Chapter 10Depreciation

Howard Godfrey, Ph.D., CPAUNC Charlotte

Copyright © 2013, Dr. Howard GodfreyEdited October 23, 2013.

Introduction Alternate Dep. Methods

Capital Cost Recovery MACRS Tables

Section 179 Election Straight-Line Election

Qualified Taxpayers Alt. Dep. System (ADS)

Qualified Property Listed Property Limits

Limits on Deduction Depletion

MACRS Depletion Methods

MACRS Property Cost Depletion

Basis-Cost Recovery Percentage Depletion

Recovery Period Intangible Assets

MACRS Conventions Summary

10. Depreciation, Depletion, Amortization

Capital Cost Recovery

Section 179 Election

Qualified Taxpayers

Qualified Property

Limits on Deduction

Concept Review• The capital recovery concept allows a

taxpayer to recover all invested capital before income is taxed– An asset’s basis is the maximum investment

that qualifies as capital for recovery• Legislative grace allows the capital to be

recovered systematically over the life of the asset

Categories of Assets • Realty includes land and buildings• Personalty is any asset that is not

realty and includes machinery and equipment

• Personal-use property is any property used for personal purposes

Capital Expenditures • The cost of a business asset with a

useful life extending beyond the current year may be–Deducted currently–Capitalized until disposal or–Capitalized with the cost allocated to

the years the asset’s use benefits (cost recovery period)

Basis of Property • Basis is the taxpayer’s unrecovered

investment in an asset that can be recovered without tax cost

• As the asset’s basis is recovered (through depreciation, depletion or amortization deductions), basis is reduced and is called adjusted basis

Basis of Property • The original basis of an asset includes

– Cash plus fair market value of property given up by the purchaser

– Money borrowed and used to pay for the property

– Liabilities of the seller assumed by the purchaser

– Expenses of the purchase such as attorney fees or brokerage commissions

After-Tax Cost • Tax savings from depreciation

deductions reduce the effective after-tax cost of an asset

• The annual tax saving equals the depreciation deduction multiplied by the marginal tax rate

• Recovering an asset’s basis over a shorter time period reduces the after-tax cost of the asset

Methods of Recovery• Depreciation: used for tangible assets

that –Are used for a business or production of

income purpose–Have a determinable life

• Depletion: used for wasting assets• Amortization: used for intangible

assets

History of Depreciation

Based on facts and circumstances related to asset life and taxpayer’s

situation

ACRSBased on method and life

prescribed by law

MACRSBased on method and life

prescribed by law; less accelerated than ACRS

1981 1987

Section 179 Electionto Expense Assets

Congress simplified depreciation• Asset lives used for depreciation

are specified in the tax law.• Do not subtract estimated salvage

value when computing depreciation.

• Standard Conventions: Mid-Month, Mid-Year, Mid-Quarter

Section 179 Election• A taxpayer may elect to expense

rather than capitalize qualifying property placed in service during the year.

• Promotes administrative convenience

• Treated as a depreciation deduction

Section 179 Election Qualifying Property

• Tangible, personal property–Real estate does not qualify

• Used in a trade or business–Investment property does not

qualify

Section 179 Deduction LimitsThe Sec. 179 limit of $500,000

for 2013 was not extended to 2014.

New limit is $25,000 Until Congress Acts.

Section 179 Deduction Limits• Limitations apply to each entity• Cannot exceed $500,000 in 2013• Cannot exceed taxable income

from the business–Excess may be carried forward

Section 179 Deduction Phase-Out•Deduction decreased if total cost of qualifying property placed in service exceeds $2,000,000– by $1 for every $1 of value over

$2,000,000.What is maximum Section 179 write-off.– See next 2 slides

Firefly, Inc., (1)acquires equipment in July 2013 for $2,100,000. a. What is Firefly's maximum Sec.

179 deduction for 2013? b. What happens to any part of the

annual limit not deducted in 2013? c. What is the depreciable basis of

the equipment? Explain.

