Chapter 8
Depreciation, Cost Recovery,
Amortization, and Depletion
Individual Income Taxes
Copyright ©2009 Cengage Learning
Individual Income Taxes
C8-1
Cost Recovery
• Recovery of the cost of business or incomeproducing assets is through:
– Cost recovery or depreciation: tangible assets
– Amortization: intangible assets
– Depletion: natural resources
Individual Income Taxes
C8-2
Nature of Property
• Property includes both realty (real property) and personalty
(personal property)
– Realty generally includes land and buildings permanently affixed
to the land
– Personalty is defined as any asset that is not realty
• Personalty includes furniture, machinery, equipment, and many other
types of assets
• Personalty (or personal property) should not be confused
with personal use property
– Personal use property is any property (realty or personalty) that is
held for personal use rather than for use in a trade or business or an
income-producing activity
• Write-offs are not allowed for personal use assets
Individual Income Taxes
C8-3
General Considerations
(slide 1 of 3)
• Basis in an asset is reduced by the amount of cost
recovery that is allowed and by not less than the
allowable amount
– Allowed cost recovery is cost recovery actually taken
– Allowable cost recovery is amount that could have been
taken under the applicable cost recovery method
• If no cost recovery is claimed on property
– The basis of the property must still be reduced by the
amount that should have been deducted
• i.e., The allowable cost recovery
Individual Income Taxes
C8-4
General Considerations
(slide 2 of 3)
• If personal use assets are converted to
business or income-producing use
– Basis for cost recovery and for loss is lower of
• Adjusted basis or
• Fair market value at time property was converted
– Losses that occurred prior to conversion can not
be recognized for tax purposes through cost
recovery
Individual Income Taxes
C8-5
General Considerations
(slide 3 of 3)
• MACRS applies to:
– Assets used in a trade or business or for the
production of income
– Assets subject to wear and tear, obsolescence,
etc.
– Assets must have a determinable useful life
– Assets that are tangible personalty or realty
Individual Income Taxes
C8-6
MACRS-Personalty
• MACRS characteristics:
MACRS Personalty
Statutory lives:
Method:
Convention:
3, 5, 7, 10 yrs
200% DB
Half Yr
or
.
15, 20 yrs
150% DB
Mid-Quarter
DB = declining balance with switch to straight-line
Straight-line depreciation may be elected
Individual Income Taxes
C8-7
Half-Year Convention
• General rule for personalty
• Assets treated as if placed in service (or
disposed of) in the middle of taxable year
regardless of when actually placed in
service (or disposed of)
Individual Income Taxes
C8-8
Example: Half-Year Convention
• Bought and placed an asset in service on
March 15 (Tax year end is December 31)
– Treated as placed in service June 30
– Six months cost recovery in year 1 (and year
disposed of, if within recovery period)
Individual Income Taxes
C8-9
Additional First-Year Depreciation
• The Economic Stimulus Act of 2008 provides for
additional first-year depreciation on qualified
property
– Applies to property acquired after 12/31/07 and before
01/01/09 and placed in service before 01/01/09
• Allows an additional 50% cost recovery in year
asset is placed in service
• Qualified property includes most types of new
property other than buildings
– Property that is used but new to the taxpayer does not
qualify
Individual Income Taxes
C8-10
Example: Additional
First-Year Depreciation
Maple Company acquires a 5-year class asset on
March 20, 2008, for $20,000. Maple’s cost recovery
deduction for 2008 is computed as follows:
50% additional first-year
depreciation ($20,000 X .50)
MACRS cost recovery
[($20,000 - $10,000) X .20 (Table 8–1)]
