depreciation, cost recovery, amortization, and depletionatrc/mybooks/cwu/swaneys/winter 2017/4095...

Depreciation, Cost Recovery,Amortization, and Depletion

L E A R N I N G O B J E C T I V E S : After completing Chapter 8, you should be able to:

LO.1State the rationale for the cost consumption conceptand identify the relevant time periods fordepreciation, ACRS, and MACRS.

LO.2Determine the amount of cost recovery underMACRS.

LO.3Recognize when and how to make the § 179expensing election, calculate the amount of thededuction, and apply the effect of the election inmaking the MACRS calculation.

LO.4Identify listed property and apply the deductionlimitations on listed property and on luxuryautomobiles.

LO.5Determine when and how to use the alternativedepreciation system (ADS).

LO.6Report cost recovery deductions appropriately.

LO.7Identify intangible assets that are eligible foramortization and calculate the amount of thededuction.

LO.8Determine the amount of depletion expense, includ-ing being able to apply the alternative tax treatmentsfor intangible drilling and development costs.

LO.9Identify tax planning opportunities for cost recovery,amortization, and depletion.

C H A P T E R O U T L I N E

8-1 Depreciation and Cost Recovery, 8-38-1a Nature of Property, 8-38-1b Placed in Service Requirement, 8-38-1c Cost Recovery Allowed or Allowable, 8-38-1d Cost Recovery Basis for Personal Use Assets Converted

to Business or Income-Producing Use, 8-4

8-2 Modified Accelerated Cost Recovery System (MACRS):General Rules, 8-48-2a Personalty: Recovery Periods and Methods, 8-58-2b Realty: Recovery Periods and Methods, 8-88-2c Straight-Line Election, 8-9

8-3 Modified Accelerated Cost Recovery System (MACRS):Special Rules, 8-108-3a Additional First-Year Depreciation, 8-108-3b Election to Expense Assets (§ 179), 8-11

8-3c Business and Personal Use of Automobilesand Other Listed Property, 8-12

8-3d Alternative Depreciation System (ADS), 8-17

8-4 Reporting Procedures, 8-18

8-5 Amortization, 8-19

8-6 Depletion, 8-228-6a Intangible Drilling and Development Costs (IDCs), 8-238-6b Depletion Methods, 8-23

8-7 Tax Planning, 8-258-7a Cost Recovery, 8-258-7b Amortization, 8-278-7c Depletion, 8-278-7d Cost Recovery Tables, 8-28

C H A P T E R

8

THE BIG PICTURE

CALCULATING COST RECOVERY DEDUCTIONS

Dr. Cliff Payne purchased and placed in service $612,085 of new fixed assets in his dental practice during

the current year.

Office furniture and fixtures $ 70,000

Computers and peripheral equipment 67,085

Dental equipment 475,000

Using his financial reporting system, he concludes that the depreciation expense on Schedule C of Form

1040 is $91,298.

Office furniture and fixtures ($70,000 � 14.29%) $10,003

Computers and peripheral equipment ($67,085 � 20%) 13,417

Dental equipment ($475,000 � 14.29%) 67,878

$91,298

In addition, this year Dr. Payne purchased another personal residence for $300,000 and converted his

original residence to rental property. He also purchased a condo in the prior year for $170,000 near his

office that he is going to rent to a third party.

Has Dr. Payne correctly calculated the depreciation expense for his dental practice? Will he be able to

deduct any depreciation expense for his rental properties?

Read the chapter and formulate your response.

ª ERSLER DMITRY/SHUTTERSTOCK.COM

8-1

FRAMEWORK 1040 Tax Formula for Individuals

This chapter coversthe boldfaced portionsof the Tax Formulafor Individuals thatwas introduced inConcept Summary 3.1on p. 3-3. Belowthose portions arethe sections of Form1040 where the resultsare reported.

Income (broadly defined) .......................................................................................................... $xx,xxx

Less: Exclusions ..................................................................................................................... (x,xxx)

Gross income.......................................................................................................................... $xx,xxx

Less: Deductions for adjusted gross income......................................................................... (x,xxx)

FORM 1040 (p. 1)

12 Business income or (loss). Attach Schedule C or C-EZ . . . . . . . . . .

Adjusted gross income............................................................................................................ $xx,xxx

Less: The greater of total itemized deductions or the standard deduction................................ (x,xxx)

Personal and dependency exemptions ........................................................................... (x,xxx)

Taxable income ...................................................................................................................... $xx,xxx

Tax on taxable income (see Tax Tables or Tax Rate Schedules) ................................................. $ x,xxx

Less: Tax credits (including income taxes withheld and prepaid) ................................................ (xxx)

Tax due (or refund) ................................................................................................................. $ xxx

T he Internal Revenue Code allows a depreciation, cost recovery, amortization,or depletion deduction based on an asset’s cost. These deductions are applica-tions of the recovery of capital doctrine (discussed in Chapter 4). Cost recovery

deductions are based on the premise that the asset acquired (or improvementmade) benefits more than one accounting period. Otherwise, the expenditure isdeducted in the year incurred.1

Congress completely overhauled the depreciation rules in 1981 by creating theaccelerated cost recovery system (ACRS) , which shortened depreciable lives andallowed accelerated depreciation methods. In 1986, Congress made substantial modifi-cations to ACRS, which resulted in the modified accelerated cost recovery system(MACRS) . Tax professionals use the terms depreciation and cost recovery inter-changeably. Concept Summary 8.1 provides an overview of the various depreciationsystems and the time frames involved.

Concept Summary 8.1Depreciation and Cost Recovery: Relevant Time Periods

System Date Property Is Placed in Service

Pre-1981 depreciation Before January 1, 1981, and certain property placed in service afterDecember 31, 1980.

Accelerated cost recovery system (ACRS) After December 31, 1980, and before January 1, 1987.

Modified accelerated cost recovery system (MACRS) After December 31, 1986.

1See Chapter 6 and the discussion of capitalization versus expense.

8-2 PART 3 Deductions and Credits

The statutory changes that have taken place since 1980 have widened the gap thatexists between the accounting and tax versions of depreciation. The tax rules that existedprior to 1981 were much more compatible with generally accepted accounting principles.

This chapter focuses on the MACRS rules because they cover more recent propertyacquisitions (i.e., after 1986).2 The chapter concludes with a discussion of the amortizationof intangible property and startup expenditures and the depletion of natural resources.

Taxpayers may “write off” (deduct) the cost of certain assets that are used in a tradeor business or held for the production of income. A write-off may take the form ofdepreciation (or cost recovery), depletion, or amortization. Tangible assets, other thannatural resources, are depreciated. Natural resources, such as oil, gas, coal, and timber,are depleted. Intangible assets, such as copyrights and patents, are amortized. Gener-ally, no write-off is allowed for an asset that does not have a determinable useful life.

8-1 DEPRECIATION AND COST RECOVERY

8-1a Nature of PropertyProperty includes both realty (real property) and personalty (personal property). Realtygenerally includes land and buildings permanently affixed to the land. Personalty isdefined as any asset that is not realty.3 Do not confuse personalty (or personal property)with personal use property. Personal use property is any property (realty or personalty)that is held for personal use rather than for use in a trade or business or an income-producing activity. Cost recovery deductions are not allowed for personal use assets.

