CHAPTER 8

Depreciation, Cost Recovery, Amortization, and Depletion 8-5 ISCUSSION QUESTIONS

. If property which is classified as personalty is used in a trade or business or income producing activity, it is subject to cost recovery. Personalty that is held for personal use is not eligible for cost recovery. p. 8-3 . The basis of the property must be reduced by the amount of cost recovery that should have been deducted (i.e., the cost recovery allowable). p. 8-4 . Land is not eligible for cost recovery. However, improvements to the land such as landscaping are eligible for cost recovery. pp. 8-6 and 8-9 . The relevant issues for Henry are:

Can a portion of the purchase costs of a ski resort, which are allocated to the construction costs of the resorts mountain roads, trails, and slopes, be depreciated?

If such costs can be depreciated, what is the correct recovery period?

Can costs incurred subsequent to the purchase, attributable to maintenance of such mountain roads, trails, and slopes, be depreciated? pp. 8-5 and 8-9 . The relevant issues for Pale are:

What property qualifies for cost recovery?

Is the property used in Pales trade or business?

What is the cost recovery period for the property? pp. 8-5 and 8-9 . The half-year convention must be used for all MACRS personalty except when the mid- quarter convention applies. The mid-quarter convention must be used when more than 40% of the value of property, other than real property, is placed in service during the last quarter of the tax year. pp. 8-8 and 8-9 . The asset is treated as if it were sold in the middle of the year, and hence, one-half year of cost recovery is allowed for the year of the sale. p. 8-7 and Concept Summary 8-2 . Real property does not enter into the 40% test to determine whether the mid-quarter convention must be used for personalty. In addition, only personalty that is purchased in the fourth quarter is included in making the 40% determination. p. 8-8 . The asset is treated as if it were sold in the middle of the quarter, and hence, one-half quarter of cost recovery is allowed in the quarter of the sale. If the sale is in the first quarter, the fraction is 0.5/4; in the second quarter 1.5/4; in the third quarter 2.5/4; and in the fourth quarter 3.5/4. p. 8-9

10. The relevant tax issues for Jed are: Whether the costs associated with the tin added to the original bath mixture may be deducted as business expenses or must be capitalized. If the costs must be capitalized, what is the period of their cost recovery? Whether the costs associated with the additional tin added to the bath mixture may be deducted as business expenses or must be capitalized. pp. 8-1 to 8-9 11. The MACRS straight-line election may be made on a portion of the assets, but it must apply to all assets in a particular class. p. 8-10 12. Even if MACRS straight-line is elected, personal property is still subject to the mid- quarter convention if more than 40% of the value of property, other than real property, is placed in service during the last quarter of the tax year. pp. 8-10, 8-12, and Concept Summary 8-3 13. An asset used in connection with an individuals personal investments would not be an asset used in a trade or business. Therefore, the asset would not qualify for the 179 expensing election. Neither investment property nor personal use property is eligible for the 179 expensing election. Investment property is eligible for cost recovery, however. pp. 8-5 and 8-10 14. The basis of the asset is reduced by the 179 limited expensing deduction (after applying the $420,000 limitation and before the taxable income limitation) before computing the MACRS cost recovery. pp. 8-11 and 8-12 15. The 179 amount eligible for expensing in a carryforward year is limited to thelesser of (1) the statutory dollar amount $105,000 reduced by the cost of 179 property placed in service in excess of $420,000 in the carryforward year or (2) the business income limitation in the carryforward year. p. 8-11 16. Taxable income, for 179 purposes, is defined as the aggregate amount of taxable income of any trade or business of the taxpayer without regard to the amount expensed under 179. Therefore, the taxable income computation for purposes of the 179 limit includes the deduction for MACRS. pp. 8-11 and 8-12 17. The following issues are relevant for Ana: Is the new motor home inventory? Is the new motor home an asset subject to cost recovery? Does the new motor home qualify for the 179 expensing election? pp. 8-5, 8-6, and 8-10 18. An automobile is listed property and consequently must pass the predominantly business use test to be eligible for MACRS statutory percentage cost recovery. However, by weighing more than 6,000 pounds, the automobile is not subject to the statutory