Total cost recovery
Individual Income Taxes
$10,000
2,000
$12,000
C8-11
Mid-Quarter convention
• Applies when more than 40% of personalty
is placed in service during last quarter of
year
• Assets treated as if placed into service (or
disposed of) in the middle of the quarter in
which they were actually placed in service
(or disposed of)
Individual Income Taxes
C8-12
Example: Mid-Quarter
Convention
• Business with 12/31 year end purchased and
placed in service the following 5-year class assets:
Asset 1: on 3/28 for $50,000, and
Asset 2: on 12/28 for $100,000
• More than 40% placed in service in last quarter;
therefore, mid-quarter convention used:
Asset 1: $50,000 × .20 × 200% × 10.5/12 = $17,500
Asset 2: $100,000 × .20 × 200% × 1.5/12 = $5,000
• Table 8-2 provides the relevant percentages to be
used when applying the mid-quarter convention
Individual Income Taxes
C8-13
MACRS-Realty
(slide 1 of 2)
• MACRS characteristics:
MACRS Realty
Residential Rental Nonresid. Realty
Statutory lives:
27.5 yrs
31.5 yrs or 39 yrs
Method:
Straight-line
Convention:
Mid-month
• Residential rental real estate
– Includes property where 80% or more of gross rental
revenues are from nontransient dwelling units
– e.g., Apartment building
Individual Income Taxes
C8-14
MACRS-Realty
(slide 2 of 2)
• Mid-month Convention
– Property placed in service at any time during a
month is treated as if it was placed in service in
the middle of the month
– Example: Business building placed in service
April 25 is treated as placed in service April 15
Individual Income Taxes
C8-15
Optional Straight-line Election
• May elect straight-line rather than
accelerated depreciation on personalty
placed in service during year
– Use the class life of the asset for the recovery
period
– Use half-year or mid-quarter convention as
applicable
– Election is made annually by class of property
Individual Income Taxes
C8-16
Leasehold Improvement Property
(slide 1 of 2)
• If lessor is owner of leasehold improvement
property, depreciation is calculated as follows:
– Real Property – Use straight-line method over 27.5 or
39 year statutory recovery periods
– Tangible personal property – Use the shorter MACRS
lives and accelerated methods
• When these improvements are disposed of or
abandoned by the lessor due to lease termination
– Property is treated as disposed of by the lessor
– A loss can be taken for the unrecovered basis
Individual Income Taxes
C8-17
Leasehold Improvement Property
(slide 2 of 2)
• If lessee is owner of leasehold improvement
property
– Costs of leasehold improvements are recovered in
accordance with the general cost recovery rules
• Cost recovery period is determined without regard to the lease
term
– Any unrecovered basis in the leasehold improvement
property not retained by the lessee is deducted in the
year the lease is terminated
Individual Income Taxes
C8-18
Election to Expense Assets
-Section 179 (slide 1 of 5)
• General rules
– Can elect to immediately expense up to
$250,000 (for 2008) of business tangible
personalty placed in service during the year
– Cannot use § 179 for realty or production of
income property
Individual Income Taxes
C8-19
Election to Expense Assets
-Section 179 (slide 2 of 5)
• Section 179 general rules
– Amount expensed reduces depreciable basis
– Any elected § 179 expense is taken before the
50% additional first-year depreciation is
computed
– The base for calculating the standard MACRS
deduction is net of the § 179 expense and the
50% additional first-year depreciation
Individual Income Taxes
C8-20
Election to Expense Assets
-Section 179 (slide 3 of 5)
• Annual limitations:
– Expense limitation ($250,000 for 2008) is
reduced by amount of § 179 property placed in
service during year that exceeds $800,000
• Example: In 2008, taxpayer placed in
service $815,000 of § 179 property.