Firefly-Page 10-6 Compute

1 Cost of equipment $2,100,000

2 Threshold - Sec. 179 write-off 2,000,000

3 Excess (Reduction in 179 limit) 100,000

4 Regular Section 179 limit 500,000

5 Adjusted Sec. 179 limit (4 - 3) 400,000

6 Cost of equipment $2,100,000

7 Remaining basis for deprec. 1,700,000

The bonus depreciation allowance of 50% of the cost of equipment, etc. (after subtracting Sec. 179 write-off) has not been extended.There is no bonus depreciation for 2014.Just Sec. 179 write-off and regular depreciation.

20

1 Equipment is 7-year property. Compute Write-off2 Cost of equipment $2,050,0003 Threshold - Sec. 179 write-off 2,000,0004 Excess (Reduction in 179 limit) 50,0005 Regular Section 179 limit 500,0006 Adjusted Sec. 179 limit (5 - 4) 450,000 $450,0007 Cost of equipment $2,050,0008 Remaining basis for deprec. 1,600,000 9 Bonus Depreciation Rate 50%10 Bonus Depreciation Amount 800,000 800,000 11 Remaining basis for deprec. 800,000 12 Rate for regular depreciation 14.29%13 Regular depreciation $114,320 114,320 14 Total write-off $1,364,320

Section 179 Strategy • Expensing the assets with the longest

class life generally maximizes the value of the Section 179 deduction

• Section 179 expensing can also alter the application of the mid-quarter convention because property expensed under Section 179 is not counted in calculating the 40% test for the mid-quarter convention.

• The 100% bonus depreciation (until end of 2011) makes Sec. 179 pretty irrelevant.

MACRS

MACRS Property

Basis-Cost Recovery

Recovery Period

MACRS Conventions

• MACRS applies to –New and used tangible, depreciable

property–Used in a trade or business or for the

production of income• Depreciable basis is:

– The asset’s original basis for depreciation – Reduced by any § 179 deduction

• Adjusted basis: the remaining unrecovered capital of an asset = asset basis minus accumulated depreciation

MACRS Recovery Period• Each asset is placed in a MACRS class

according to its class life–Most personal property is in a 3, 5, or 7

year class–Most land improvements and

specialized property are in a 10, 15, or 20 year class

–Real estate is in a 27.5, 31.5, or 39 year class

MACRS Conventions• Three assumptions are made about the

time property was placed in service during the year– Mid-year convention applies to all property

except real estate– Mid-month convention applies to real estate

only– Mid-quarter convention applies to some

personal property (when major acquisitions are made in final quarter)

Mid-Year Convention• Assumes property is placed in service and

will be disposed of at the mid-point of the year–One-half year depreciation allowed in

the first year of service–One-half year depreciation allowed in

the last year of service• IRS tables reflect the mid-year adjustment

only for the first year

Year 3-Year 5-Year 7-Year

1 33.33% 20.00% 14.29%2 44.45% 32.00% 24.49%3 14.81% 19.20% 17.49%4 7.41% 11.52% 12.49%5 11.52% 8.93%6 5.76% 8.92%7 8.93%8 4.46%

MACRS Tables-Pg 10-14

Asset Cost: $1,000, life is 5 years

Asset bought on 1-2-10.

Beg. SL DDB DDB Mid-Year

Basis Life Rate Rate Dep. [Tax]

$1,000 5 20% 40%

Asset Cost: $1,000, life is 5 yrs. Mid-Yr.

Asset bought on 1-2-10. See Table 10-4.

Beg. SL DDB DDB Mid-Year

Basis Life Rate Rate Dep. [Tax]

$1,000 5 20% 40% $400 $200

$800

Compare last column with IRS table.

Asset Cost: $1,000, life is 5 yrs. Mid-Yr.

Asset bought on 1-2-10. See Table 10-4.

Beg. SL DDB DDB Mid-Year

Basis Life Rate Rate Dep. [Tax]

$1,000 5 20% 40% $400 $200

$800 40% $320

$480 40% $192

$288 40% $115

$173 40% $69

Compare last column with IRS table.

