Module 10
Cost Recovery Deductions
Cost Recovery Topics

Depreciation
 Accelerated
Cost Recovery System
 Modified Accelerated Cost Recovery System
Amortization
 Depletion

Economics of Cost Recovery
Expenditure benefits more than 1 tax year
 §263 denies a current deduction
 Cost recovery allows deduction over time
 Tax policy issues

 Marginal
efficiency of capital affected by tax
savings
 Recovery

periods
Recovery methods
Cost Recovery Tax Savings

Assumptions
 $10,000
asset
 35% marginal tax rate
 10% interest rate
Cost Recovery Tax Savings

Assumptions
 $10,000
asset
 35% marginal tax rate
 10% interest rate
M e th o d o f
C o st R e c o v e ry
A fte r-ta x N P V
D e d u c tio n
E x p en se
$ 3 ,5 0 0
A c c e le ra te d
$ 2 ,9 7 7
(o v e r 5 y e a rs)
S tra ig h t lin e
(o v e r 5 Y e a rs)
$ 2 ,7 8 6
o f
The Depreciation Allowance:
Basic Requirements
Key Learning Objective

Basic requirement
 Qualifying
property
 Placed in service
 Depreciable basis
Qualifying Property
Limited (Exhaustible) Useful Life
 Qualifying Use of Property

 Trade
or Business
 Income-Producing Activity
Placed in Service (PLIS)

PLIS when taxpayer can demonstrate
 Readiness
 Availability
 Capacity

to perform
Date PLIS can effect amount of cost
recovery
 Change
in tax law
 Affect modifying convention
Cost Recovery Basis

Initial basis
 Purchased
property
 Constructed property
 Personal property converted to business use

Subsequent changes in basis
 Capital
improvements
 Depreciation “allowed or allowable”
 Return of capital
Compliance Query: Conversion
from Personal to Business Use
Purchased home for $125,000
 IF FMV = $112,000 at conversion

 What

is basis for depreciation?
IF FMV = $150,000 at conversion
 What
is basis for depreciation?
Solution to Compliance Query:
Conversion from Personal Use
Get lower of basis or FMV
 Basis if converted when FMV = $112,000

 $112,000--lose
decline in value during personal
use

Basis if converted when FMV = $150,000
 $125,000--no
appreciation
step up for unrealized
MACRS--The Basic Rules
Key Learning Objectives
Class life
 Depreciable basis
 Recovery method
 Modifying convention

Class Life = Recovery Period

Equipment
5 & 7 year classes

 Most
common
 Tangible equipment

 Some
animals &
specialized equipment

apartments
& rental houses
Non-residential
 39

year
In service after 8-9-93
 31.5
10,15,20
 Specialized
 Generally

3 year class
Real Estate
Residential--27.5 year
uses

year
In service before 8-8-93
Class Life
Rev. Procs. 87-56 & 88-22
IRS provides information as to class life
 Assets used in all businesses

 Classes

Assets used in particular activities
 Classes

00.11 - 00.4
01.1 - 80.0
Equipment with no class life given

Use 7 years
Research Query:
MACRS Recovery Periods

This year Sea Drilling
 Installed
sidewalks around its office building
 Purchased five floating drilling platforms for
at-sea exploration.

See Rev. Proc. 87-56 in the OnPoint Service
to determine recovery periods.
Solution--Research Query

Sidewalks -- MACRS life of 15 years
 used
in all business activities
 listed in Class 00.3

Drilling platforms -- MACRS life of 5 years
 used
in specific activities
 listed in Class 13.0
TaxPoint:
Class 57.0-- 7 Gets You 5

Class 57.0 reads as follows:
 Distributive Trades
and Services: Includes
assets used in wholesale and retail trade, and
personal and professional services. Includes
section 1245 assets used in marketing
petroleum and petroleum products
 If used in a “distributive trade or service,” an
asset normally classified as 7-year property
would get 5-year class life.
Depreciable (Recovery) Basis
Salvage value always ignored
 Equipment (equipment)

