Basic Tax Tax Depreciation

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					Basic Tax:
Tax Depreciation


  Professor Jack Williams
Overview: Policy
 The cost of acquiring property in a trade or
  business or property held for the production
  of income is generally a nondeductible capital
  expenditure if the property has a useful life of
  more than one year. IRC §263.
 Because the income tax is imposed on net
  income, it is appropriate to allow a deduction
  for the cost of the item of property that is used
  in producing income.
 The issue is when and in what manner a tax
  code permits the deduction.
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Overview cont’d
 Depreciation deduction has traditionally been
  used through spreading the cost of
  acquisition (basis less salvage value) over
  the useful life of the property. IRC §168.
 In 1981, Congress enacted the Accelerated
  Cost Recovery System (ACRS).
     Permitted the entire cost of qualifying property
      to be deducted over a period of time usually
      much shorter than an economic useful life.
      IRC §169(e).
                                                         3
Overview: Methods
 In 1986, the ACRS rules were modified,
   leaving a tax system with two (and possibly
   three) depreciation models that may be
   applicable –
  1.   Pre 1981: §167 depreciation rule
  2.   Post 1981/Pre 1986: Old ACRS rule
  3.   1986 on: Current ACRS rule
 A taxpayer may also elect to “expense” a
   capital expenditure of qualifying property up
   to a certain ceiling per tax year. IRC §179.

                                                   4
Overview: Treatment of Basis
 Basis of property that qualifies for
  depreciation deduction must be reduced by
  the amount of the deductions allowed or
  allowable for such deductions. IRC
  §1016(a)(2).




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Depreciation Deductions
 Depreciation deduction permitted in the
  amount of a “reasonable allowance” for the
  exhaustion, wear and tear, or obsolescence
  of property either used in a trade or business
  or held for the production of income. IRC
  §167(a).
 Deduction for depreciation not available for
  inventory, property held for sale to customers,
  or property used for personal purposes.
 Deduction permissible only where property is
  subject to exhaustion – not for real property.
                                                6
Reasonable Allowance
 For depreciation, reasonable allowance is a
  function of the following attributes:
     Basis (Cost)
     Salvage value
     Useful life
     Method of computation employed




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Basis (Cost)
 Depreciation deduction computed by
  reference to adjusted basis rules applied in
  calculating gain on sale. IRC §167(c).
 Property converted from personal to
  business:
      Basis is FMV at time of conversion or adjusted
       basis, whichever is lower.
 Mixed use property
   Must allocate basis between business and
    personal use with deduction for depreciation
    limited to business use.
                                                    8
Useful Life
 Length of time the property may be reasonably
  expected to be used in the taxpayer’s business.
      Not necessarily the period of time that the property
       may be useful in some other trade or business.
 In 1971, IRS issued useful life guidelines listing
  various properties to overcome fact-intensive
  inquiries.
      Taxpayer may rely on these guidelines without further
       proof of useful life
 If useful life is unascertainable or indefinite, such as
  antiques, no depreciation deduction permitted.

                                                               9
Useful Life: Intangible Assets
 Compare goodwill (no ascertainable useful life) with
  customer mailing list (ascertainable useful life).
 Congress has provided special rules for amortization
  (fancy name for depreciation of intangibles) of certain
  types of intangibles that allow the cost of the assets
  to be deducted over a 15 year period. IRC §197(a)
  and (c).
      Qualifying intangibles include goodwill, going concern
       value, business records, copyright or patent
      Taxpayer could not have created the asset. IRC
       §197(c)(2).

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Salvage Value
 Salvage value is the amount, determined at
  the time of acquisition, the property may be
  sold for at the end of its useful life to the
  taxpayer.
 Need not be scrap value – at the end of the
  property’s useful life to the taxpayer!
 Salvage value limits total depreciation
  deductions to adjusted basis minus salvage
  value under IRC §167.

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Methods of Computing Depreciation
 For depreciable property not covered by the
  ACRS rules, there are three methods of
  computing depreciation:
     Straight Line Method
     Declining Balance Method
     Sum of Years Digit Method




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Straight Line Method
 Method:
     Depreciable base is the item’s adjusted basis
      less its salvage value.
     Depreciable rate is the a fraction, the
      numerator of which is 1 and the denominator
      of which is the number of years of the item’s
      useful life.
 Result:
     Equal amount of depreciation deductions each
      year.
                                                      13
Example: Straight Line Method
 Property costs $10,000 with a salvage value
  of $2,000. Useful life of item in taxpayer’s
  hands is 5 years.
 Depreciation deduction per year is $1,600
  ($10,000-$2,000=$8,000) × (1/5). Reg.
  §1.167(b)-1.
 Total depreciation over useful life is $1,600
  per year over 5 years or $8,000. This is the
  check!