In summary, both realty and personalty can be either business use/income-producing property or personal use property. Examples include:

• A residence (realty that is personal use),

• An office building (realty that is business use),

• A dump truck (personalty that is business use), and

• Common wearing apparel (personalty that is personal use).

It is imperative that this distinction between the classification of an asset (realty orpersonalty) and the use to which the asset is put (business or personal) be understood.

Assets used in a trade or business or for the production of income are eligible for costrecovery if they are subject to wear and tear, decay or decline from natural causes, orobsolescence (e.g., an automobile that the taxpayer rents to third parties). Assets that donot decline in value on a predictable basis or that do not have a determinable useful life(e.g., land, stock, and antiques) are not eligible for cost recovery.

8-1b Placed in Service RequirementThe key date for the commencement of depreciation is the date an asset is placed inservice. This date, and not the purchase date of an asset, is relevant. This distinction isparticularly important for an asset that is purchased near the end of the tax year, butnot placed in service until after the beginning of the following tax year.

8-1c Cost Recovery Allowed or AllowableThe basis of cost recovery property is reduced by the cost recovery allowed (and by notless than the allowable amount). The allowed cost recovery is the cost recovery actuallydeducted, whereas the allowable cost recovery is the amount that could have beentaken under the applicable cost recovery method. If the taxpayer does not claim anycost recovery on property during a particular year, the basis of the property still isreduced by the amount of cost recovery that should have been deducted (the allowablecost recovery).

2§ 168. The terms depreciation and cost recovery are used interchangeably in thetext and in § 168. The ACRS rules and the pre-1981 rules are covered in theonline appendix Depreciation and the Accelerated Cost Recovery System (ACRS).

3Refer to Chapter 1 (text Section 1-5a) for further discussion.

LO.1

State the rationale for thecost consumption conceptand identify the relevant timeperiods for depreciation,ACRS, and MACRS.

CHAPTER 8 Depreciation, Cost Recovery, Amortization, and Depletion 8-3

8-1d Cost Recovery Basis for Personal Use AssetsConverted to Business or Income-Producing UseIf personal use assets are converted to business or income-producing use, the basis forcost recovery and for loss is the lower of the adjusted basis or the fair market value atthe time the property was converted. As a result of this lower-of basis rule, losses thatoccurred while the property was personal use property are not recognized for taxpurposes through the cost recovery of the property.

8-2 MODIFIED ACCELERATED COST RECOVERYSYSTEM (MACRS): GENERAL RULES

Under the modified accelerated cost recovery system (MACRS), the cost of an asset isrecovered over a predetermined period that generally is shorter than the useful life ofthe asset or the period that the asset is used to produce income. The MACRS rules weredesigned to encourage investment, improve productivity, and simplify the pertinent lawand its administration.

MACRS provides separate cost recovery systems for realty and personalty. Based oncost recovery periods (called class lives), methods, and conventions specified in the Inter-nal Revenue Code, the IRS provides tables that identify cost recovery allowances forpersonalty and for realty. Excerpts from those tables are provided in text Section 8-7d.

Concept Summary 8.2 provides an overview of the class lives, methods, and conven-tions that apply under MACRS.

E XAMP L E

1

On March 15, year 1, Jack purchased a copier, to use in his business, for $10,000. The copieris 5-year property, and Jack elected to use the straight-line method of cost recovery. Jackmade the election because the business was a new undertaking and he reasoned that inthe first few years of the business, a large cost recovery deduction was not needed.

Because the business was doing poorly, Jack did not even claim any cost recovery deductions in years3 and 4. In years 5 and 6, Jack deducted the proper amount of cost recovery. Therefore, the allowed costrecovery (cost recovery actually deducted) and the allowable cost recovery are computed as follows.

Cost Recovery Allowed Cost Recovery Allowable

Year 1 $1,000 $1,000

Year 2 2,000 2,000

Year 3 –0– 2,000

Year 4 –0– 2,000

Year 5 2,000 2,000

Year 6 1,000 1,000

If Jack sold the copier for $800 in year 7, he would recognize an $800 gain ($800 amount realized�$0 adjusted basis); the adjusted basis of the copier is zero ($10,000 cost� $10,000 total allowablecost recovery in years 1 through 6).

E XAMP L E

The Big Picture

2

Return to the facts of The Big Picture on p. 8-1. Five years ago, Dr. Payne purchased a personal resi-dence for $250,000. In the current year, with the housing market down, Dr. Payne found a largerhome that he acquired for his personal residence. Because of the downturn in the housing market,however, he was not able to sell his original residence and recover his purchase price of $250,000.The residence was appraised at $180,000.

Instead of continuing to try to sell the original residence, Dr. Payne converted it to rental prop-erty. The basis for cost recovery of the rental property is $180,000 because the fair market value isless than the adjusted basis. The $70,000 decline in value is deemed to be personal (because itoccurred while the property was held for personal use by Dr. Payne) and therefore nondeductible.

LO.2

Determine the amount of costrecovery under MACRS.


8-2a Personalty: Recovery Periods and Methods

Classification of PropertyMACRS provides that the cost recovery basis of eligible personalty (and certain realty) isrecovered over 3, 5, 7, 10, 15, or 20 years. Property is classified by recovery periodunder MACRS through the use of Asset Depreciation Range (ADR) midpoint lives issuedby the IRS.4 See Exhibit 8.1 for examples of assets in each class.5

Accelerated depreciation is allowed for these six MACRS classes of property. Doubledeclining balance is used for the 3-, 5-, 7-, and 10-year classes, with a switchover tostraight-line depreciation when the latter computation yields a larger amount. Costrecovery for the 15- and 20-year classes is based on the 150-percent declining balance

E X H I B I T 8.1 Cost Recovery Periods: MACRS Personalty

PropertyClass

Generally Includes Assets with theFollowing ADR Lives Examples

3-year 4 years or less Tractor units for use over-the-road

A racehorse that is more than 2 years old, or any other horse that is more than12 years old, at the time it is placed in service

Special tools used in the manufacturing of motor vehicles, such as dies,fixtures, molds, and patterns

5-year More than 4 years and less than 10 years Automobiles and taxis

Light and heavy general-purpose trucks

Calculators and copiers

Computers and peripheral equipment

Rental appliances, furniture, carpets

7-year 10 years or more and less than 16 years Office furniture, fixtures, and equipment

Agricultural machinery and equipment

10-year 16 years or more and less than 20 years Vessels, barges, tugs, and similar water transportation equipment

Assets used for petroleum refining or for the manufacture of grain and grain millproducts, sugar and sugar products, or vegetable oils and vegetable oil products

Single-purpose agricultural or horticultural structures

15-year 20 years or more and less than 25 years Land improvements

Assets used for industrial steam and electric generation and/or distribution systems

Assets used in the manufacture of cement

20-year 25 years or more Farm buildings except single-purpose agricultural and horticultural structures

Water utilities

Concept Summary 8.2MACRS: Class Lives, Methods, and Conventions

Personalty Realty

Class lives 3 to 20 years Residential: 27.5 yearsNonresidential: 39 years

Method 200% declining balance for property with class livesless than 15 years

150% declining balance for property with15- or 20-year class lives

Straight-line

Convention Half-year or mid-quarter Mid-month

4Personalty is assigned to recovery classes based on asset depreciation range(ADR) midpoint lives (Rev.Proc. 87–56, 1987–2 C.B. 674). ADR lives gener-ally represent estimates of an asset’s useful economic life.

