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Solutions to Chapter 6 Problems

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					Solutions to Chapter 6 Problem Assignments
NOTE: These solutions are before the new tax bill was passed.
Check Your Understanding
1. Basis
   Linda inherited a car from her Uncle Ted. Ted purchased the car two years ago for $38,000.
   The car had a value of $30,000 at the date of Ted’s death. What is Linda's basis for the car?
   Solution: Linda’s basis is $30,000, the fair market value at the date of death.

2. Depreciation
   Cynthia, a sole proprietor, has incurred a loss this year and would like to claim no depreciation
   this year and then take double depreciation next year. Can she elect to do this?
   Solution: No, depreciation must be taken in the year to which it is allocated; if not taken, basis
              is still reduced for the allowable depreciation.

3. Section 179 Expensing and Bonus Depreciation
   What limits are placed on the amount and type of property that can be expensed under Section
   179? Compare the characteristics of Section 179 expensing to bonus depreciation.
   Solution: Only tangible business personalty is eligible for Section 179 expensing and there is
             an annual limit on expensing. For 2009 and 2010 the limit is $250,000. This limit
             must be reduced dollar-for-dollar for qualifying investments that exceed $800,000.
             The amount expensed is also limited to taxable income for the year.
             Section 179 expensing can be claimed on both new and used personalty and
             continues to be in effect for property acquired after 2010. Bonus depreciation could
             only be claimed for new (not used) personalty acquired in 2009. Unlike Section 179
             expensing, bonus depreciation was not phased out based on the dollar amount of
             qualifying investments. The taxpayer must elect to claim any Section 179 expensing
             but bonus depreciation was assumed to be claimed unless the taxpayer elected not to
             claim it.

5. Section 179 Expensing
   Delta Corporation purchased three assets during the current year: an automobile costing
   $60,000, office furniture costing $260,000, and a warehouse costing $750,000. Which asset(s)
   should Delta Corporation elect Section 179 expensing for and why?
   Solution: The corporation should expense $250,000 of the furniture’s cost because it is 7-year
             property and because the amount of depreciation expensed under Section 179 for
             automobiles is subject to the ceiling limitations. The warehouse is not eligible for
             Section 179 expensing because it is not personalty.

6. Limitations on Automobile Depreciation
   Carl purchases a Jaguar automobile for $60,000. Carl plans to use the automobile exclusively
   in his business and boasts that he intends to recover his cost through MACRS depreciation
   deductions over five years. What restrictions have been imposed to reduce the tax benefits of
2 Solutions Manual for Taxation for Decision Makers


  purchasing a luxury automobile for business use? Explain how the restrictions work. Will he
  be able to circumvent these restrictions by leasing the vehicle?
  Solution: Carl’s depreciation deductions on the automobile are subject to ceiling limits that
             restrict maximum annual depreciation deductions to an amount set by the
             government. He cannot use the normal 5-year recovery period percentages to
             determine depreciation. His first year depreciation is limited to $3,060, the second
             to $4,900, the third to $2,950, and the fourth and all succeeding years to $1,775
             using the tables for 2010.
             He cannot completely circumvent these limits by leasing the auto because the
             deductions for lease expenses are partially offset by a lease inclusion amount (from
             IRS tables) that is based on the fair market value of the auto at lease inception; this
             is designed to prevent taxpayers from taking advantage of leasing to avoid the
             depreciation limits. Taxpayers can compare the after-tax cost of leasing versus
             buying using present value concepts.

7. Mixed Use of Auto
   An employee uses her employer’s auto 75 percent for business use and 25 percent for personal
   use. The personal use is taxed to her as income. What percentage of the auto can the employer
   consider used for business and depreciate? Will your answer change if the employee’s
   business use decreases to only 35 percent?
   Solution: As long as the employer includes the value of the personal use of the auto in the
             employee’s income, the employer may treat the auto as used 100 percent for
             business and is not required to allocate depreciation to the business-use portion. The
             answer will not change if business use decreases to 35 percent as long as the value
             of personal use is included in the employee’s income. This would only make a
             difference if the auto was the employee’s and the employee was taking the
             depreciation deduction.
Crunch the Numbers
16. Basis for Depreciation
    Two years ago, Warren purchased a computer for $4,000. Until this year, he used it
    exclusively for personal purposes. At the beginning of the current year, Warren opened a
    consulting business and began using the computer solely for business purposes. At the time
    he began his business, Warren’s computer was worth $600. What basis must Warren use in
    calculating his depreciation on the computer?
    Solution: $600. Warren uses the lower of his basis or fair market value at the date the asset is
               converted from personal to business use.