 Reduction
for §179 Election
 Reduction for 50% of certain business credits

Realty
 Exclusion
of any land costs
 Reduction for rehabilitation credits
MACRS Recovery Methods

200% declining balance
 3,5,7,10

year classes of equipment
150% declining balance
 15
and 20 year classes of equipment
Conversion to straight-line allowed
 Straight-line

 All
realty
Modifying Convention
Year of Acquisition
Equipment
 General rule--half-year convention
 Exception--mid-quarter convention IF
 More
than 40%
 In service in last quarter
Realty
 Mid-month convention
The Four Quarters of Mid-Quarter

Applies to all assets according to quarter
placed in service
Table 10-3-A. MACRS 5-Year property
Year
1
2
3
4
5
6
Midyear
First
quarter
Second
quarter
Third
quarter
Fourth
quarter
20.00% 35.00% 25.00% 15.00% 5.00%
32.00
26.00
30.00
34.00 38.00
19.20
15.60
18.00
20.40 22.80
11.52
11.01
11.37
12.24 13.68
11.52
11.01
11.37
11.30 10.94
5.76
1.38
4.26
7.06
9.58
Compliance Query:
Modifying Convention

A calendar year taxpayer places in service:
D a te
M a rc h
O c to b e r
D ecem ber
A sse t T y p e
C o st
M a c h in e
(N o c la ss life )
W a re h o u se
$ 2 5 0 ,0 0 0
C o m p u te r
(C la ss life = 5 )
$ 1 0 0 ,0 0 0
$ 1 0 ,0 0 0
Solution to Compliance Query:
Modifying Convention

First test for mid-quarter
 The
warehouse is ignored for the 40% test
 4th quarter divided by all Equipment acquisitions

10,000 ÷ 260,000 = 3.8%
 This

is less than 40%
The half-year convention applies
Solution--Compliance Query
Appropriate MACRS Deduction
Machine ($250,000 x .1429) . . . . . $35,725
Computer ($10,000 x .20) . . . . . .
2,000
Warehouse ($100,000 x .00535) . .
535
The mid-month convention applies to buildings.
Note that the tables other than five -year are on the
TaxPoint disk.
Compliance Query:
Modifying Convention

If we reverse the month of acquisition for the
equipment that our calendar year taxpayer places
in service, we get a different answer for the
computer and equipment but not the building.
Date
December
October
March
Asset Type
Cost
Machine
(No class life)
Warehouse
$ 250,000
Computer
(Class life = 5)
$100,000
$ 10,000
Solution to Compliance Query:
Modifying Convention

First test for mid-quarter
 The
warehouse is ignored for the 40% test
 4th quarter divided by all equipment acquisitions

250,000 ÷ 260,000 = 96.2%
 This

is more than 40%
The mid-quarter convention applies
The Four Quarters of Mid-Quarter


The computer was placed in service in March, so it is first
quarter mid quarter 5-year property--35%.
The equipment is fourth quarter, mid quarter 7 year, so this
table doesn’t apply. You will find 3.57% in the 7 year 4th
quarter mid-quarter table on the disk.
Table 10-3-A. MACRS 5-Year property
Year
1
2
3
4
5
6
Midyear
First
quarter
Second
quarter
Third
quarter
Fourth
quarter
20.00% 35.00% 25.00% 15.00% 5.00%
32.00
26.00
30.00
34.00
38.00
19.20
15.60
18.00
20.40
22.80
11.52
11.01
11.37
12.24
13.68
11.52
11.01
11.37
11.30
10.94
5.76
1.38
4.26
7.06
9.58
Solution--Compliance Query
Appropriate MACRS Deduction
Machine ($250,000 x .0357) . . . . . $8,925
Computer ($10,000 x .35) . . . . . . . . 3,500
Warehouse ($100,000 x .00535) . . . . 535
The mid-month convention applies to buildings.
Note that the tables other than five -year are on the
TaxPoint disk.
Compliance Query: MACRS
Deduction in Year 2, (no disposition)

