Principles of Taxation
Chapter 6
Property Acquisitions and
Cost Recovery Deductions
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Objectives
Slide 6-2
 Expense versus capitalize
 Define tax basis and adjusted basis.
 Show how leverage reduces the after-tax cost
of assets.
 Compute cost of goods sold.
 Use recovery period, method and convention
to compute MACRS depreciation.
 Explain the limited expensing election.
 Understand role of depreciation in NPV of
after-tax cash flows.
 Amortize intangibles, deplete resources.
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Expense vs. Capitalize
Slide 6-3
 Deduction permitted for all “ORDINARY
AND NECESSARY” business expenses
 Deduction prohibited for “PERMANENT
improvements to increase the value of
property”
 Some types of capitalized costs can be
recovered through amortization or
depreciation.
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Expense vs. Capitalize
Slide 6-4
 Repairs and maintenance? Source of IRS
dispute due to facts.
Environment cleanup and prevention
costs: TRA1997 has a provision
allowing firms to elect to deduct rather
than capitalize expenditures to abate or
control hazardous substances at
contaminated areas.
 Capitalize expenditures that increase the
value or useful life of an asset.
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Tax Subsidies Permit
Expensing
Slide 6-5
 R&D expenses (this is BIG).
 Allowing deduction for R&D is a tax
subsidy. What is the GAAP rationale for
requiring expense under SFAS 2?
 Y2K costs - IRS has ruled these can be
expensed.
 Various oil and gas: IDC, depletion
 Advertising.
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Tax Basis
Slide 6-6
 Tax basis = unrecovered cost
 Starting basis generally equals COST basis:
 original purchase price, or
 FMV of asset if cost more difficult to
measure.
 When do you recover the cost? Depreciation
or sale. Example: For depreciable equipment,
adjusted basis is the original basis reduced by
depreciation. You can think of adjusted basis as being
the tax equivalent of “net book value” of the asset, but
with tax depreciation instead of book depreciation.
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Tax Basis and Leverage
Slide 6-7
 Cost basis is the entire cost, even if asset
purchased with debt.
 Deductions for interest and cost recovery
(depreciation) can improve NPV of after-tax
cash flows. AP1, 2
 Study example in text regarding After-Tax Cost of
Leveraged Purchase. Note especially the footnote
describing the effect of borrowing rate versus
internal discount rate.
 Tax deductions made some leveraged tax shelters
in early 1980’s had positive NPV even when pre-tax
flows were breakeven or negative. Chapters 9 and
15 will discuss limits on such tax shelter losses.
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Cost Recovery
Slide 6-8




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Cost of goods sold
depreciation
amortization
depletion
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Cost of goods sold
Slide 6-9
 Similar to GAAP
1) Beginning inventory
2) PLUS purchases
3) = inventory available for sale
4) MINUS ending inventory
5) = CGS
 Tax versus GAAP differences may occur in
capitalization of indirect costs. Tax requires
“uniform capitalization” under Section 263.
AP4
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Cost of goods sold
Slide 6-10
 Uniform capitalization rules (IRC Section 263)
 Indirect costs that “benefit or are incurred
by reason of the performance of
production or resale activities”
 Examples? Officers’ comp (VP Mfg.),
employee benefits, building rent,
insurance, depreciation.
Why might there be book-tax differences in
indirect costs being capitalized?
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Cost of goods sold
Slide 6-11
 What are permissible Inventory methods?
Which one requires book-tax conformity?
 1) FIFO
 2) specific ID
 3) LIFO - If use LIFO for tax, must also use
LIFO for books.
 In times of inflation, LIFO reduces book
and taxable income.
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Depreciation
Slide 6-12
 Depreciation applies to tangible assets (things
you can touch, versus intangibles like patents,
goodwill) that:
 Lose value over time due to wear and tear,
obsolescence
Buildings depreciate even though real
estate often increases in value.
 Have a reasonably ascertainable useful life
Artwork is not generally depreciable.