17. Basis for Depreciation
    Last year, Anne purchased a condo unit for $125,000. She used the condo as her personal
    residence. In the current year, when the condo unit appraises at $132,000, Anne moves out
    and converts the condo to rental property. What basis can Anne use when computing her
    depreciation on the rental condo unit?
    Solution: $125,000. Anne uses the lower of her basis or fair market value at the date the
               condo is converted from personal to rental property.
                                   Chapter 6: Property Acquisitions and Cost Recovery Deductions 3


18. Gift Basis
    David received a gift of stock from Ted this year when the stock was worth $24,000. Ted
    purchased the stock for $18,000 five years ago and paid $2,000 of gift taxes on the gift. What
    is David’s basis for the stock?
    Solution: $18,500. David uses Ted’s basis increased by a portion of the gift tax related to the
               appreciation on the gift determined as follows:
               $2,000 gift tax x [($24,000 - $18,000)/$24,000] = $500 gift tax related to
               appreciation.
               $18,000 carryover basis from donor + $500 gift tax = $18,500.

19. Gift Basis
    Ellen received a gift of stock from Gisela this year when the stock was worth $50,000. Gisela
    purchased the stock for $60,000 four years ago. Calculate Ellen’s basis for the stock if she
    sells it
    a. for $65,000
    b. for $45,000
    c. for $55,000
    Solution: a. $60,000. The donor’s basis is always used to determine a gain.
               b. $50,000. Fair market value (when it is lower than the donor’s basis) is used to
               determine loss.
               c. $55,000. When the selling price is between the donor’s basis and the lower fair
               market value, there is no gain or loss. Effectively, basis equals the selling price.

20. MACRS Depreciation/Averaging Conventions
    Azona Corporation (a calendar-year taxpayer) purchased only one business asset during the
    current year, used 7-year property that cost $1,080,000. Compute Azona’s MACRS
    depreciation assuming that
    a. the asset was purchased and placed in service on September 30, 2010.
    b. the asset was purchased and placed in service on October 1, 2010.
    Solution: a. Azona’s first-year depreciation is $154,332 ($1,080,000 x 14.29%) regular
               MACRS depreciation. (Note that Azona is not eligible to claim Section 179
               expensing because it placed more than $1,050,000 property in service this year.)
               b. Azona’s first-year depreciation is $38,556 ($1,080,000 x 3.57% mid-quarter rate
               for a 4th quarter acquisition).

21. Depreciation/Section 179 Expensing with Bonus Depreciation
    In 2009, Lenux Corporation purchased $810,000 of new office furniture. Lenux claimed the
    maximum allowable depreciation deduction (including having made any allowable
    elections). Calculate Lenux’s total depreciation deduction for 2009 and 2010.
    Solution: The total depreciation deduction for 2009 was $565,726.50. $240,000 is the
               maximum that can be expensed under Section 179 ($250,000 less the excess of
               $810,000 over $800,000); bonus depreciation = $285,000 [$810,000 - $240,000) x
               50%]; regular MACRS depreciation = $40,726.50 [($810,000 - $240,000 -
               $285,000) x 14.29%]. Office furniture is 7-year property.
               The depreciation deduction for 2010 is $69,796.50 [($810,000 - $240,000 –
               $285,000) x 24.49%].
4 Solutions Manual for Taxation for Decision Makers




22. Depreciation/Section 179 Expensing
    Kondar Corporation spent $850,000 to purchase used machinery during 2010.
    a. What is the maximum that Kondar may elect to expense under Section 179 for the year?
    b. What is the basis for calculating regular MACRS depreciation on this machinery?
    c. What is Kondar’s maximum depreciation deduction for 2010?
    Solution: a. $200,000 ($250,000 less the excess of $850,000 over $800,000).
               b. $650,000 ($850,000 - $200,000).
               c. $292,885 ([$650,000 x 14.29%] + $200,000). The machinery is 7-year property.