Mid-Month Convention• Assumes property is placed in service

and will be disposed of at the mid-point of a month–One-half month allowed at the

beginning–One-half month allowed at disposition

• IRS tables reflect the adjustment only for acquisition

Date of acquistion 01/01/13Asset BuildingType of asset WarehouseConvention Mid-MonthNew property cost $1,000,000Life [Pg 10-16] 39.0 Full-year Rate (12 mo) 0.02564 Fraction [11.5 / 12] 0.95833 Depreciation Rate 0.02457 IRS Rate [Table 10-5] 2.461%Depreciation-Yr 1 $24,610

Mid-Quarter Convention• If > 40% of the total depreciable basis

of all personal property is placed in service during the 4th quarter of the year, mid-quarter:–Assumes property is placed in service

and will be disposed of at the mid-point of a quarter rather than at mid-year

–Determine the 40% after taking §179 expense

Mid-Quarter Factors

Months Year Factor

Quarter - 1 10.5 12 0.875

Quarter - 2 7.5 12 0.625

Quarter - 3 4.5 12 0.375

Quarter - 4 1.5 12 0.125

Example: buy asset in last qtr.

Assume bought on Nov. 15.

That gives 1.5 months.

Date of acquistion 12/01/13Asset ComputerConvention Mid-QtrNew property cost $100,000Life - IRS- [Pg-10-16, 53] 5.0 Full-year Rate - SL 20.00%Full-year Rate DDB 40.00%

Fraction [0.5 / 4] 12.50%Depreciation Rate 5.00%IRS Rate [Table App-10-6] 5.00%Depreciation-Yr 1 $5,000

Alternate Dep. Methods

MACRS Tables

Straight-Line Method

Alternate Dep. System

Listed Property Limits

Depreciation Method Alternatives

• Regular MACRS –with Section 179

• Straight-line MACRS

• Straight-line Alternative Depreciation System (ADS)

Regular MACRS• Method is double declining balance

–IRS tables provide the depreciation rate • Designed to permit full recovery of

depreciable basis• Incorporate the conventions

• Maximizes acquisition year deduction using the Section 179 election

Straight-Line MACRS• Taxpayers may elect to use the

slower straight-line method–Election is made each year–MACRS recovery periods are

used–Mid-year convention applies

Text Problem 51. Straight-line option

Cost: $100,000, life is 7 yrs. Mid-Yr.

Asset bought on 1-2-13. Page 10-56

Beg. Godfrey Table Mid-Year

Basis Life S/L Rate A10-11 [Tax]

$100,000 7 14.2857% 7.14% $7,140.00

$92,860 7 14.2857% 14.29% $14,290.00

$78,570 7 14.2857% 14.29% $14,290.00

$64,280 7 14.2857% 14.29% $14,290.00

Alternative Depreciation System• Taxpayers may elect to use ADS • Use is mandatory for Alternative

Minimum Taxable Income• Uses a longer recovery period than

MACRS • Election is made on a class-by-class,

year-by-year basisTable 10-7. 5-yr. Page 10-22S/L:20%, Mid year: 10%. 150% DB:15%

Limits on Listed Property• Most mixed-use property is

considered listed property and subject to special limitations–Examples: automobiles,

computers, cellular phones, etc.

Limits on Listed Property• Treatment depends on the percentage

of business usage–if >50% business use, treated like other

depreciable assets–if < 50% business use, deductions are

limited to ADS without Section 179 –In either case, only the business portion

of the asset’s basis is depreciable

Limit on Passenger Autos• The total amount of depreciation

and § 179 expense that can be deducted is limited–Annual maximum limit set and

linked to the year the car was placed in service

–Annual limit is further reduced by the business use %

Adequate Record Keeping• Listed property is subject to strict

record keeping requirements• No deduction without proof of

–Why? The business purpose of the use

–What? The amount–When? The dates of use–Where? The reality of the use

Year Autos Vans1 $11,160 $11,3602 $5,100 $5,3003 $3,050 $3,1504 $1,875 $1,875

Later $1,875 $1,875

Vehicles - 2013-Table 10-10

New law added $8,000 for Yr. 1.