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Depreciation
Slide 6-13
 MACRS - Modified Accelerated Cost
Recovery System
 Fixed recovery methods and periods
Personalty and other short-lived
property:
DDB: 3, 5, 7, 10
150% DB:15, 20
Realty: SL method: 27.5 years
residential, 39 years non-residential
(specialty realty 20, 25, 50)
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Depreciation Conventions Personalty
Slide 6-14
 Table 6-2 incorporates a half-year convention
- provides only 1/2 of the regular rate in the
year the property is put in service.
 When dispose of asset, multiply table amount
by 1/2 in the year of sale.
 Buy $10,000 of 7-year property in 1997. Sell
the property in 1999. What is 1997, 1998 and
1999 depreciation?
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Depreciation Conventions Personalty
Slide 6-15
 Exception to mid-year convention:
 IF > 40% personalty is acquired during the
last quarter of the year, THEN
 Compute depreciation separately for
EACH quarter’s acquisition.
 See the MID-QUARTER tables. (Instructor
hand out in class.) ONLY adjust table
amounts in year of disposition.
 AP6, TPC 1.
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Depreciation Conventions Realty
Slide 6-16
 Mid-month convention. Get 1/2 of a month in month
acquired. Built into Table 6-3. Choose column for
month put in service. Use this same column
throughout the asset life. AP10.
 Like personalty, you have to adjust table amount in
year of disposition. Get 1/2 of a month for the
month of disposition.
 Buy apartment building for $1,000,000 in August
1995. Sell in March 1999. What is depreciation in
1995 - 1999?
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Depreciation Conventions
Slide 6-17
 What is the purpose of the half-year,
midquarter and midmonth conventions?
 Balance 1) prevent taxpayer from claiming
a full year of depreciation if hold only for a
portion of the year against
 2) Easier rules than computing actual days
held.
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Expensing Election
Slide 6-18
 Applies to tangible personalty
 1998 $18,500. See AP8.
 Limits:
 Expense cannot create a business loss.
 Expense reduced $ for $ if purchases >
$200,000. AP9.
 Reduces recordkeeping, benefit for small
businesses
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Other depreciation details
not in text.
Slide 6-19
 Combination business and personal use
property - “listed property” - such as
computers, phones, cars. Only use
accelerated depreciation if business use >
50%.
 Cars have additional depreciation limits per
year.
 Different depreciation methods apply for
Alternative Minimum Tax purposes (Chapter
10, 14).
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Lease versus Buy
Slide 6-20
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 Example in text compares purchasing for cash
up-front to an operating lease.
 Tax rules are similar to financial rules for
determining whether a lease is capital or
ordinary. A capital lease is treated like a
purchase by the lessee.
 A lessee who obtains assets through an
operating lease:
 gives up interest and depreciation
deductions (because lessor still owns the
asset), but
 doesn’t have deemed debt on financial
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balance sheet.
Amortization of Intangibles
Slide 6-21
 Generally requires a determinable useful life.
 Organizational costs are amortizable straight
line method over 60 months.
 Start-up costs are also amortizable straight
line method over 60 months - some
exceptions.
 Expansion costs may be currently deductible.
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Leasehold costs and
improvements
Slide 6-22
 Cost of acquiring lease is amortized over the
period of lease.
 Improvements to leased property are
capitalized and depreciated according to type
of property.
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Purchased intangibles
Slide 6-23
 Allocate lump-sum price to assets by relative
FMVs.
 Residual = goodwill.
 Tax = 15 years SL, GAAP = 40 years SL.
Book-tax difference is temporary under
current tax laws.
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Depletion
Slide 6-24
 Cost depletion = unrecovered basis * units
sold / estimated beginnning units.
 Percentage depletion
 statutory % of gross income. See Q18.
 Deduct the greater of cost or percentage
depletion.
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Review - book-tax differences
Slide 6-25
 Temporary differences due to: depreciation,
inventory methods, goodwill amortization
(this used to be permanent before 1992 when
goodwill was not amortizable for tax).
 AP11.
 Permanent differences due to % depletion (in
excess of cost).
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