Do not leave the column you started in!
Machine ($250,000 x .2755) . . . . . $ 68,875
Computer ($10,000 x .26) . . . . . . . .$ 2,600
Warehouse ($100,000 x .02564) . . $ 2,564

Note that the tables other than five -year are on the
TaxPoint disk.
Modifying Convention
Year of Disposition
 Applies
to both equipment & realty
 Use same convention as in year acquired
 If
mid-month, count the months, subtract 1/2 month,
divide by 12
 If mid-year, use 1/2
 If mid-quarter, count the quarters, subtract 1/2
quarter, divide by 4
Compliance Query MACRS
Deduction in Year 3, (sell in July)

Do not leave the column you started in!
Machine
($250,000 x .1968 x 2.5 ÷ 4) . . . . $30,750
Computer
($10,000 x .1560 x 2.5 ÷ 4) . . . . . .$975
Warehouse
($100,000 x .02564 x 6.5÷12) . . . . $1,389
Compliance Query:
Once More, on Your Own
Mac Co. a calendar-year corporation
 Placed in service in October
 $250,000 of computers

 only
assets acquired that year
What is the recovery deduction for Year 1?
 If Mac sells the computer in June, of Year 3
what is the year 3 recovery deduction?

Solution--Compliance Query:
Once More, on Your Own.
Solution Year 1: 5 year/ mid-quarter property
$250,000 x .05 = $12,500
Solution Year 3: still 5 year/mid-quarter
$250,000 x .2280 x (1.5/4) = $21,375
 Mid-quarter,
divide by 4
count the quarters, subtract 1/2 quarter,
MACRS - Special Elections
Key Learning Objectives
The requirements for the §179 election
 The two straight-line recovery methods
available under MACRS

§179 Immediate Expensing
Election

Qualifying personal property
equipment used in an active trade or business
Year of acquisition only
$20,000 maximum annual election -- 2000
 $ for $ phaseout of $ 20,000 for acquisitions
over $200,000
 Can’t create a loss with §179 deduction

Tax Planning Query
Make a §179 Election?
Minor Co. a calendar-year corporation
 PLIS a $15,000 computer in April


(the only asset acquired that year).
Taxable income for the current year is $500
before considering MACRS recovery
 Minor had profits of $120,000 in each of the
preceding five years.
 What factors should Minor consider in
evaluating a §179 election?

Solution--Tax Planning Query
Make a §179 Election?
Key Factor--Expected profitability in future
Electing §179
Expense $15,000
Deduction limited to
$500 (limited to
taxable income)
$14,500 may be carried
to the next year
Not Electing §179
MACRS deduction =
$3,000 ($15,000 x .05)
creating an NOL
NOL may be carried
back to the third prior
tax year
Refund = $975
($2,500 x .39)
Tax Planning Query:
Place In Service This Year or Next?
Meta Co. a calendar-year corporation
 Put in service in February

 $120,000
equipment (only acquisition to date)
Meta wants to acquire $83,000 of furniture
 Should Meta placed the furniture in service

 in

December or January of the next tax year?
What factors should Meta consider in
deciding when to buy the furniture?
Solution--Tax Planning Query
Place In Service This Year or Next?
If placed in service in December

Total acquisitions = $203,000
 Maximum
§179 = 17,000. (20,000 - 3000)
 Expensed property not used in test for mid-quarter

Could expense either equipment or furniture
 If
equipment, then mid-quarter

83,000 ÷ (203,000-17,000) = 44.6%
 If furniture, then half year
 (83,000-17,000) ÷ (203,000-17,000) = 35.5%
Solution--Tax Planning Query
Place In Service This Year or Next?
If placed in service in January of next year
 Then for the current year
Maximum §179 is $ 20,000 (assumes 2000)
 The half-year convention will apply

 no
acquisitions in fourth quarter
MACRS Straight-Line Options
Acquisition year conventions apply
 Must make election by class by year
 Straight-line over the MACRS life
 Straight-line over the class life
Alternative depreciation system (ADS)