– The § 179 expense limit is reduced to $235,000
[$250,000 – ($815,000 – $800,000)]
Individual Income Taxes
C8-21
Election to Expense Assets
-Section 179 (slide 4 of 5)
• Annual limitations:
– Election to expense cannot exceed taxable
income (before § 179) of taxpayer’s trades or
businesses
• Any amount expensed under § 179 over taxable
income limitation may be carried over to
subsequent year(s)
• Amount carried over still reduces basis currently
Individual Income Taxes
C8-22
Election to Expense Assets
-Section 179 (slide 5 of 5)
Example: Taxpayer buys 5-year property for
$275,000 on August 15, 2008 and elects immediate
expensing of the maximum amount. The total
deduction for the year is calculated as follows:
§ 179 expense
50% additional first-year depreciation
[($275,000 - $250,000) X .50]
Standard MACRS calculation
[($275,000 - $250,000 - $12,500) X .20]
Total cost recovery allowed in 2008
Individual Income Taxes
$250,000
12,500
2,500
$265,000
C8-23
Listed Property (slide 1 of 4)
• There can be substantial limits on cost recovery of
assets considered listed property
• Listed property includes the following:
– Passenger automobile
– Other property used as a means of transportation
– Property used for entertainment, recreation, or
amusement
– Computer or peripheral equipment
– Cellular telephone
Individual Income Taxes
C8-24
Listed Property (slide 2 of 4)
• To be considered as predominantly used for
business, business use must exceed 50%
• Use of asset for production of income is not
considered in this 50% test
• However, both business and production of
income use percentages are used to
compute cost recovery
Individual Income Taxes
C8-25
Listed Property (slide 3 of 4)
• To be considered as predominantly used for
business (cont’d)
• If 50% test is met, then allowed to use
statutory percentage method of cost
recovery with some limitations
Individual Income Taxes
C8-26
Listed Property (slide 4 of 4)
• If asset is not used predominantly for
business i.e., business use does not exceed
50%
– Must use straight-line method
– If business use falls to 50% or lower after year
property is placed in service, must recapture
excess cost recovery
Individual Income Taxes
C8-27
Passenger Auto Cost
Recovery Limits (slide 1 of 7)
For autos placed in service in 2007, cost recovery limits are:
Year
Recovery Limitation
1
$3,060
2
4,900
3
2,850
Succeeding years until
the cost is recovered
1,775
• If passenger automobile qualifies for 50% additional firstyear depreciation (i.e., new property), the 2008 recovery
limitation is increased by $8,000
– The initial-year cost recovery limitation increases from $3,060 to
$11,060 ($3,060 + $8,000)
Individual Income Taxes
C8-28
Passenger Auto Cost
Recovery Limits (slide 2 of 7)
• Limits are for 100% business use
– Must reduce limits by percentage of personal
use
• Limit in the first year includes any amount
the taxpayer elects to expense under § 179
Individual Income Taxes
C8-29
Passenger Auto Cost
Recovery Limits (slide 3 of 7)
Example: Taxpayer acquired an auto in 2008 for
$30,000 and used it 80% for business
2008 cost recovery allowance:
{[($30,000 X 50%) +
($15,000 X 20%)] X 80%}
$14,400
But deduction is limited to
× Business use %
Cost recovery allowance
$11,060
.80
$8,848
Individual Income Taxes
C8-30
Passenger Auto Cost
Recovery Limits (slide 4 of 7)
• Limit on § 179 deduction
– For certain vehicles not subject to the statutory
dollar limits imposed on passenger automobiles
the § 179 deduction is limited to $25,000
• The limit applies to sport utility vehicles with an
unloaded GVW rating of more than 6,000 pounds
and not more than 14,000 pounds
Individual Income Taxes
C8-31
Passenger Auto Cost
Recovery Limits (slide 5 of 7)
• Listed property that fails the >50% business usage
test in year property is placed in service must be
recovered using the straight-line method
– Such property does not qualify for the 50% additional
first-year depreciation
• If the >50% business usage test is failed in a year
after the property is placed in service, straight-line
method must be used for remainder of property’s
life
– Cost recovery of passenger auto under straight-line
listed property rule still subject to annual limits
Individual Income Taxes
C8-32
Passenger Auto Cost
Recovery Limits (slide 6 of 7)
• Change from predominantly business use
– If the business use percentage falls to 50% or lower
after the year the property is placed in service, the
property is subject to cost recovery recapture
– The amount recaptured as ordinary income is the excess
cost recovery
• Excess cost recovery is the excess of the cost recovery
deductions taken in prior years using the statutory percentage
method over the amount that would have been allowed if the
straight-line method had been used
Individual Income Taxes
C8-33
Passenger Auto Cost
Recovery Limits (slide 7 of 7)
• Leased autos subject to “inclusion amount”
rule
– Using IRS tables, taxpayer has gross income
equal to each lease year’s inclusion amount
– Purpose is to prevent avoidance of cost
recovery dollar limits applicable to purchased
autos by leasing autos
Individual Income Taxes
C8-34