Base is $3,160.

56. On June 1, 2013, Kirsten buys an automobile for $60,000. Her mileage log for the year reveals the following: 20,000 miles for business purposes; 7,000 miles for personal reasons; and 3,000 miles commuting to and from work. What is Kirsten's maximum cost-recovery deduction for 2013?

Initial basis $60,000Business use percentage 66.67%Bus. depreciable basis $40,000MACRS % (Table A10-2) 20%

Total MACRS depreciation $8,000Annual depreciation limit

auto (Table A10-10) $11,160Business use percentage 66.67%Depreciation limit-2013 $7,440

Page 10-24

Text Problem 56 - Auto

Vehicle Ceiling Limits

• When a vehicle is used less than 100% for business purposes, the ceiling limit allowed is reduced accordingly

• If an employee uses an employer’s car for personal use but is taxed on that use, the employer calculates depreciation as if all use is business use– Special rules apply to cars used by a more-than-5%

owner or someone related to the employer

Heavy SUVs• Heavy SUVs (gross vehicle weight over

6,000 lbs.) are not subject to the vehicle depreciation ceiling limits

• But the 2004 Jobs Creation Act reduced to $25,000 the cost of heavy SUVs (acquired after 10/22/04) that can be expensed under Section 179

Leased Automobiles

• Taxpayers who lease autos can deduct the business portion of lease payments, but must add a lease inclusion amount to income

• The inclusion amount is obtained from an IRS table, based on – the car's FMV and the tax year in which the

lease commences, and – is prorated for the number of days the car is

leased

Lease Inclusions• Examples of inclusion amounts for a new auto

leased in 2009– If FMV = $40,000 then – $58 for year 1, – $127 for year 2, – $188 for year 3, $225 for year 4, and – $259 for year 5 and later years

Depletion Depletion Methods Cost Depletion Percentage Depletion

Intangible Assets

Summary

Depletion• The basis of natural resource assets

subject to wasting away is recovered using depletion

• Basis used is generally fees paid to acquire a lease and the costs of the lease, exploration, and drilling

• Computed using two methods – Figure both each year and use the largest as

deduction

Cost Depletion Method• Allocates unrecovered basis over the

number of estimated units of resource

= Depletion per Unit Unrecovered Basis Estimated Recoverable Units

Cost Depletion = Depletion per Unit X # of Units Sold

Percentage Depletion Method• Depletion is the lesser of

–50% of taxable income before depletion, or

–Gross income from the sale of the natural resource times a statutory depletion rate• Different statutory % for each type

of resource is given in IRS tables

On July 4 of the current year, Lawrence invests $240,000 in a mineral property. He estimates that he will recover 800,000 units of the mineral from the deposit. During the current year, Lawrence recovers and sells 100,000 units of the mineral for $3.50 per unit.a. What are Lawrence's cost depletion

deduction for the current year and his adjusted basis for the mineral deposit after deducting depletion?

On July 4 of the current year, Lawrence invests $240,000 in a mineral property. Cost depletion is calculated using the units of production method. Each year the remaining depreciable basis is allocated based on the formula:Units Recovered During the YearTotal Estimated Units RemainingFor Lawrence, this results in a deduction for cost

depletion of $30,000. $240,000 x 100,000 = $30,000

800,000

Lawrence invests $240,000 in mineral property. b. If the percentage depletion rate for the mineral is 10%, what are his depletion deduction for the current year and his adjusted basis for the mineral deposit?Percentage depletion is calculated by multiplying the selling price of the mineral by the statutory rate for the mineral. Sales are $350,000 (100,000 x $3.50) and percentage depletion is $35,000 ($350,000 x 10%). Property basis after deducting percentage depletion is $205,000 ($240,000 - $35,000).