5§ 168(e).


method, with an appropriate straight-line switchover.6 The appropriate computationmethods and conventions are built into the tables, so it is not necessary to calculate theappropriate percentages.

To determine the amount of the cost recovery allowances, identify the asset by class andgo to the appropriate table for the percentage. The MACRS percentages for personaltyappear in Exhibit 8.3 (see text Section 8-7d). Concept Summary 8.3 provides an overview ofthe various conventions that apply under the MACRS statutory percentage method.

Taxpayers may elect the straight-line method to compute cost recovery allowancesfor each of these classes of property. Certain property is not eligible for accelerated costrecovery and must be depreciated under an alternative depreciation system (ADS). Boththe straight-line election and ADS are discussed later in the chapter.

MACRS views property as placed in service in the middle of the asset’s first year (thehalf-year convention ).7 Thus, for example, the statutory recovery period for propertywith a life of three years begins in the middle of the year an asset is placed in serviceand ends three years later. In practical terms, this means that taxpayers must wait anextra year to recover the full cost of depreciable assets. That is, the actual write-offs areclaimed over 4, 6, 8, 11, 16, and 21 years. MACRS also allows for a half-year of costrecovery in the year of sale or retirement.

FINANCIAL DISCLOSURE INSIGHTS Tax and Book Depreciation

A common book-tax difference relates to thedepreciation amounts that are reported for GAAP andFederal income tax purposes. Typically, tax depreciationdeductions are accelerated; that is, they are claimed inearlier reporting periods than is the case for financialaccounting purposes.

Almost every tax law change since 1980 has includeddepreciation provisions that accelerate the related deductionsrelative to the expenses allowed under GAAP. Accelerated

cost recovery deductions represent a means by which thetaxing jurisdiction infuses the business with cash flow createdby the reduction in the year’s tax liabilities.

For instance, recently, about one-quarter of General Elec-tric’s deferred tax liabilities related to depreciation differences.For Toyota’s and Ford’s depreciation differences, that amountwas about one-third. And for the trucking firm Ryder Systems,depreciation differences accounted for all but 1 percent of thedeferred tax liabilities.

E XAMP L E

3

Half-Year Convention

Kareem acquires a 5-year class asset on April 10, 2016, for $30,000. Kareem’s cost recovery deduc-tion for 2016 is computed as follows.

MACRS cost recovery [$30,000 � .20 (Exhibit 8.3)] $6,000

Concept Summary 8.3Statutory Percentage Method under MACRS

Personal Property Real Property*


Cost recovery deduction in theyear of disposition**

Half-year for year of sale orhalf-quarter for quarter of sale

Half-month for month of sale

*Straight-line method must be used.**A disposition can include a sale, exchange, abandonment, or retirement. For simplicity, we will assume a sale in this

chapter.

6§ 168(b). 7§ 168(d)(4)(A).


Mid-Quarter ConventionThe half-year convention arises from the simplifying presumption that assets gener-ally are acquired at an even pace throughout the tax year. However, Congress wasconcerned that taxpayers might defeat that presumption by placing large amounts ofproperty in service towards the end of the taxable year (and, by doing so, receive ahalf-year’s depreciation on those large, end-of-year acquisitions).

To inhibit this behavior, Congress added the mid-quarter convention that applies ifmore than 40 percent of the value of property other than eligible real estate (discussedin a later section) is placed in service during the last quarter of the year.8 Under this con-vention, property acquisitions are grouped by the quarter they were acquired for costrecovery purposes. Acquisitions during the first quarter are allowed 10.5 months (threeand one-half quarters) of cost recovery; the second quarter, 7.5 months (two and one-half quarters); the third quarter, 4.5 months (one and one-half quarters); and the fourthquarter, 1.5 months (one-half quarter). The percentages are shown in Exhibit 8.4.

E XAMP L E

5

Silver Corporation acquires the following new 5-year class property in 2016.

Property Acquisition Dates Cost

February 15 $ 200,000

July 10 400,000

December 5 600,000

Total $1,200,000

Under the statutory percentage method, Silver’s cost recovery allowances for the first two yearsare computed below. Because more than 40% ($600,000/$1,200,000 ¼ 50%) of the acquisitionsare in the last quarter, the mid-quarter convention applies.

2016

Mid-Quarter ConventionDepreciation (Exhibit 8.4)

TotalDepreciation

February 15 $200,000 � .35 $ 70,000

July 10 $400,000 � .15 60,000

December 5 $600,000 � .05 30,000

$160,000

2017

Mid-Quarter ConventionDepreciation (Exhibit 8.4)

TotalDepreciation

February 15 $200,000 � .26 $ 52,000

July 10 $400,000 � .34 136,000

December 5 $600,000 � .38 228,000

$416,000

Without the mid-quarter convention, Silver’s 2016 MACRS deduction would have been$240,000 [$1,200,000 � .20 (Exhibit 8.3)]. The mid-quarter convention slows down the taxpayer’savailable cost recovery deductions.

E XAMP L E

4

Assume the same facts as in Example 3. Kareem sells the asset on March 5, 2018. Kareem’s costrecovery deduction for 2018 is $2,880 [$30,000� 1=2 � :192 (Exhibit 8.3)].

8§ 168(d)(3).


When “mid-quarter” property is sold, the property is treated as though it were sold atthe midpoint of the quarter. So in the quarter when sold, cost recovery is allowed forone-half of the quarter.

8-2b Realty: Recovery Periods and MethodsUnder MACRS, the cost recovery period for residential rental real estate is 27.5 years, and thestraight-line method is used. Residential rental real estate includes property where 80 percentor more of the gross rental revenues are from residential units (e.g., an apartment building).Hotels, motels, and similar establishments are not residential rental property. Low-incomehousing is classified as residential rental real estate. Nonresidential real estate uses a recov-ery period of 39 years; it also is depreciated using the straight-line method.9

Some items of real property are not treated as real estate for purposes of MACRS. Forexample, single-purpose agricultural structures are in the 10-year MACRS class. Landimprovements are in the 15-year MACRS class.

All eligible real estate is depreciated using the mid-month convention .10 Regardlessof when the property is placed in service, it is deemed to have been placed in service at

E XAMP L E

6

Assume the same facts as in Example 5, except that Silver Corporation sells the $400,000 asset onNovember 30, 2017. The cost recovery allowance for 2017 is computed as follows (Exhibit 8.4).

February 15 $200,000 � .26 $ 52,000

July 10 $400,000 � .34 � (3.5/4) 119,000

December 5 $600,000 � .38 228,000

Total $399,000

E XAMP L E

The Big Picture

7

Return to the facts of The Big Picture on p. 8-1. If the placed-in-service date for the office furnitureand fixtures and computers and peripheral equipment is September 29 and the placed-in-servicedate for the dental equipment is October 3, Dr. Payne’s total cost recovery is computed as follows.

Office furniture and fixtures:

MACRS cost recovery $70,000 � .1071 (Exhibit 8.4) $ 7,497

Computers and peripheral equipment:

MACRS cost recovery $67,085 � .15 (Exhibit 8.4) 10,063

Dental equipment:

MACRS cost recovery $475,000 � .0357 (Exhibit 8.4) 16,958

Total cost recovery $ 34,518

Note the implications of the mid-quarter convention. If the dental equipment had been placedin service before October 1 (the beginning of the fourth quarter), the total cost recovery deductionwould have been $91,298 (p. 8-1).