                                                  14
Declining Balance Method
 Method:
   Depreciable base of the item is adjusted basis
    reduced by depreciation deductions in prior
    years but not reduced by salvage value.
   Depreciation rate of the item is same fraction
    used by straight line method (numerator is 1
    and denominator is number of years of useful
    life) multiplied by a factor not exceeding 2.
         If the factor is 2, we call this method the double
          declining balance method
         If factor is 1.5, we call it the 150% method

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Declining Balance Method cont’d
     Although salvage value not taken into account
      in calculation depreciable base under this
      method, item may not be depreciated below
      salvage value.
     In each year of the item’s useful life, the
      depreciable base changes, but the
      depreciable rate remains constant. Reg.
      §1.167-(b)-2.
 Result:
     Accelerated depreciation deductions
                                                  16
   Example: Declining Balance Method
Property costs $10,000 with    Year Base    Rate     Allow
a salvage value of $2,000.
Useful life of item in                               ance
taxpayer’s hands is 5 years.
                               1   $10,000 40%       $4,000
*Even though the last
                                           (2×1/5)
deduction appears to be
$864, it is limited to $160    2   $6,000   40%      $2,400
because the salvage value
of the property is $2,000.
Thus, no depreciation
deduction in Year 5 at all.    3   $3,600   40%      $1,440

Total deductions = $8,000
                               4   $2,160   40%      $160*
                                                              17
Sum of Year Digits Method
 Method:
    Depreciable base of the item is the adjusted basis
     reduced by its salvage value.
    Depreciable rate of the item is a fraction, the numerator
     of which changes each year to the number of years
     remaining in the useful life of the item and the
     denominator of which is the sum of all digits in the
     useful life of the item.
    In each year of the item’s useful life, the depreciable
     base remains constant while the depreciable rate
     changes. Reg. §1-167(b)-3.
 Result:
    Accelerated depreciation deductions

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Example: Sum of Year Digits Method
                           Year   Base     Rate   Allowa
 Property costs $10,000                           nce
 with a salvage value of
 $2,000. Useful life of
                           1      $8,000   5/15   $2,667
 item in taxpayer’s
 hands is 5 years.
                           2      $8,000   4/15   $2,133

 Total deductions =
 $8,000                    3      $8,000   3/15   $1,600


                           4      $8,000   2/15   $1,067


                           5      $8,000   1/15   $533   19
Basis/Depreciation Deduction
Relationship
 Key – Basis must be reduced by amounts
 allowed (actually taken) or allowable (which
 could have been taken) as depreciation
 deduction.




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ACRS
 1981 version (Old ACRS) -- §168
 1986 version (Current ACRS) -- §168
 The purpose of ACRS was to permit faster
  deductions for depreciation under the §167
  situations and to reduce litigation.




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ACRS/General Depreciation
 Basic differences under ACRS:
   Useful life of property mostly irrelevant –
    property now generally assigned to 1 of 10
    classes with periods ranging from 3 to 50
    years.
   Salvage value irrelevant – 1005 of cost
    deductible.
   No distinction between old and new property.
   Only two methods for ACRS deductions –
    accelerated rate prescribed by statute or
    straight line method
                                                   22
ACRS: Tangible Property
 General attributes for depreciation found at
  §167 also apply to §168 ACRS.
 Limited to tangible property.




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Expensing Personal Property
 Taxpayer may elect to expense (as opposed to
    capitalize) the acquisition of certain personal
    property. IRC §179.
   Must reduce basis by deduction allowed.
   If you elect to expense only portion, you may
    depreciate the remainder of cost but must reduce
    basis by expensed costs first.
   Qualified property is generally personal property
    under §1245.
   Such property must be used in a trade or business;
    holding for production of income not good enough.
   Dollar limit: $100,000 with a §179(b)(1) and (2)
    limitation and taxable income limitation §179(b)(3).

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ACRS under IRC §168
 Tangible property
 Employ the following under §168:
     Applicable depreciation method
     Applicable recovery period
     Applicable convention concepts
 Generally mandatory and not elective where
  applicable



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Depreciation Method
 Generally, the double declining method switching to
  the straight line method in the taxable year in which
  the straight line method (applied to the adjusted basis
  as of the beginning of the year) produces a greater
  deduction than that computed under the double
  declining method. §168(b)(1).
 For property in the 15 and 20 year class, the 150%
  declining method is used in the manner described
  above. §168(b)(2).
 Taxpayer may irrevocably elect to employ straight
  line method as to all items in a particular class placed
  in service during the taxable year. §168(b)(5).
 Regardless of the method, salvage value is zero.
  §168(b)(4).
                                                         26
Recovery Period
 Determined by class reference.
 Six classification of personal property.
  §168(e)(1).
 IRS assigns property to one of six
  classifications based on “class life” which in
  turn is based on physical characteristics of
  the item and nature of trade or business in
  which it is used by the taxpayer. §168(i)(1).
 Class life is derived conceptually from notion
  of useful life under §167.

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Classifications: IRC §168(e)(1)
Property treated as: If such property has class life (in
                     years) of:
3-year property      4 or less

5-year property       More than 4 but less than 10

7-year property       10 or more but less than 16

10-year property      16 or more but less than 20

15-year property      20 or more but less than 25

20-year property      25 or more                           28
Convention
 Must place property subject to depreciation into
  service in a tax year.
 What do we do with a mid-year entry of an item into
  service?
 Three (two apply to personal property) conventions:
      Half-year – all property treated as placed in service
       mid-year (assess gaming the game!)
      Mid-quarter – if basis of property in last quarter
       exceeds 40% of total basis of property placed in
       service for the entire year, then must use mid-quarter.


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ACRS and Real Property
 Classification:
    Residential rental property
    Nonresidential real property

 Depreciation Method:
    Straight line method with salvage value set at zero

 Recovery Period:
    Residential – 27.5 years
    Nonresidential – 39 years

 Convention
    Mid-month convention


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Conclusion
 Questions???




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