 Major
exceptions to the class life rule:
 Autos
and computers (5 years)
 equipment with no class life (12 years)
 Realty (40 years)
Compliance Query:
Which MACRS Elections?
Melon Corp. a calendar-year corporation
 PLIS a $29,000 machine in March 2000
(the only asset acquired this year)
 The machine does not have a class live
 Melon elects §179
 What is the TOTAL cost recovery under

 Regular
MACRS recovery
 Straight-line MACRS recovery
 Alternative Depreciation System (ADS)
Solution--Compliance Query
Which MACRS Elections?
§179 deduction = $20,000
Remaining basis = $ 9,000
No class live so MACRS = 7 and ADS = 12
MACRS = $1,286 ($9,000 x .1429)
MACRS SL = $ 643 ($9,000 x 1/7 x .5)
ADS SL = $ 375 ($9,000 x 1/12 x .5)
TOTAL deduction increased by $ 20,000 in
each case
MACRS--Special Restrictions
Key Learning Objectives
The anti-churning rules
 Restrictions applicable to listed properties

 Including

special limits on automobiles
MACRS computations for alternative
minimum tax (AMT) purposes
Anti-churning Rules
Prevent Perceived Abuse
Prevents using sales between related parties
to change depreciation methods when tax
law changes
 If related party sale occurs, the transaction
is ignored, old recovery method continues

Listed Property Rules: Personal
Use Can Limit Recovery
Applies only to equipment
 Subject to restriction if Qualified Business
Use (QBU) < 50%

 QBU
generally limited to non-employee
trade/business use
Listed Property Rules: Personal
Use Can Limit Recovery
Straight line over CLASS LIFE used in any
year QBU < 50%
 Test must be applied each year

 Recapture
applies if MACRS used prior to
failing the business usage test
Compliance Query:
Change in QBU
Sue Adams , a calendar-year taxpayer
 Placed in service in March
 $10,000 computer

the only asset acquired this year
 §179 NOT elected
 For Year 1 QBU = 90%.
 For Year 2 QBU = 40%.


What are Sue’s recovery deductions?
Solution--Compliance Query
Change in QBU
Year 1
MACRS recovery =
$1,800
($10,000 x .2 x .9)
($10000 ÷ 5 x 2 x .9)
Note ADS would have
been $900
($10,000 ÷ 5 x .9)
Year 2
ADS straight-line
recovery = $800
($10,000 x 1/5 x .40).
$900 recaptured as
additional income
This is the difference
between MACRS Yr 1
(1800) & ADS Yr 1 (900)
Luxury Auto Rules--Everyone
Bought a $15,300 Car in 1999

Limits for autos placed into service in 2000
 First
year
 Second year
 Third year
 Remaining years
$3,060
$5,000
$2,950
$1,775
(15,300 x .20)
(15,300 x .32)
Luxury Auto Rules
IBM follows them too!
Indexed annually for inflation
 Limit is reduced by personal use
 Limit applies to recovery and §179 election
 Special rules for leased autos

Compliance Query: Recovering
the Cost of Autos
Deck’s Realty, a calendar-year taxpayer
 Placed in service in May, 1999
 $40,000 auto (the only asset acquired that year)
 QBU = 80%
 What is the 1999 cost recovery deduction?

Solution to Compliance Query:
Recovering the Cost of Autos
Car is half year, five year property
 MACRS and §179 are available
 If this was not a car, without §179, the
deduction would be

 40,000

x .2 x .8 = 6,400
But auto rules limit deduction to
 $2,448
(3,060 x .80)
Alternative Minimum Tax
Cost Recovery
Alternative Depreciation System (ADS)
 Equipment--150% DB over class life
 Realty--Straight-line over 40 years
 ADS--150% & SL OK for regular tax

 To
slow down deduction
 To reduce record keeping

Election on class by class,
year-by-year basis
TaxPoint: Possible Taxpayer
Depreciation Records
Regular federal income tax
 Alternative minimum tax
 Earnings and profits determination
 Adjusted current earnings determination
 State income tax
 Financial accounting records
 Regulatory agency mandated methods

Compliance Query
Name That Method!
Technoid Corporation, 12/31 year end.
 Put in service in May $20,000 of new
equipment (the only asset acquired that year).
 Technoid may choose one of 8 different
methods of cost recovery for this
equipment.
 Can you name them?