TAX IN THE NEWS Cost Segregation

Cost segregation identifies certain assets withina commercial property that can qualify for shorter depreciationschedules than the building itself. The identified assets are clas-sified as 5-, 7-, or 15-year property, rather than 39-year property,as part of the building. This allows for greater accelerated

depreciation, which reduces taxable income and hence the taxliability.

For instance, a telecommunications system might be segre-gated from the building in which it is installed. This allows thesystem to be depreciated over 5 or 7 years, instead of 39 years.

9§§ 168(b), (c), and (e). A 31.5-year life is used for such property placed inservice before May 13, 1993.

10§ 168(d)(1).


the middle of the month. This allows for one-half month’s cost recovery for the monththe property is placed in service. If the property is sold before the end of the recoveryperiod, one-half month’s cost recovery is permitted for the month of sale (no matterwhen the property is sold).

Cost recovery is computed by multiplying the applicable rate (Exhibit 8.8) by the costrecovery basis.

8-2c Straight-Line ElectionAlthough MACRS requires straight-line depreciation for all eligible real estate, the tax-payer may elect to use the straight-line method for depreciable personal property.11

The property is depreciated using the class life (recovery period) of the asset witha half-year convention or a mid-quarter convention, whichever applies. The electionis available on a class-by-class and year-by-year basis (see Concept Summary 8.4).The percentages for the straight-line election with a half-year convention appear inExhibit 8.5.

E XAMP L E

8

Real Estate Cost Recovery

Alec acquired a building on April 1, 1999, for $800,000. If the building is classified as residentialrental real estate, the cost recovery deduction for 2016 is $29,088 (:03636� $800,000).

If the building is sold on October 7, 2016, the cost recovery deduction for 2016 is $23,028[:03636� (9:5=12)� $800,000]. (See Exhibit 8.8 for percentage.)

E XAMP L E

10

Mark acquired a building on November 19, 2016, for $1.2 million. If the building is classified asnonresidential real estate, the cost recovery deduction for 2016 is $3,852 [:00321� $1,200,000(Exhibit 8.8)]. The cost recovery deduction for 2017 is $30,768 [:02564� $1,200,000 (Exhibit 8.8)].

If the building is sold on May 21, 2017, the cost recovery deduction for 2017 is $11,538[:02564� (4:5=12)� $1,200,000 (Exhibit 8.8)].

E XAMP L E

9

Jane acquired a building on March 2, 1993, for $1 million. If the building is classified as non-residential real estate, the cost recovery deduction for 2016 is $31,740 (:03174 � $1,000,000).

If the building is sold on January 5, 2016, the cost recovery deduction for 2016 is $1,323[:03174� (:5=12)� $1,000,000]. (See Exhibit 8.8 for percentage.)

Concept Summary 8.4Straight-Line Election under MACRS

Personal Property Real Property*


Cost recovery deduction in theyear of disposition**

Half-year for year of saleor half-quarter for quarterof sale

Half-month for month of sale

Elective or mandatory Elective Mandatory

Breadth of election Class by class

*Straight-line method must be used.**A disposition can include a sale, exchange, abandonment, or retirement. For simplicity, we will assume a sale in this

chapter.

11§ 168(b)(5).


8-3 MODIFIED ACCELERATED COST RECOVERYSYSTEM (MACRS): SPECIAL RULES

8-3a Additional First-Year DepreciationAs noted in Chapter 1, Congress uses the tax system to stimulate the economy—especiallyin challenging economic times. Such is the case with additional first-year depreciation(also referred to as bonus depreciation). Under this provision, taxpayers can take an addi-tional 50 percent cost recovery in the year qualified property is placed in service.12

The term qualified property includes most new depreciable assets other than build-ings with a recovery period of 20 years or less. The term new means the original or firstuse of the property. Property that is used but “new to the taxpayer” does not qualify.

The additional first-year depreciation is taken in the year in which the qualifyingproperty is placed in service; it may be claimed in addition to the otherwise availabledepreciation deduction. After the additional first-year depreciation is determined, thestandard MACRS cost recovery allowance is calculated by multiplying the cost recov-ery basis (original cost recovery basis less additional first-year depreciation) by theappropriate MACRS percentage. A taxpayer may elect not to take additional first-yeardepreciation.

E XAMP L E

The Big Picture

12

Assume the same facts as in Example 11, except that Dr. Payne sells the computers andperipheral equipment on November 21, 2017. His cost recovery deduction for 2017 is $6,709($67,085� :20� 1=2) (Exhibit 8.5).

E XAMP L E

The Big Picture

11

Return to the facts of The Big Picture on p. 8-1. If Dr. Payne elects the straight-line method of costrecovery, his total cost recovery is computed as follows.

Office furniture and fixtures

($70,000 � .0714) (Exhibit 8.5) $ 4,998


($67,085 � .10) (Exhibit 8.5) 6,709

Dental equipment

($475,000 � .0714) (Exhibit 8.5) 33,915

Total cost recovery $45,622

If Dr. Payne does not elect the straight-line cost recovery method, his cost recovery deductionis $91,298 (as detailed on p. 8-1).

E XAMP L E

13

Bonus Depreciation

Morgan acquires, for $50,000, and places in service a 5-year class asset on March 20, 2016.Morgan’s total 2016 cost recovery deduction is:

50% additional first-year depreciation ($50,000 � .50) $25,000

MACRS cost recovery [($50,000 � $25,000) � .20 (Exhibit 8.3)] 5,000


12§ 168(k). Additional first-year depreciation is allowed for qualified propertyplaced in service after 2011 and before 2020. The additional first-yeardepreciation percentage decreases from 50% to 40% in 2018 and then to

30% in 2019. No bonus depreciation is scheduled for tax years after 2019.Different rules applied between 2008 and 2011.


8-3b Election to Expense Assets (§ 179)Section 179 (Election to Expense Certain Depreciable Business Assets) permits thetaxpayer to elect to write off up to $500,000 of the acquisition cost of tangible personalproperty used in a trade or business. Amounts that are expensed under § 179 are noteligible for additional first-year depreciation or cost recovery under MACRS.

The § 179 expensing election is an annual election that applies to the acquisi-tion cost of property placed in service that year. The immediate expense electiongenerally is not available for real property or for property used for the production ofincome.13

Any elected § 179 expense is taken before additional first-year depreciation is com-puted. The base for calculating the remaining standard MACRS deduction is net of the§ 179 expense and any additional first-year depreciation.

E XAMP L E

The Big Picture

15

Return to the facts of The Big Picture on p. 8-1, and assume that the tax year is 2016. If Dr. Paynetakes additional first-year depreciation, his total cost recovery is computed as follows.

Office furniture and fixtures

Additional first-year depreciation ($70,000 � .50) $ 35,000



Additional first-year depreciation ($67,085 � .50) 33,543


Dental equipment

Additional first-year depreciation ($475,000 � .50) 237,500



If Dr. Payne does not elect additional first-year depreciation, his cost recovery deduction is$91,298 (as detailed on p. 8-1).

E XAMP L E

14

Bonus Depreciation

Assume the same facts as in Example 13. Morgan sells the asset on October 22, 2017. Morgan’s2017 cost recovery deduction for the asset is $4,000 [$25,000 basis for MACRS recovery � 1=2 yearconvention � .32 (Exhibit 8.3)].