23. Depreciation/Section 179 Expensing with Bonus Depreciation
    Corando Corporation purchased $340,000 of new factory equipment at the beginning of the
    year. Answer the following questions for the equipment if it was purchased in (1) 2009 or (2)
    2010.
    a. What is the maximum that Corando may elect to expense under Section 179 for the year?
    b. What is the basis for calculating bonus and regular MACRS depreciation on this
       equipment?
    c. What is Corando’s maximum depreciation deduction?
    Solution: a. $250,000 for 2009 and 2010.
               b. $90,000 ($340,000 - $250,000) basis for bonus depreciation and $45,000
               [$340,000 - $250,000 – ($90,000 x 50%) basis for regular depreciation for 2009.
               No bonus depreciation in 2010 so the basis for regular MACRS depreciation is
               $90,000 ($340,000 - $250,000).
               c. $301,430.50 [($45,000 x 14.29%) + ($90,000 x 50%) + $250,000] for 2009.
               $262,861 for 2010 [$250,000 + ($90,000 x 14.29%)].

24. Depreciation/Averaging Conventions for Fiscal-year Corporation
    Kensington Corporation, Inc. (an October 31 fiscal year-end corporation) plans to purchase
    $1,100,000 of used office fixtures (7-year property). This will be Kensington’s only
    personalty acquired during the year. Kensington’s management is willing to purchase and
    place the property in service anytime during the year to maximize its depreciation
    deductions.
    a. Compute the depreciation expense for the first year assuming all of the property is
       purchased and placed in service on June 19, 2010.
    b. Compute the depreciation expense for the first year, assuming all of the property is
       purchased and placed in service on September 19, 2010.
    c. What course of action do you recommend for Kensington?
    Solution: a. $157,190. The property is not eligible for the Section 179 expensing because the
              total investment exceeds $1,050,000. If placed in service in June, the half-year
              convention is used: $1,100,000 x 14.29% = $157,190.
              b. $39,270. The mid-quarter convention applies: $1,100,000 x 3.57% = $39,270.
              c. To maximize the first-year deduction the property should be placed in service
              sometime prior to August 1 to avoid the mid-quarter convention.

25. Depreciation of Realty
    Tatum Corporation (a calendar-year taxpayer) purchases a building on June 6 of the current
                                   Chapter 6: Property Acquisitions and Cost Recovery Deductions 5


   year for $300,000, of which $60,000 is for the land. What is the depreciation for the first year
   if the building is
   a. a warehouse?
   b. a rental apartment building?
   Solution: a. $3,338 ($240,000 x 1.391%). This is 39-year property placed in service in
               month 6.
               b. $4,728 ($240,000 x 1.97%). This is 27½-year property placed in service in
               month 6.

26. Depreciation in Disposal Year
    At the beginning of 2010, AB Corporation (a calendar-year corporation) owned the following
    assets:
                                    Office Furniture Computer Equipment
      Date placed in service           11/15/07              4/15/06
      Initial cost                      $20,000              $10,000
      Accumulated depreciation          $10,160               $8,272
      Recovery period                    7-year               5-year
      Averaging convention            Mid-quarter           Half-year
    On February 1, 2010, AB sold its office furniture. On March 15, 2010, AB sold its computer
    equipment. Compute AB Corporation’s depreciation deduction for 2010 for these two assets.
    Solution: Office Furniture: $352 ($20,000 x 14.06% x 1.5/12)
                Computer Equipment: $576 ($10,000 x 11.52% x ½)

