of the assets with
income productivity from the particular asset.
Tax choices: 1) Deduction for the entire cost in
the acquisition year.
2) No deduction until disposition of the asset.
3) Determine actual value decline during year.
4) Allocate some amount of the acquisition cost
to each year of the asset’s anticipated usage (&
possibly overstate the annual deemed cost?).
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Current Depreciation
Deduction System p.902
1) Determine the useful life (e.g., machinery &
equipment; office and industrial buildings).
2) Determine anticipated salvage value (but,
not relevant under current system, MACRS).
3) Determine the method of allocation to each
year (e.g., does a greater decline in value occur
during earlier years)? Straight line, declining
balance (e.g., DDB); some other system (e.g.,
income forecast)?
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§168 – Statutory
Depreciation Rules p.902
1) Recovery period – depends on the class of
property. See §168(c)&(e). Real property?
2) Recovery method - §168(b). Choices include
DDB, 150% DB and straight line.
With salvage value at zero. §168(b)(4).
3) “Placed in service” conventions - §168(d) re
half-year convention, except for real property.
4) Limited expensing – without regard to rules
above - §179. $500,000 (§179(b)) – made
permanent in PATH
(2015).
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Additional depreciation
Issues
p.904
1) First year – full year’s depreciation?
Allocated? Or, use an accounting convention
(see prior screen)?
2) “Component” depreciation – divide parts of
a building (e.g., elevators & escalators) into its
various components to allocate useful lives?
3) Available depreciation necessitates a
reduction in income tax basis (under §1016) – so
as to avoid using tax basis twice for tax
reduction purposes.
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Additional depreciation
Issues
p.914
Possible “recapture” of depreciation.
If claiming too much depreciation (when
contrasted with economic depreciation):
recapture the excess depreciation at disposition?
Characterization: Ordinary income? See §1245.
What about “market gain? Example: buy at
100x, depreciate to 85x, sell at 110x. Result?
Impose an interest charge for excess deduction?
Real property – limited recapture under §1250.
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Depletion for Oil & Gas
and Minerals
p.916
Cost depletion for (1) oil & gas, and (2) hard
minerals properties is allowed under §611.
Tax basis is allocated over the estimated
recoverable units for the property.
Alternative method: §613 - Percentage depletion
enables a deduction for a percentage of the
gross income derived from the production
(except for major, integrated oil companies).
But, no limitation on the deduction amount even
after cost basis equivalent is recovered. Why?
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Defining an “Economic
Interest”
p.917
To qualify for a depletion deduction the
taxpayer must have an “economic interest” in
the property being depleted. What is the
purpose of this concept? Looking for an
investment return from the production of the oil
or mineral.
An “economic interest” can include a royalty
interest, a working interest, a carved-out
interest, etc.
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Percentage Limitation
Questions
p.916
What limits on the % depletion deduction?
- Percentage limit for 50 percent of the taxable
income from the property.
- What is the “cutoff point” for determining
“gross income” from production? See
Cannelton Sewer Pipe Co. - when the clay comes
from mine or when clay pipe is finally sold?
Cf., oil & gas production – the “cutoff point” is
at the wellhead for determining gross income.
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Intangible Drilling Costs
& G&G Costs
p.918
§263(c) authorizes regulations to enable current
expensing for “intangible drilling and
development” costs. What are IDCs? What
percentage of the total drilling costs? Why
permit this deduction? Cf, capitalization.
Consider the tax benefit of the combination of
(1) the IDC deduction (no cost basis is
established), and (2) the percentage depletion
deduction (no cost basis is necessary).
Cf., oil &gas exploration costs.
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Hard Mineral Costs
p.917-918
§616 – development expenditures can be
currently deducted – when incurred after
proving existence of the deposit.
§617 – exploration expenditures are currently
deductible, at the election of the taxpayer.
These are costs incurred to identify the existence
and location of the mineral deposit.
Recapture of the deducted amount when
reaching the production stage.
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Timber Tax Treatment
p.918
Possible election to treat timber income as
capital gain. §631(a).
Possible alternative for §1231 treatment for
timber royalties.
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Chapter 15
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