E XAMP L E

16

Kelly acquires equipment (5-year class asset) on February 1, 2016, at a cost of $525,000 and electsto expense $500,000 under § 179. Kelly takes the statutory percentage cost recovery for 2016(see Exhibit 8.3). As a result, the total deduction for the year is calculated as follows.

§ 179 expense $500,000

50% additional first-year depreciation [($525,000 � $500,000) � 50%] 12,500

Standard MACRS calculation [($525,000 � $500,000 � $12,500) � .20] 2,500

$515,000

LO.3

Recognize when and how tomake the § 179 expensingelection, calculate the amountof the deduction, and applythe effect of the election inmaking the MACRScalculation.

13The § 179 amount allowed is per taxpayer, per year. On a joint return, the statu-tory amount applies to the couple. If the taxpayers are married and file sepa-rate returns, each spouse is eligible for 50% of the statutory amount.

The annual expense and phaseout amounts ($500,000 and $2 million,respectively) apply to 2010 and subsequent tax years. These amounts are

adjusted for inflation beginning in 2016 and rounded to the nearest $10,000multiple.

Limited types of “qualified real property,” computer software, and heat-ing and air conditioning units also are eligible for expensing.


Annual LimitationsTwo additional limitations apply to the amount deductible under § 179. First, the ceil-ing amount on the deduction ($500,000) is reduced dollar for dollar when § 179 prop-erty placed in service during the taxable year exceeds a maximum amount ($2,010,000in 2016; $2 million in 2015). Second, the § 179 deduction cannot exceed the taxpayer’strade or business taxable income, computed without regard to the § 179 amount.

Any § 179 amount in excess of taxable income is carried forward to future taxable yearsand added to other amounts eligible for expensing. For 2016, the § 179 amount eligible forexpensing in a carryforward year is limited to the lesser of (1) the statutory dollar amount($500,000) reduced by the cost of § 179 property placed in service in excess of $2,010,000in the carryforward year or (2) business taxable income in the carryforward year.

Effect on BasisThe basis of the property for cost recovery purposes is reduced by the § 179 amountafter accounting for the current-year amount of property placed in service in excess ofthe specified maximum amount ($2,010,000 for 2016). This adjusted amount does notreflect any business income limitation.

Conversion to Personal UseConversion of the expensed property to personal use at any time results in recaptureincome (see Chapter 14). A property is converted to personal use if it is not usedpredominantly in a trade or business.14

8-3c Business and Personal Use of Automobilesand Other Listed PropertyLimits exist on MACRS deductions for automobiles and other listed property that areused for both personal and business purposes.15 If the listed property is predominantlyused for business, the taxpayer can use the MACRS tables to recover the cost. In caseswhere the property is not predominantly used for business, the cost is recovered usingthe straight-line method.

ETHICS & EQUITY Section 179 Limitation

Joe Moran worked in the construction businessthroughout most of his career. In June of the current year, hesold his interest in Ajax Enterprises LLC for a profit of $300,000.Shortly thereafter, Joe started his own business, which involvesthe redevelopment of distressed residential real estate.

In connection with his new business venture, Joepurchased a dump truck at a cost of $70,000. The newbusiness struggled and showed a net operating loss for theyear. Joe is considering expensing the $70,000 cost of thetruck under §179 on this year’s tax return. Evaluate Joe’s plan.

E XAMP L E

17

Jill owns a computer service and operates it as a sole proprietorship. In 2016, taxable income is$138,000 before considering any § 179 deduction. If Jill spends $2.3 million on new equipment,her § 179 expense deduction for the year is computed as follows.

§ 179 deduction before adjustment $ 500,000

Less: Dollar limitation reduction ($2,300,000 � $2,010,000) (290,000)

Remaining § 179 deduction $ 210,000

Business income limitation $ 138,000

§ 179 deduction allowed $ 138,000

§ 179 deduction carryforward ($210,000 � $138,000) $ 72,000

14See Reg. § 1.179–1(e) and related examples. 15§ 280F.

LO.4

Identify listed propertyand apply the deductionlimitations on listed propertyand on luxury automobiles.


Listed property includes:

• Any passenger automobile.

• Any other property used as a means of transportation.

• Any property of a type generally used for purposes of entertainment, recreation,or amusement.

• Any computer or peripheral equipment, with the exception of equipment usedexclusively at a regular business establishment, including a qualifying home office.

• Any other property specified in the Regulations.

Automobiles and Other Listed Property Used Predominantly in BusinessFor listed property to be considered as predominantly used in business, its businessusage must exceed 50 percent.16 The use of listed property for production of incomedoes not qualify as business use for purposes of the more-than-50% test. However,both production of income and business use percentages are used to compute the costrecovery deduction.

In determining the percentage of business usage for listed property, a mileage-basedpercentage is used for automobiles. For other listed property, one employs the mostappropriate unit of time (e.g., hours) for which the property actually is used (rather thanits availability for use).17

Limits on Cost Recovery for AutomobilesThe law places special limitations on cost recovery deductions for passenger automo-biles. These statutory dollar limits were imposed on passenger automobiles becauseof the belief that the tax system was being used to underwrite automobiles whose costand luxury far exceeded what was needed for the taxpayer’s business use.

A passenger automobile is any four-wheeled vehicle manufactured for use on pub-lic streets, roads, and highways with an unloaded gross vehicle weight (GVW) ratingof 6,000 pounds or less.18 This definition specifically excludes vehicles used directlyin the business of transporting people or property for compensation, such as taxicabs,ambulances, hearses, and trucks and vans as prescribed by the Regulations.

The following “luxury auto” depreciation limits apply.19

Date Placedin Service First Year Second Year Third Year

Fourth andLater Years

2015* $3,160 $5,100 $3,050 $1,875

2012–2014 $3,160 $5,100 $3,050 $1,875

2010–2011 $3,060 $4,900 $2,950 $1,775

2009 $2,960 $4,800 $2,850 $1,775

* Because the 2016 indexed amounts are not yet available, the 2015 amounts are used in the Examples and end-of-chapterproblem materials.

E XAMP L E

18

On September 1, 2016, Emma places in service listed 5-year recovery property. The property cost$10,000. She elects not to take any available additional first-year depreciation.

If Emma uses the property 40% for business and 25% for the production of income, the propertyis not considered as predominantly used for business. The cost is recovered using straight-line costrecovery. Emma’s cost recovery allowance for the year is $650 ($10,000� :10� 65%).

If, however, Emma uses the property 60% for business and 25% for the production of income,the property is considered as used predominantly for business. Therefore, she may use the statutorypercentage method. Emma’s cost recovery allowance for the year is $1,700 ($10,000� :20� 85%).

16§ 280F(b)(3).17Reg. § 1.280F–6T(e).

18§ 280F(d)(5).19§ 280F(a)(1); Rev.Proc. 2015–19 (2015–8 I.R.B.656).


For an automobile placed in service prior to 2009, the limitation for subsequent years’cost recovery is based on the limits for the year the automobile was placed in service.20

In the event a passenger automobile used predominantly for business qualifies for addi-tional first-year depreciation (i.e., new property), the first-year recovery limitation isincreased by $8,000.21 Therefore, for acquisitions made in 2015, the initial-year cost recov-ery limitation increases from $3,160 to $11,160 ($3,160 þ $8,000).