Solution - Compliance Query
Name That Method!
§179 election & normal MACRS
 §179 election & straight-line MACRS
 §179 election & ADS straight-line
 §179 election & 150% ADS (AMT)
 Normal MACRS recovery only
 Straight-line MACRS recovery only
 Straight-line ADS recovery only
 150% ADS (AMT) recovery

Ace Co., a calendar-year taxpayer, Placed in
service in 2000 the following assets. What is
Ace’s maximum cost recovery deduction?
Date
June
June
June
July
Asset
Auto
Warehouse
Apartment
Equipment
Cost
$ 10,000
100,000
200,000
20,000
(10 year CL)
October
Punch Machine
38,000
(8 year CL)
November Drill Machine
(No Class Life)
December Cutting Machine
(12 year CL)
30,000
104,000
Solution to Concepts Review:

Step 1: Separate equipment and realty



Equipment--$202,000
Realty--$300,000
Step 2: Separate reality into
 Residential
(27.5 year recovery) -- 200,000
 Non-residential (39 year recovery) -- 100,000
Solution to Concepts Review:

Step 3: Calculate §179 deduction
 20,000-2,000
= 18,000
 Before selecting consider impact on midquarter test (none in this problem)
 Generally best to take from property with
longest recovery period-- but no set rule
 In
next slide you will see that mid-quarter applies.
Therefore largest deduction will come from
expensing some of the 4th quarter, mid-quarter stuff.
Solution to Concepts Review:

Step 4: Determine modifying convention for
equipment
 Allocate
equipment by quarter
 2th
Qtr -- $ 10,000
 3th Qtr.-- $ 20,000
 4th Qtr.--$172,000
 MQ
convention applies to equipment
 172,000÷
202,000 = 85.1%
Solution to Concepts Review:

Step 5: Stop to consider impact of listed
property and luxury auto rules.
 None
in this problem.
 Since cost of car is only $10,000, the first year
will not exceed 3,060.
Solution to Concepts Review:
Total Deduction

Warehouse


$200,000 x .0197) = 3,940

2nd qtr, MQ 5 year
$10,000 x .25
= 2,500
Equip


3rd qtr, MQ 7 year
($20,000 x .1071) = 2,142
Punch Machine





4th qtr, MQ 5 year
38,000 x .05)
= 1,900
Drill Machine

Auto


$100,000 x .0139 = 1,390
Rental Apartment



$34,013
4th qtr, MQ 7 year
30,000 x .0357 = 1,071
Cutting Machine



4th qtr, MQ 7 year
expense
depreciate 86,000
18,000
3,070
Cost Recovery of Intangibles
Key Learning Objectives
General tax rules for amortization of
intangibles
 Special rules for §197 intangibles
 Special provisions for research and
experimentation expenses

Amortization--Cost Recovery for
Intangible Assets
Need estimated useful or legal life
 Straight-line recovery
 Whole month convention used
 Special 5-year recovery period

 Organization
& start-up costs
§197 purchased intangibles
 Research & experimentation expenditures

§197 Amortizing Goodwill
Post 8/10/93 Acquisitions

Acquisitions of a business if purchase price
includes intangibles
 Goodwill
 Going
concern value
 Other purchased intangibles (covenants not to
compete, customer lists, workforce, etc...)
Amortize over 15 years
 Amortization begins in month of acquisition

Compliance Query
§197 Intangibles
As part of the acquisition of Bee Company,
Ace Company paid $20,000 for Bee’s
contractual agreement not to enter into a
competing business for the next 10 years.
What is Ace’s recovery period for the
$20,000?
 Solution--The agreement not to compete is a
§197 intangible and must be amortized over
15 years. The contract is irrelevant.

