Chapter 7
Property Acquisitions and
Cost Recovery Deductions
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.
7-2
Objectives
Decide if an expenditure should be deducted or
capitalized
Define tax basis and adjusted basis
Explain why leverage can reduce the after-tax cost
of assets
Compute cost of goods sold for tax purposes
Understand the MACRS framework
Apply the Section 179 expensing election
Compute amortization of purchased intangibles
Distinguish between cost and percentage depletion
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Expense or Capitalize?
Deduction allowed for all ordinary and necessary
business expenses
Deduction prohibited for permanent improvements
to increase the value of property
Cost of improvement is capitalized
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Capitalized Costs
Similar to GAAP, if an expenditure creates or
enhances an identifiable asset with a useful life
substantially beyond the current year, the
expenditure must be capitalized
Some capitalized costs can be recovered through
depreciation, amortization, or depletion deductions
 A capitalized cost that is not depreciable, amortizable, or
depletable is recovered only on disposition of the asset
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Expense or Capitalize?
Repairs and maintenance
Expenditures that are regular and recurring in nature and
do not materially add to either the value or the useful life
of an asset are deductible
Repair and maintenance expense
The distinction between a repair and a capital
improvement is frequently a matter of dispute between
taxpayers and the IRS
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Tax Subsidies Permit Expensing
The tax law permits immediate expensing of certain
capital expenditures
Indirect federal subsidy for taxpayers who make these
tax-preferred expenditures
One example is research and development (R&D)
expenditures
Indirect federal subsidy to encourage business to engage
in basic research
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Tax Subsidies Permit Expensing
Other examples include:
Advertising
Industry specific deductions:
 Farmers can deduct soil and water conservation
expenditures as well as the cost of fertilizers
 Oil and gas producers can deduct intangible drilling and
development costs (IDC) of wells
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Tax Basis
Basis is key to calculating cash flows because
taxpayers recover basis at no tax cost
Tax basis = unrecovered dollars represented by
an asset
Every asset has a tax basis
In most cases, the initial basis of an asset is cost
Cost is the FMV of cash, property, or services
expended to acquire an asset
Includes sales tax and incidental costs relating to
placing the asset in service
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Adjusted Tax Basis
Adjusted basis equals initial basis reduced by
depreciation, amortization, or depletion deductions
An asset’s adjusted tax basis may be different than
the asset’s adjusted book basis
Initial book and tax basis may be different
Book and tax recovery deductions may be different
≠
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Tax Basis and Leverage
Leverage is the use of borrowed funds to purchase
assets
Cost basis includes the amount of borrowed funds
Firm A used $10 of its own cash and $80 of borrowed
cash to buy an asset
Firm A’s cost basis is $90
Interest paid on borrowed funds is deductible
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Cost Recovery Methods
Inventory = cost of goods sold
Tangible assets = depreciation
Intangible assets = amortization
Natural resources = depletion
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Cost of Goods Sold
Calculating cost of goods sold
Beginning inventory
Capitalized costs
Inventory available for sale
(Ending inventory)
Cost of goods sold
Capitalized costs may be greater for tax than book
Unicap rules for capitalization of indirect costs (overhead)
Temporary unfavorable book/tax difference
Reverses through cost of goods sold
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Inventory Valuation Methods
Taxpayers may value ending inventory and cost of
goods sold by using:
Specific identification method
First-In, first-out convention (FIFO)
Last-in, first-out convention (LIFO)
Must be consistent with financial reporting
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Depreciation
Depreciation applies to tangible assets that:
Lose value over time due to wear and tear, obsolescence
Buildings are depreciable but land is not
Have a reasonably ascertainable useful life
Artwork is not depreciable
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Depreciation
Before 1981, tax depreciation was based on an
asset’s estimated useful life. Under MACRS,
estimated useful life is irrelevant
The MACRS recovery period is usually shorter than
an asset’s estimated useful life. What affect does
this have on the purchasing behavior of firms?