There are also separate cost recovery limitations for trucks and vans and for electric auto-mobiles. Because these limitations are applied in the same manner as those imposed onpassenger automobiles, these additional limitations are not discussed further in this chapter.

The luxury auto limits are imposed before any percentage reduction for personaluse. In addition, the limitation in the first year includes any amount the taxpayer electsto expense under § 179.22 If the passenger automobile is used partly for personal use,the personal use percentage is ignored for the purpose of determining the unrecoveredcost available for deduction in later years.

The cost recovery limitations are maximum amounts. If the regular MACRS calcula-tion produces a lesser amount of cost recovery, the lesser amount is used.

The luxury auto limitations apply only to passenger automobiles and not to otherlisted property.

E XAMP L E

19

On July 1, 2016, Dan places in service a new automobile that cost $40,000. He does not elect§ 179 expensing, and he elects not to take any available additional first-year depreciation. The caris used 80% for business and 20% for personal use in each tax year. Dan chooses the MACRS200% declining-balance method of cost recovery (the auto is a 5-year asset).

The depreciation computation for 2016 through 2021 is summarized in the table below. Thecost recovery allowed is the lesser of the MACRS amount or the recovery limitation.

Year MACRS AmountRecovery

LimitationDepreciation

Allowed

2016 $6,400 $2,528 $2,528

($40,000 � .2000 � 80%) ($3,160 � 80%)

2017 $10,240 $4,080 $4,080

($40,000 � .3200 � 80%) ($5,100 � 80%)

2018 $6,144 $2,440 $2,440

($40,000 � .1920 � 80%) ($3,050 � 80%)

2019 $3,686 $1,500 $1,500

($40,000 � .1152 � 80%) ($1,875 � 80%)

2020 $3,686 $1,500 $1,500

($40,000 � .1152 � 80%) ($1,875 � 80%)

2021 $1,843 $1,500 $1,500

($40,000 � .0576 � 80%) ($1,875 � 80%)

If Dan continues to use the car after 2021, his cost recovery is limited to the lesser of the recoverable basisor the recovery limitation (i.e., $1,875� business use percentage). For this purpose, the recoverable basisis computed as if the full recovery limitation was allowed even if it was not. Thus, the recoverable basis asof January 1, 2022, is $23,065 ($40,000� $3,160� $5,100� $3,050� $1,875� $1,875� $1,875).

If Dan takes additional first-year depreciation, the calculated amount of additional first-yeardepreciation is $16,000 ($40,000� 50%� 80%). However, the deduction would be limited to$8,928 [($8,000þ $3,160)� 80%].

E XAMP L E

20

On April 2, 2016, Gail places in service a used automobile that cost $10,000. The car is alwaysused 70% for business and 30% for personal use. The cost recovery allowance for 2016 is $1,400($10,000 � .20 MACRS table factor � 70%), and not $2,212 ($3,160 passenger auto maximum � 70%).

20Cost recovery limitations for years prior to 2009 are found in IRS Publication 463.21§ 168(k)(2)(F). The $8,000 amount will decrease to $6,400 in 2018 and $4,800 in

2019. No increase in the first-year recovery limitation will be allowed after 2019.

22§ 280F(d)(1).


Special LimitationA $25,000 limit applies for the § 179 deduction when the luxury auto limits do not apply.The limit is in effect for sport utility vehicles (SUVs) with an unloaded GVW rating ofmore than 6,000 pounds and not more than 14,000 pounds.23

Automobiles and Other Listed Property Not Used Predominantlyin BusinessFor automobiles and other listed property not used predominantly in business in theyear of acquisition (i.e., 50 percent or less), the straight-line method under the alterna-tive depreciation system is required (see text Section 8-3d).24 Under this system, thestraight-line recovery period for automobiles is five years. However, the cost recoveryallowance for any passenger automobile cannot exceed the luxury auto amount.

The straight-line method is used even if, at some later date, the business usage of theproperty increases to more than 50 percent. In that case, the amount of cost recoveryreflects the increase in business usage.

Change from Predominantly Business UseIf the business use percentage of listed property falls to 50 percent or less after the yearthe property is placed in service, the property is subject to cost recovery recapture. Theamount required to be recaptured and included in the taxpayer’s ordinary income is theexcess cost recovery.

Excess cost recovery is the excess of the cost recovery deduction taken in prior yearsusing the statutory percentage method over the amount that would have been allowedif the straight-line method had been used since the property was placed in service.25

E XAMP L E

21

During 2016, Jay acquires and places in service a new SUV that cost $70,000 and has a GVWof 8,000 pounds. Jay uses the vehicle 100% of the time for business use. The total deductionfor 2016 with respect to the SUV is computed as follows.

§ 179 expense $25,000

50% additional first-year depreciation [($70,000 � $25,000) � 50%] 22,500

Standard MACRS calculation [($70,000 � $25,000 � $22,500) � .20 (Exhibit 8.3)] 4,500

$52,000

E XAMP L E

22

Auto Not Predominantly Used in Business

On July 27, 2016, Fred places in service an automobile that cost $20,000. The auto is used 40% forbusiness and 60% for personal use. The cost recovery allowance for 2016 is $800 [$20,000 � .10(Exhibit 8.7) � 40%].

E XAMP L E

23

Assume the same facts as in Example 22, except that the automobile cost $50,000. The cost recov-ery allowance for 2016 is $1,264 [$50,000 � .10 (Exhibit 8.7) ¼ $5,000 (limited to $3,160) � 40%].

E XAMP L E

24

Assume the same facts as in Example 22, except that in 2017, Fred uses the automobile 70% forbusiness and 30% for personal use. Fred’s cost recovery allowance for 2017 is $2,800 [$20,000 �.20 (Exhibit 8.7) � 70%], which is less than 70% of the second-year limit.

23§ 179(b)(6).24§ 280F(b)(1).

25§ 280F(b)(2).


After the business usage of the listed property drops below the more-than-50% level,the straight-line method is used for the remaining life of the property.

Concept Summary 8.5 illustrates the cost recovery rules for various types of listedproperty.

E XAMP L E

25

Seth purchased a new car on January 22, 2016, at a cost of $20,000. Business usage was 80% in2016, 70% in 2017, 40% in 2018, and 60% in 2019. Seth elects not to take any available additionalfirst-year depreciation. Seth’s excess cost recovery to be recaptured as ordinary income in 2018 is:

2016

MACRS [($20,000 � .20 � 80%) (limited to $3,160 � 80%)] $ 2,528

Straight-line [($20,000 � .10 � 80%) (limited to $3,160 � 80%)] (1,600)

Excess $ 928

2017

MACRS [($20,000 � .32 � 70%) (limited to $5,100 � 70%)] $ 3,570

Straight-line [($20,000 � .20 � 70%) (limited to $5,100 � 70%)] (2,800)

Excess $ 770

2018

2016 excess $ 928

2017 excess 770

Ordinary income recapture $1,698

E XAMP L E

26

Assume the same facts as in Example 25. Seth’s cost recovery deduction for 2018 and 2019 is:

2018 $1,220 [($20,000 � .20 � 40%) limited to $3,050 � 40%]

2019 $1,125 [($20,000 � .20 � 60%) limited to $1,875 � 60%]

Concept Summary 8.5Listed Property Cost Recovery

No

No Yes

NoYes Yes

ListedProperty

Is the Propertya PassengerAutomobile?