Research and Experimentation
Expenditures (R&E)
Definition--incident to product or process
 Three tax options:

 Expense
immediately
 Amortize over a period of not less than 5 years
 Capitalize
Any tangible property must be capitalized
and depreciated
 Any R&E credit allowed reduces the
deduction

Compliance Query

Which of the following expenditures do not
qualify as R&E?
 Depreciation
on research building
 Wages of R&E employees
 Consumer survey costs
 Blueprints and drawings of product

Solution:
 The
consumer surveys are development costs
and do not qualify.
Depletion Deductions
Key Learning Concept
Requirements for the depletion deduction
 Computations under the

 Cost
and
 Percentage methods
Depletion--General Concepts
Cost recovery for natural resources
 Allowed to anyone with an economic
interest in the minerals or natural resource
in place
 Two methods of computing depletion:

 Cost
method
 Percentage (statutory) method

Taxpayer may deduct the larger of the two
methods
TaxPoint: Blood as a Mineral?



In the case of Margaret Green, 74 TC 1229, the
taxpayer attempted to deplete the mineral content
of her blood using statutory recovery.
She received commissions for donating her blood
(a rare AB-type), and argued that she should be
able to deplete her blood supply.
The Tax Court disagreed, stating that such
minerals were not “natural deposits,” and eventual
loss of ability to regenerate minerals was not
relevant.
Cost Method of Depletion

Determine a depletion rate per unit
 Undepleted
cost/estimated remaining
recoverable units
Multiply the rate times the number of units
sold during the tax year
 Total recovery may not exceed investment
cost

Percentage Method of Depletion
Determine statutory (code) rate for
particular resource
 Multiply rate times the gross income from
the property
 Statutory depletion is further limited to:

 50%
of the taxable income from the property
(100% of taxable income for oil properties)
 65% of the taxpayer’s taxable income

Percentage depletion may exceed cost
Compliance Query






Sierra Co. paid $600,000 to lease land for mining
uranium (22% rate).
Mine is estimated to contain 200,000 tons of ore.
This year, Sierra extracted 60,000 tons of ore and
sold 40,000 tons for $20 per ton.
Sierra’s gross income for the year was $700,000
($800,000 sales less a $100,000 royalty)
Expenses totaled $480,000.
What is Sierra’s depletion deduction ?
Solution--Compliance Query

Cost depletion:
 $600,000/200,000

x 40,000 = $120,000
Percentage (statutory) depletion:
 $700,000
x .22 = $154,000, limited to:
 ($700,000 - $480,000) x .50 = $110,000

Deduction is $120,000 (larger of the two)
Research Query




M Company discovered that Sleasy had drilled a
slant hole under their property and had stolen
50,000 barrels of oil.
M initiated a lawsuit to recover the value of the
stolen oil.
Early Win, an attorney, agreed to represent M
Company on a 1/3 contingency basis (receives 1/3
of the value if M wins, and nothing if M loses).
If Win wins the case, can he take a depletion
deduction on his 1/3 of the proceeds?
Solution--Research Query
No, Win will not qualify for depletion. In a
similar case, Parr v. Schofield (89 F Supp
98), the Court of Appeals for the 5th Circuit
stated that such recoveries were not
depletable gross income because the legal
contract did not cause a transfer of an
interest in the mineral property to the
attorney.
 (Federal Tax Coordinator, Para.N-2113)

Appendix--Pre-1981
Depreciation
Useful life
 Salvage value
 Maximum depreciation recovery methods:

 Equipment
 Realty
Appendix--Pre-1987 ACRS
Equipment classes (3, 5, 10, and 15)
 Realty classes (15, 18, and 19)
 Acquisition year assumption
 Maximum recovery rates:

 Equipment
 Realty
§179 expensing option
 Straight-line options