The shorter lives reduce the after-tax cost of the assets
and acts as an incentive for firms to make capital
acquisitions
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MACRS Recovery Periods and Methods
Depreciation for 3, 5, 7, and 10-year recovery
property is computed under the 200% declining
balance method
Depreciation for 15 and 20-year recovery property
is computed under the 150% declining balance
method
Depreciation for 25, 27.5, 39, and 50-year recovery
property is computed under the straight-line
method
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Depreciation Conventions for Personalty
Depreciation for 3, 5, 7, 10, 15, and 20-year recovery
property (personalty) is generally based on a half-year
convention
One-half year of depreciation is allowed for the year in
which property is placed in service
Convention built in to IRS Tables
One-half year of depreciation is allowed for the year in
which property is disposed of
Not built into IRS Tables
Midquarter convention applies if more than 40% of
personalty acquired in a year is placed in service in the 4th
quarter
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Depreciation Convention for Realty
Depreciation for 25, 27.5, 39, and 50-year
recovery property (realty) is based on a midmonth
convention
One-half month of depreciation is allowed for the month
in which property is placed in service
Convention built into IRS Tables
One-half month of depreciation is allowed for the month
in which property is disposed of
Not built into IRS Tables
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Limited Depreciation for Passenger Automobiles
Maximum annual depreciation per vehicle placed
in service in 2012
2012
2013
2014
2015
$3,160
$5,100 (2nd year)
$3,050 (3rd year)
$1,875 (4th year and beyond)
Compute depreciation per MACRS, then apply the
limit
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Section 179 Expensing Election
Taxpayer may expense a limited amount of cost of
qualifying property placed in service in a year
Limited amount is $500,000 in 2013
Qualifying property is depreciable personalty and off-theshelf software
Capitalized cost (unexpensed) is recovered through
MACRS
Limited amount is reduced by the aggregate cost
of qualifying property in excess of a threshold
Threshold is $2,000,000 in 2013
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Section 179 Example
Mayer Inc. purchased $609,200 of qualifying
property in 2013
Mayer may expense $500,000 of the cost and capitalize
$109,200 as the depreciable basis of the property
Lowe Inc. purchased $2,070,000 of qualifying
property in 2013
Lowe must reduce its limited amount by $70,000
($2,070,000 - $2,000,000 threshold)
Lowe may expense $430,000 of the cost ($500,000 –
$70,000) and capitalize $1,640,000 as the depreciable
basis of the property
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Taxable Income Limitation
The deduction for a Section 179 expense is limited
to taxable business income before the deduction
Any nondeductible expense carries forward to future
years
In 2013, Boyd Inc. elected to expense $112,000 of
the cost of qualifying property
Boyd’s taxable income before any Section 179 deduction
was $91,800
Boyd’s Section 179 deduction is limited to $91,800
Boyd has a $20,200 expense carryforward to 2014
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Bonus Depreciation
100% bonus depreciation permits immediate
expensing of 100% of the cost of qualifying
property placed in service after September 8, 2010
and before January 1, 2012
Qualifying property is new depreciable personalty,
computer software and certain leasehold improvements
50% bonus applies to acquisitions after December
31, 2012 and before January 1, 2014
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Bonus Depreciation Example
Evans Inc. acquired new depreciable personalty
costing $4 million on January 3, 2013
Evans could deduction $2 million ($4 million × 50%) in
2013 using bonus depreciation
The remaining $2 million depreciable basis would be
recovered under MACRS, beginning in 2013
If the property were acquired on January 3, 2011
Evans may deduct the entire $4 million cost in 2011 using
bonus depreciation
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Intangible Assets
Intangible assets have no physical substance
Examples include leases, patents, and other contractual
rights
The basis of an intangible asset is amortized on a
straight-line method over the determinable life
Intangible assets with no determinable life are not
amortizable
Examples include securities and partnership interests
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Organizational and Start-Up Costs
Organizational costs of a corporation or partnership include
legal, accounting, and filing fees attributable to the formation
of the entity
Start-up costs include the cost of investigating a new
business and expenses incurred before the new business is
operational
Both costs are subject to the same cost recovery rule
First $5,000 is deductible
Deduction reduced by any amount of cost in excess of $50,000
 Nondeductible costs are capitalized and amortized over 15
years
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Leasehold Costs and Improvements
The cost of acquiring a lease is amortized over the
term of the lease
Physical improvements to leased property are
capitalized and depreciated over the appropriate
MACRS recovery period
This cost recovery rule applies even if the term of the
lease is shorter than the MACRS recovery period
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Acquisition Intangibles
A firm that purchases an entire business for a
lump-sum price must allocated the cost to both
tangible and intangible assets
Cost allocation based on FMV of identifiable assets
Any residual cost is allocable to purchased goodwill
Capitalized cost of most acquisition intangibles
(including goodwill) is amortized over 15 years
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Amortization of Purchased Goodwill
For tax purposes, the cost of purchased goodwill is
amortized over 15 years
For book purposes, goodwill is not amortized
Amortization deduction results in a favorable book/tax
difference
Firms must test purchased goodwill annually for
any impairment to its value
Any write-down of goodwill is a nondeductible expense
resulting in an unfavorable book/tax difference
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Depletion
Taxpayers recover the capitalized cost of
productive mines and wells through depletion
Depletion deduction equals the greater of cost
depletion or percentage depletion
 Cost depletion = unrecovered basis × units of production
sold/estimated total units in the ground
Percentage depletion = statutory % of gross income from
the mine or well
Allowable even after basis
has been reduced to zero
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