dollar limits on cost recovery. However, the AJCA of 2004 provides that SUVs with a GVW between 6,000 pounds and 14,000 pounds are subject to a $25,000 ceiling in calculating the 179 expense rather than the normal ceiling for 2005 of $105,000. pp. 8-14 and 8-15 19. Passenger automobiles are subject to the statutory dollar limits on cost recovery regardless of whether they meet the more-than-50 percent business use test. p. 8-15 20. The purpose of the lease inclusion amount is to prevent taxpayers from circumventing the cost recovery dollar limitations by leasing instead of purchasing an automobile. The dollar amount is taken from an IRS table and is prorated for the number of days of the lease term included in the taxable year. This amount is then adjusted to reflect the business and income producing use of the automobile. pp. 8-17 and 8-18 21. The amortization period for a 197 intangible is 15 years regardless of the actual useful life. p. 8-20 22. Self-created goodwill is not eligible for amortization. For goodwill to qualify for amortization, it must be purchased. p. 8-20 23. The following issues are relevant for Orange Motors: Does the noncompete agreement come under 197 for intangibles? Was the noncompete agreement in connection with the acquisition of a trade or business? Can the cost of the noncompete agreement be amortized over a period other than the normal statutory period if the noncompete agreement is legally enforceable for a shorter period of time? What is the normal statutory period for amortizing intangibles? p. 8-20 24. Intangible drilling and development costs can either be written off as an expense in the year in which they are incurred or capitalized and written off through depletion. p. 8-22 25. To calculate cost depletion, the adjusted basis of the asset (e.g., mineral interest) is divided by the estimated recoverable units of the asset to arrive at the depletion per unit. The depletion per unit is then multiplied by the number of unitssold in that particular year to arrive at the deduction for depletion (assuming the percentage depletion amount is not larger). pp. 8-22 and 8-23 PROBLEMS 26. Cost of asset Less: Greater of allowed and allowable cost recovery: 2003 2004 Basis at the end of 2004 Less: Cost recovery for 2005 ($100,000 X 3.636% X .5/12) Basis on date of sale Gain on sale of asset ($98,000 $95,757) pp. 8-4, 8-9, and Table 8-8

$100,000 $ 455 3,636 (4,091) $ 95,909 (152) $95,757 $ 2,243

27. Joss basis for cost recovery is $175,000 because the fair market value of the house at the date of the conversion from personal use to rental property ($210,000) is greater than the $175,000 adjusted basis. p. 8-4 28. MACRS cost recovery ($150,000 X 14.29%) (Table 8-1) The property is 7-year property. Exhibit 8-1 pp. 8-5 to 8-9 29. MACRS cost recovery ($220,000 X .10) (Table 8-1) pp. 8-5 to 8-9 30. a. 2005 MACRS ($200,000 X 20%) (Table 8-1) b. 2006 MACRS cost recovery [$200,000 X 32% (Table 8-1) X 1/2] pp. 8-5 to 8-9 $21,435

$22,000

$40,000 $32,000

31. The mid-quarter convention must be used because the cost of the computers acquired in the 4th quarter exceeds 40% of the cost of all the personal property acquired during the year ($600,000/$140,000 = 43%). Furniture (7-year class) MACRS cost recovery ($50,000 X .1785) (Table 8-2) $ 8,925 Trucks (5-year class) MACRS cost recovery ($30,000 X .15) (Table 8-2) 4,500 Computers (5-year class) MACRS cost recovery ($60,000 X .05) (Table 8-2) 3,000 Total cost recovery $16,425 pp. 8-5 to 8-9 32. a. 1996: $850,000 X 1.177% (Table 8-8) b. 2005: $850,000 X 2.564% (Table 8-8) X 4.5/12 $8,173 pp. 8-9 and 8-10 $10,005