27. Section 179 Expensing Limitation and Bonus Depreciation
    On March 1, 2009, the Harry Corporation purchased and placed in service office furniture
    costing $350,000. Compute the maximum amount Harry Corporation could elect to expense
    under Section 179 and claim as bonus depreciation for this furniture in 2009 if
    a. this is new furniture and it is the only asset placed in service this year by Harry
       Corporation.
    b. in addition to the $350,000 of new office furniture, Harry Corporation also acquired and
       placed in service $950,000 of new factory equipment during the year.
    c. this is used furniture and in addition to this $350,000 of used office furniture, Harry
       Corporation also acquired and placed in service $600,000 of new factory equipment
       during the year.
    d. What is Harry Corporation’s total depreciation expense deduction for 2009 for each of the
       above scenarios?
    e. Determine the answers to a. through d. if Harry Corporation purchased the $350,000 of
       equipment on March 1, 2010 instead of 2009.
    Solution: a. $250,000 Section 179 expensing and $50,000 [($350,000 - $250,000) x 50%]
              bonus depreciation.
               b. $175,000 ($350,000 x 50%) bonus depreciation but no Section 179 expensing is
               permitted because Harry Corporation placed more than $1,050,000 of eligible
               property in service this year.
               c. $100,000 ($250,000 - [($350,000 + $600,000) - $800,000] Section 179
               expensing but no bonus depreciation is permitted because the furniture is used
               property.
6 Solutions Manual for Taxation for Decision Makers


               d.     (a) Total depreciation for 2009 is $307,145 [($250,000 Section 179 +
                      $50,000 bonus depreciation + ($50,000 x 14.29% = $7,145 regular
                      MACRS depreciation)]
                       (b) Total depreciation for 2009 is $742,885. Depreciation for the new
                      office furniture is $200,007.50 [$175,000 bonus depreciation + ($175,000
                      x 14.29% = 25,007.50 regular MACRS depreciation)]. Depreciation for the
                      other $950,000 of new factory equipment acquired in 2009 is $542,877.50
                      [$950,000 x 50% bonus depreciation = $475,000) + ($475,000 x 14.29% =
                      67,877.50 regular MACRS depreciation).
                      (c) Total depreciation for 2009 is $478,595. Depreciation for the used
                      office furniture is $135,725 [$100,000 Section 179 expensing + ($250,000
                      x 14.29% = $35,725 regular MACRS depreciation)]. Depreciation for the
                      $600,000 of new factory equipment is $342,870 [($600,000 x 50% =
                      $300,000 bonus depreciation) + ($300,000 x 14.29% = $42,870 regular
                      MACRS depreciation].
               e.     (a) $250,000 Section 179 expensing; no bonus depreciation allowed in
                      2010.
                      (b) No Section 179 expensing is permitted because Harry Corporation
                      placed more than $1,050,000 of eligible property in service this year; no
                      bonus depreciation in 2010.
                      (c) $100,000 Section 179 expensing ($250,000 – [($350,000 + $600,000) -
                      $800,000]. No bonus depreciation in 2010.
                      (d) (a) Total depreciation for 2010 is $264,290 [($250,000 Section 179 +
                           ($100,000 x 14.29% = $14,290 regular MACRS depreciation)]
                           (b) Total depreciation for 2010 is $185,770. Depreciation for the new
                           office furniture is $50,015 ($350,000 x 14.29% regular MACRS
                           depreciation)]. Depreciation for the other $950,000 of new factory
                           equipment acquired in 2010 is $135,755 ($950,000 x 14.29% regular
                           MACRS depreciation).
                           (c) Total depreciation for 2010 is $221,465. Depreciation for the used
                           office furniture is $135,725 [$100,000 Section 179 expensing +
                           ($250,000 x 14.29% = $35,725 regular MACRS depreciation)].
                           Depreciation for the $600,000 of new factory equipment is $85,740
                           ($600,000 x 14.29% regular MACRS depreciation).