Is the Propertya PassengerAutomobile?

Is the PropertyUsed Predominantly

for Business?

Straight-line cost recovery reduced by the personal

use percentage

Straight-line cost recovery subject to the recovery

limitations that apply (based on the year placed in service) and reduced by the personal

use percentage

Statutory percentage cost recovery reduced

by the personal use percentage

Statutory percentage cost recovery subject to the recovery limitations that apply (based on the year placed in service) and reduced by the personal use

percentage


Leased AutomobilesA taxpayer who leases a passenger automobile reports an inclusion amount in grossincome. The inclusion amount is computed from an IRS table for each taxable year forwhich the taxpayer leases the automobile. The purpose of this provision is to preventtaxpayers from circumventing the luxury auto and other limitations by leasing, insteadof purchasing, an automobile.

The inclusion amount is based on the fair market value of the automobile; it is pro-rated for the number of days the auto is used during the taxable year. The prorateddollar amount then is multiplied by the business and income-producing usagepercentage.26 The taxpayer deducts the lease payments, multiplied by the business andincome-producing usage percentage. In effect, the taxpayer’s annual deduction for thelease payment is reduced by the inclusion amount.

Substantiation RequirementsListed property is subject to the substantiation requirements of § 274. This means thatthe taxpayer must prove for any business usage the amount of expense or use, the timeand place of use, the business purpose for the use, and the business relationship to thetaxpayer of persons using the property.

Substantiation requires adequate records or sufficient evidence corroborating the tax-payer’s statement. However, these substantiation requirements do not apply to vehiclesthat, by reason of their nature, are not likely to be used more than a de minimis amountfor personal purposes.27

8-3d Alternative Depreciation System (ADS)The alternative depreciation system (ADS) must be used:28

• To calculate the portion of depreciation treated as an alternative minimumtax (AMT) adjustment for purposes of the corporate and individual AMT (seeChapter 15).29

• To compute depreciation allowances for property:• Used predominantly outside the United States.

• Leased or otherwise used by a tax-exempt entity.

• Financed with the proceeds of tax-exempt bonds.

• Imported from foreign countries that maintain discriminatory trade practices orotherwise engage in discriminatory acts.

• To compute depreciation allowances for earnings and profits purposes (seeChapter 19).

E XAMP L E

27

On April 1, 2016, Jim leases and places in service a passenger automobile worth $52,400. The leaseis to be for a period of five years. During the taxable years 2016 and 2017, Jim uses the automobile70% for business and 30% for personal use.

Assuming that the dollar amounts from the IRS table for 2016 and 2017 are $53 and $115,respectively, Jim includes in gross income:

2016 $53 � (275/366) � 70% ¼ $28

2017 $115 � (365/365) � 70% ¼ $81

In each year, Jim still can deduct 70% of the lease payments made, related to his business useof the auto.

26Reg. § 1.280F–7(a).27§§ 274(d) and (i).28§ 168(g).

29This AMT adjustment applies for real and personal property placed in ser-vice before 1999. However, it also applies for personal property placed inservice after 1998 if the taxpayer uses the 200% declining-balance methodfor regular income tax purposes. See Chapter 15.

LO.5

Determine when and howto use the alternativedepreciation system (ADS).


In general, ADS depreciation is computed using straight-line recovery. However,for purposes of the AMT, depreciation of personal property is computed using the150 percent declining-balance method with an appropriate switch to the straight-linemethod.

The taxpayer must use the half-year or the mid-quarter convention, whichever isapplicable, for all property other than eligible real estate. The mid-month convention isused for eligible real estate. The applicable ADS rates are found in Exhibits 8.6, 8.7,and 8.9. Generally, personal property is depreciated under the ADS using the appropri-ate asset class life (e.g., 5- or 7-year) and the 150 percent declining-balance method.ADS uses straight-line depreciation for all realty, over a 40-year class life.30

Taxpayers may elect to use the 150 percent declining-balance method to computethe regular income tax rather than the 200 percent declining-balance method that isavailable for personal property. If this election is made, there is no difference betweenthe cost recovery for computing the regular income tax and the AMT.31

Rather than determining depreciation under the regular MACRS method, taxpayersmay elect straight-line under ADS for property that qualifies for the regular MACRSmethod. One reason for making this election is to avoid a difference between deduct-ible depreciation and earnings and profits depreciation, thereby reducing the number ofcost recovery computations that must be made.32

8-4 REPORTING PROCEDURESSole proprietors engaged in a business file a Schedule C, Profit or Loss from Business, toaccompany Form 1040. A 2015 Schedule C is illustrated, as the 2016 Schedule C is notyet available.

The top part of page 1 requests certain key information about the taxpayer (e.g.,name, address, Social Security number, principal business activity, and accountingmethod used). Part I provides for the reporting of items of income. If the businessrequires the use of inventories and the computation of cost of goods sold (see Chapter16 for when this is necessary), Part III must be completed and the cost of goods soldamount transferred to line 4 of Part I.

E XAMP L E

28

On March 1, 2016, Abby purchases computer-based telephone central office switching equipmentfor $80,000. Abby elects not to take any available additional first-year depreciation. If Abbyuses statutory percentage cost recovery (assuming no § 179 election), her deduction for 2016 is$16,000 [$80,000� :20 (Exhibit 8.3, 5-year class property)].

If Abby elects to use ADS 150% declining-balance cost recovery for the regular income tax(assuming no § 179 election), the cost recovery allowance for 2016 is $12,000 [$80,000� :15(Exhibit 8.6, 5-year class property)].

E XAMP L E

29

Polly acquires an apartment building on March 17, 2016, for $700,000. She takes the maximumcost recovery allowance for determining taxable income. For 2016, Polly deducts $20,153[$700,000� :02879 (Exhibit 8.8)].

However, Polly’s cost recovery for computing her earnings and profits is only $13,853[$700,000� :01979 (Exhibit 8.9)].

30The class life for certain properties described in § 168(e)(3) is speciallydetermined under § 168(g)(3)(B).

31For personal property placed in service before 1999, taxpayers making theelection use the ADS recovery periods in computing cost recovery for theregular income tax. The ADS recovery periods generally are longer thanthe regular recovery periods under MACRS.

32This straight-line election is made on a year-by-year basis. For propertyother than real estate, the election is made by MACRS class and applies toall assets in that MACRS class. So, for example, the election could be madefor 7-year MACRS property and not for 5-year MACRS property placed inservice during the same year. For real estate, the election is made on aproperty-by-property basis.

LO.6

Report cost recoverydeductions appropriately.


Part II allows for the reporting of deductions. Some of the deductions discussed inthis chapter and their location on the form are depletion (line 12) and depreciation (line13). Other expenses (line 27) include those items not already covered (see lines 8–26).An example is research and experimental expenditures.

If depreciation is claimed, it should be supported by completing Form 4562. A 2015Form 4562 is illustrated, as the 2016 Form 4562 is not yet available. The amount listed online 22 of Form 4562 is transferred to line 13 of Part II of Schedule C.

