Chapter

7Property Acquisitions and Property Acquisitions and Cost Recovery DeductionsCost Recovery Deductions

Expense vs. CapitalizeExpense vs. Capitalize

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

Expense vs. CapitalizeExpense vs. Capitalize

Repairs and maintenance? Source of IRS dispute due to facts.

Capitalize expenditures that increase the value or useful life of an asset.

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.

Tax BasisTax Basis

Tax basis = unrecovered cost (cost - depreciation). Starting basis generally equals COST basis:

original purchase price regardless of whether acquired by debt, or

FMV of asset if cost more difficult to measure. Cost recovery of

Inventory = cost of goods sold Tangible assets = depreciation Intangible assets = amortization Natural resources = depletion

Cost of Goods SoldCost of Goods Sold

Inventory Methods (must use accrual to account for COGS 1) FIFO 2) specific ID 3) LIFO - If use LIFO for tax, must also use LIFO

for books. In times of inflation, LIFO decreases book and

taxable income.

DepreciationDepreciation

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.

DepreciationDepreciation

MACRS - Modified Accelerated Cost Recovery System Personalty:

DDB: 3, 5, 7, 10 150% DB:15, 20 General rule is half year convention

Realty: SL method: 27.5 years residential, 39 years non-residential (specialty realty 20, 25, 50) Mid Month convention

Depreciation Conventions - PersonaltyDepreciation Conventions - Personalty

Table 7-2 incorporates a half-year convention - provides only 1/2 of the regular rate in the year the property is put in service.

Anti-Abuse provision Mid-quarter convention : IF > 40% personalty is acquired during the last quarter

of the year, THEN Compute depreciation separately for EACH quarter’s

acquisition using mid-quarter tables in appendix of chapter 7

AutomobilesAutomobiles

Maximum annual depreciation limit per vehicle, indexed for inflation. Year 1 $2,960 (1st yr) Year 2 $4,800 (2nd yr) Year 3 $2,850 (3rd yr) Year 4 + $1,775 (4th +++ yrs).

Compute depreciation per MACRS, then limit above.

Expensing Election – Section 179Expensing Election – Section 179

Applies to tangible personalty. May expense $128,000 of assets purchased after 2008 and $133,000 in 2009.

Expense cannot create a business loss. Expense reduced $ for $ by purchases >

$800,000.. Reduces recordkeeping, benefit for small

businesses Planning - if buy a 3-year, 5-year and 7-year asset,

which one should you expense?

Amortization of IntangiblesAmortization of Intangibles

Generally requires a determinable useful life. Organizational costs & Start up costs

Immediately deduct up to $5,000 Amount over $5K amortized over 180 months.

Start-up costs & Organization costs are defined on pg. 177.

Expansion costs may be currently deductible.

Leasehold Costs and ImprovementsLeasehold Costs and Improvements

Cost of acquiring lease is amortized over the period of lease.

Improvements to leased property are capitalized and depreciated according to type of property.

Purchased IntangiblesPurchased Intangibles

Allocate lump-sum price to assets by relative FMVs.

Residual = goodwill. Tax = 15 years SL GAAP = 40 years pre-2002. No GAAP amortization post-2001 - evaluate for impairment annually. Book-tax difference is permanent post-2001.