28. Depreciation/Section 179 Expensing Limitation
    David operates his business as a sole proprietorship. In 2010, he spends $20,000 for a new
    machine (7-year property). His business income, before consideration of any Section 179
    deduction, is $17,000. David elects to expense $20,000 under Section 179. Calculate his total
    depreciation deduction for 2010.
    Solution: $17,000. David’s current-year Section 179 expense deduction is limited to his
               $17,000 of net income before the deduction. He will have a Section 179 carryover
               of $3,000 that he can use in the following year subject to similar net income
               limitations.
                                    Chapter 6: Property Acquisitions and Cost Recovery Deductions 7


32. Auto lease
    Trish entered into a 36-month lease of an automobile on January 1. She uses it 90 percent for
    business use and 10 percent for personal use. The fair market value of the automobile at the
    inception of the lease is $50,000. She made 12 monthly lease payments of $650 during the
    year.
    a. What Trish’s deduction for lease payments made during the year?
    b. What is the lease inclusion amount that Trish must include in her gross income this year?
    c. How would your answer to (b) change if the fair market value of the automobile was only
       $15,000?
    Solution: a. $650 x 12 x 90% = $7,020.
               b. $67 x 90% = $60.30 (using the lease inclusion tables for 2010).
               c. Trish would have no lease inclusion amount. The lease inclusion rules only
               apply to autos with a fair market value exceeding $16,700 for 2010.

34. Intangible Asset Amortization
    Orange Corporation acquires all of the assets of Apple Company for $10,000,000. The fair
    market value of the tangible assets totaled $8,000,000. The $2,000,000 difference is
    considered goodwill. Orange Corporation expects to continue its business operations for at
    least 40 years. What is the annual amount of amortization for the goodwill?
    Solution: $2,000,000/15 = $133,333 per year

36. Cost Depletion
    Goldrush Corporation bought a mine in year 1 for $90,000 and estimated that there were
    100,000 tons of ore to be extracted. In year 1, it mined 8,000 tons and sold 7,000 tons. In
    year 2, it mined 7,000 and sold the remaining 1,000 tons from year 1 and 6,500 of the ore
    mined in year 2. At the end of year 2, Goldrush Corporation estimated that, including the ore
    extracted but unsold, there were 160,000 tons of ore remaining. Compute the allowable cost
    depletion for year 1 and year 2.
    Solution: Year 1 = $6,300; year 2 = $3,748
               $90,000/100,000 tons = $.90 depletion rate;
               Year 1 cost depletion = $.90 x 7,000 units sold = $6,300
               ($90,000 - $6,300)/167,500* = $.4997 adjusted depletion rate;
               Year 2 cost depletion = $.4997 x 7,500 tons = $3,748
               *The $7,500 sold during the year must be added to the ending estimate of ore
               remaining to determine the depletion rate.

Think Outside the Text
These questions require answers that are beyond the material that is covered in this chapter.
45. Web Site Development Costs
    Your friend is thinking about starting up a new Internet business and would like to know how
    Web site development costs are treated for tax purposes. What are some of the costs involved
    in Web site development and what are the issues involved in determining their tax treatment?
    Solution: To operate a Web site, a business must acquire the appropriate computer hardware
              by either purchasing a Web server or renting space on a Web server from a hosting
              service or Internet service provider. If a business chooses to purchase the
8 Solutions Manual for Taxation for Decision Makers


              hardware, the company can depreciate the cost of the hardware as five-year
              recovery property. If a business chooses to outsource its hardware needs, then the
              lease payments are ordinary and necessary business expenses and are currently
              deductible.
              Determining the proper treatment of software costs is a little more complex.
              Software costs can be divided into two broad categories: developed software and
              purchased software. Developed software is software that is custom designed by a
              business for its own internal use. Purchased software may be a generic publicly
              available product or a software package designed by an outside consultant under
              circumstances where the consultant, rather than the company, bears the risk of
              failure. However, if the consultant provides services but the company bears the
              risk with regard to successful implementation, the expenses incurred should be
              regarded as the company’s software development costs. The costs of developing
              software are similar to research and experimental expenditures so the business can
              choose to either immediately expense (which is usually preferred) or amortize over
              60 months.
              If the software was purchased as part of a package or bundled with new hardware
              and not priced separately from the hardware, the business must recover the
              software costs over the useful life of the hardware which usually means five years.
              Therefore, buying software unbundled, meaning it is either not purchased with
              hardware or it is but its price is separately stated, generally results in a faster write
              off. The 2003 Tax Act made off-the-shelf software eligible to be expensed under
              Section 179. Software acquired as part of a business purchase is usually
              considered a Section 197 intangible and must be amortized over fifteen years.
              Many taxpayers use a combination of purchased and developed software, making
              it challenging to segregate the costs and apply the correct tax treatment. This can
              be even further complicated when an outside consultant provides services. It is
              important that expenses be carefully analyzed to determine whether the costs relate
              to the modification of purchased computer software or are simply installation
              costs. Costs incurred to modify purchased software are deductible, while
              installation costs must be capitalized.