IntangiblesIntangible assets are grouped into 3 categories

1) Intangibles with perpetual life that cannot be amortized

2) 15-year intangibles (including goodwill) acquired as part of a business purchase (Section 197 assets)

3) Intangibles amortizable over a life other than 15 years

Amortization• Basis of intangible assets is recovered

using straight-line method over the life of the asset

• Intangible assets acquired through purchase generally use a 15 year life

• Created assets and assets specifically excluded from use of 15-year period are amortized over their legal life

On June 2, 2013, Lokar Corporation purchases a patent for $68,000 from the inventor of a new extrusion process. The patent has 12 years remaining on its legal life. Determine the maximum 2013 cost-recovery deductions for the asset purchased.The patent acquired separately (from the inventor) is amortized over the remaining useful life.

Patent-Extrusion Allocated cost $68,000Rate per year - 12 yrs 0.083 Part year (7 months) 0.583 Amortization $3,306

Next few slides show financial accounting with full year of depreciation in year of acquisition.This is done to simplify the illustration. That is not allowed by the tax law.

Double Declining Balance – Slide 1 of 2On January 1, Year 1, office equipment was purchased and placed into service. The equipment cost $400,000, has an estimated useful life of 10 years, and an expected salvage value of $48,000. The depreciation expense under the double-declining balance method for Year 2 is:a. $64,000 b. $80,000 c. $72,000 d. $70,400

Begin. Ending End.

Book Deprec. Accum. Book

Year Value Exp. Deprec. Value

Yr. 1 400,000 80,000 80,000 320,000

Yr. 2 320,000 64,000 144,000 256,000

Note: Deprec. Expense is 20% ofbeginning Book Value with DDB.

Ignore salvage value in DDB deprec.

Double Declining Balance - Slide 2

Machine has 10-year life.

Depreciation Methods for Tax Purposes.Refer to next slide for Turtle Co. which uses straight-line method for financial reporting and accelerated method for tax returns. Asset cost $50,000 and has 5 year life.How much depreciation is shown on each report in year one? (For this illustration, use full year of depreciation with both methods.)If Turtle has a 30% tax rate, what is the tax savings for using the accelerated method? How much taxes will be saved in year 2?

Year 1 Year 2Deprec. in fin. reports $10,000 $10,000

Income tax rate 30% 30%

Taxes Saved - SL $3,000 $3,000

Deprec. on tax return

Income tax rate

Taxes Saved - DDB

Turtle Co. Tax Savings

Year 1 Year 2Deprec. in fin. reports $10,000 $10,000

Income tax rate 30% 30%

Taxes Saved - SL $3,000 $3,000

Deprec. on tax return 20,000 12,000

Income tax rate 30% 30%

Taxes Saved - DDB $6,000 $3,600

Turtle Co. Tax Savings

Cost of machine bought in Yr. 1 $100,000Date of purchase of machine 1/1/2007Expected salvage value $0Life 5 yearsMethod used for GAAP: St. LineStraight-line depreciation rate 20%Method used for Tax: DDBYear 1 - GAAP depreciationYear 1 - TAX depreciationIncome Tax Rate 40%Amount of deferred tax asset or liability at end of Year 1?Is it a Deferred Asset or Liability?[Use full year of depreciation - GAAP & Tax]

Income Tax Accounting - Big Co.

Cost of machine bought in Yr. 1 $100,000Date of purchase of machine 1/1/2007Expected salvage value $0Life 5 yearsMethod used for GAAP: St. LineStraight-line depreciation rate 20%Method used for Tax: DDBYear 1 - GAAP depreciation $20,000Year 1 - TAX depreciation $40,000Income Tax Rate 40%Amount of deferred tax asset or liability at end of Year 1?Is it a Deferred Asset or Liability?[Use full year of depreciation - GAAP & Tax]

Income Tax Accounting - Big Co.

On the preceding slide, what is the balance in the

deferred tax account at the end of year 2?