47. Goodwill
    Is the treatment of purchased goodwill the same for tax and for GAAP? Explain.
    Solution: The treatment of goodwill for tax and GAAP differs. For tax purposes, goodwill is
                amortized over a period of 15 years.
                For financial accounting, the income statement is not charged unless goodwill has
                been impaired. To test for impairment, the fair value of the reporting unit is
                compared to the carrying amount of its net assets including goodwill. If the fair
                value of the reporting unit is greater, goodwill is considered not to be impaired and
                the company does nothing. If, however, the fair value is less than the carrying
                amount of the net assets, then the “implied value” of goodwill must be determined
                and compared to the recorded goodwill to determine if a charge is necessary.
                                   Chapter 6: Property Acquisitions and Cost Recovery Deductions 9


Develop Planning Skills

60. Depreciation
    Herald Corporation, a calendar-year taxpayer, purchased and placed the following business
    assets in service during 2010:
                            Asset              Date Placed in Service Initial Cost
                 New computer equipment              April 3              $ 50,000
                 Used office furniture               July 14               500,000
                 Used office fixtures               October 29             300,000
    Herald Corporation is also considering the purchase of $180,000 of additional new office
    furniture. It could wait until January to make the purchase, or it could buy the furniture and
    place it in service in December to try to increase its current-year tax depreciation deduction.
    What impact would this proposed purchase have on Herald's depreciation deduction for its
    year ending December 31, 2010?
   Solution: If the proposed new furniture purchase is made in December, Herald Corporation's
             depreciation for 2010 will be $193,268 lower than if the furniture is purchased in
             January. Therefore, the proposed purchase should be made in January.
             If the proposed new furniture purchase is postponed until January of 2011, the
             total depreciation deduction for 2010 is $295,740 computed as follows:
           New computer
             equipment            ($50,000 x 20%) =                                         $10,000
           Used office             $500,000 x 14.29% =                                       71,450
             furniture
           Used office fixtures $300,000 - $200,000 Sec. 179 expense = $100,000
                                  x 14.29% = $14,290 + $200,000 Section 179 =               214,290
            Total depreciation                                                             $295,740
             Only $200,000 can be expensed under Section 179 because Herald placed in
             service $850,000 of eligible property ($850,000 - $800,000 = $50,000 reduction in
             expensing limit). By electing to expense $200,000 of the used office fixtures under
             Section 179, the mid-quarter convention can be avoided [($300,000-
             $200,000)/($850,000 - $200,000) = 15.4%].
             Total depreciation will decrease if the new office furniture is placed in service in
             December. Herald will only be eligible for $20,000 [$250,000 – ($1,030,000 -
             $800,000)] of Section 179 expensing because its asset purchases now total
             $1,030,000. The mid-quarter convention will be required because more than 40
             percent of personalty will be placed in service in the last quarter of the year
             [($300,000 + $180,000 - $20,000)/($1,030,000 - $20,000) = 45.5%].
             If the proposed purchase is made in December, the depreciation for the assets
             using the mid-quarter convention would be as follows:
           New computer
             equipment             ($50,000 x 25%) =                                      $12,500
           Used office furniture $500,000 x 10.71% =                                       53,550
           Used office fixtures    $300,000 - $20,000 Section 179 expense =
                                   $280,000 x 3.57% = $9,996 + $20,000 Section
                                   179 expense =                                           29,996
10 Solutions Manual for Taxation for Decision Makers


            Subtotal                                                                 $96,046
            Proposed additional
             new office furniture ($180,000 x 3.57%) =                                 6,426
            Total depreciation                                                      $102,472
              The $102,472 total depreciation is $193,268 less than the amount ($295,740) that
              would be allowed if Herald Corporation postponed the purchase until January.
              Therefore, Herald should wait until January to make the acquisition.

				
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