8-5 AMORTIZATIONTaxpayers can claim an amortization deduction on intangible assets called “amortizable§ 197 intangibles.” The amount of the deduction is determined by amortizing theadjusted basis of such intangibles ratably over a 15-year period beginning in the monthin which the intangible is acquired.33

An amortizable § 197 intangible is any § 197 intangible acquired after August 10,1993, and held in connection with the conduct of a trade or business or for the produc-tion of income. Section 197 intangibles include goodwill and going-concern value,franchises, trademarks, and trade names. Covenants not to compete, copyrights, andpatents also are included if they are acquired in connection with the acquisition of abusiness. Generally, self-created intangibles are not § 197 intangibles.

The 15-year amortization period applies regardless of the actual useful life of anamortizable § 197 intangible. No other depreciation or amortization deduction is permit-ted with respect to any amortizable § 197 intangible except those permitted under the15-year amortization rules.

Startup expenditures are partially amortizable by using a § 195 election.34 A taxpayermust make this election no later than the due date of the return for the taxable year inwhich the trade or business begins.35 If no election is made, the startup expendituresare capitalized.36

E XAMP L E

30

Thomas Andrews, Social Security number 111-11-1111, was employed as an accountant until May2015, when he opened his own practice. His address is 279 Mountain View, Ogden, UT 84201.Andrews keeps his books on the cash basis and reported the following revenue and businessexpenses in 2015.

a. Revenue from accounting practice, $192,000.b. Insurance, $5,000.c. Office supplies, $4,000.d. Office rent, $16,000.e. Copier lease payments, $3,000.f. Licenses, $2,000.g. New furniture and fixtures were acquired on May 10, for $142,000. Thomas elects § 179 expens-

ing and uses the statutory percentage cost recovery method.

Andrews reports the above information on Schedule C and Form 4562 as illustrated on the follow-ing pages.

E XAMP L E

31

On June 1, 2016, Neil purchased and began operating the Falcon Caf�e. Of the purchase price, $90,000is allocated to goodwill. The 2016 § 197 amortization deduction is $3,500 [($90,000=15)� (7=12)].

LO.7

Identify intangible assets thatare eligible for amortizationand calculate the amount ofthe deduction.

33§ 197(a).34§ 195(b).

35§ 195(d).36§ 195(a).


Form 4562Department of the Treasury Internal Revenue Service (99)

Depreciation and Amortization (Including Information on Listed Property)

▶ Attach to your tax return.▶ Information about Form 4562 and its separate instructions is at www.irs.gov/form4562.

OMB No. 1545-0172

2015Attachment Sequence No. 179

Name(s) shown on return Business or activity to which this form relates Identifying number

Part I Election To Expense Certain Property Under Section 179 Note: If you have any listed property, complete Part V before you complete Part I.

1 Maximum amount (see instructions) . . . . . . . . . . . . . . . . . . . . . . . 12 Total cost of section 179 property placed in service (see instructions) . . . . . . . . . . . 23 Threshold cost of section 179 property before reduction in limitation (see instructions) . . . . . . 34 Reduction in limitation. Subtract line 3 from line 2. If zero or less, enter -0- . . . . . . . . . . 45 Dollar limitation for tax year. Subtract line 4 from line 1. If zero or less, enter -0-. If married filing

separately, see instructions . . . . . . . . . . . . . . . . . . . . . . . . . 56 (a) Description of property (b) Cost (business use only) (c) Elected cost

7 Listed property. Enter the amount from line 29 . . . . . . . . . 78 Total elected cost of section 179 property. Add amounts in column (c), lines 6 and 7 . . . . . . 89 Tentative deduction. Enter the smaller of line 5 or line 8 . . . . . . . . . . . . . . . . 9

10 Carryover of disallowed deduction from line 13 of your 2014 Form 4562 . . . . . . . . . . . 1011 Business income limitation. Enter the smaller of business income (not less than zero) or line 5 (see instructions) 1112 Section 179 expense deduction. Add lines 9 and 10, but do not enter more than line 11 . . . . . 1213 Carryover of disallowed deduction to 2016. Add lines 9 and 10, less line 12 ▶ 13

Note: Do not use Part II or Part III below for listed property. Instead, use Part V.Part II Special Depreciation Allowance and Other Depreciation (Do not include listed property.) (See instructions.)14 Special depreciation allowance for qualified property (other than listed property) placed in service

during the tax year (see instructions) . . . . . . . . . . . . . . . . . . . . . . 1415 Property subject to section 168(f)(1) election . . . . . . . . . . . . . . . . . . . . 1516 Other depreciation (including ACRS) . . . . . . . . . . . . . . . . . . . . . . 16Part III MACRS Depreciation (Do not include listed property.) (See instructions.)

Section A17 MACRS deductions for assets placed in service in tax years beginning before 2015 . . . . . . . 1718 If you are electing to group any assets placed in service during the tax year into one or more general

asset accounts, check here . . . . . . . . . . . . . . . . . . . . . . ▶

Section B—Assets Placed in Service During 2015 Tax Year Using the General Depreciation System

(a) Classification of property(b) Month and year

placed inservice

(c) Basis for depreciation(business/investment useonly—see instructions)

(d) Recoveryperiod

(e) Convention (f) Method (g) Depreciation deduction

19a 3-year propertyb 5-year propertyc 7-year propertyd 10-year propertye 15-year propertyf 20-year property

g 25-year propertyh Residential rental

propertyi Nonresidential real

property

Section C—Assets Placed in Service During 2015 Tax Year Using the Alternative Depreciation System20a Class life

b 12-yearc 40-year

Part IV Summary (See instructions.)21 Listed property. Enter amount from line 28 . . . . . . . . . . . . . . . . . . . . 2122 Total. Add amounts from line 12, lines 14 through 17, lines 19 and 20 in column (g), and line 21. Enter

here and on the appropriate lines of your return. Partnerships and S corporations—see instructions . 2223 For assets shown above and placed in service during the current year, enter the

portion of the basis attributable to section 263A costs . . . . . . . 23For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 12906N Form 4562 (2015)

25 yrs. S/L27.5 yrs. MM S/L27.5 yrs. MM S/L39 yrs. MM S/L

MM S/L

S/L12 yrs. S/L40 yrs. MM S/L

Thomas Andrews Andrews Accounting Services 111-11-1111

142,000

-0-

Furniture and Fixtures 142,000 142,000

142,000

142,000142,000

142,000142,000

142,000

-0-


SCHEDULE C (Form 1040) 2015

Profit or Loss From Business (Sole Proprietorship)

Department of the Treasury Internal Revenue Service (99)

▶ Information about Schedule C and its separate instructions is at www.irs.gov/schedulec.▶ Attach to Form 1040, 1040NR, or 1041; partnerships generally must file Form 1065.

OMB No. 1545-0074

Attachment Sequence No. 09

Name of proprietor Social security number (SSN)

A Principal business or profession, including product or service (see instructions) B Enter code from instructions

▶

C Business name. If no separate business name, leave blank. D Employer ID number (EIN), (see instr.)

E Business address (including suite or room no.) ▶

City, town or post office, state, and ZIP code

F Accounting method: (1) Cash (2) Accrual (3) Other (specify) ▶

G Did you “materially participate” in the operation of this business during 2015? If “No,” see instructions for limit on losses . Yes No

H If you started or acquired this business during 2015, check here . . . . . . . . . . . . . . . . . ▶

I Did you make any payments in 2015 that would require you to file Form(s) 1099? (see instructions) . . . . . . . . Yes No

J If "Yes," did you or will you file required Forms 1099? . . . . . . . . . . . . . . . . . . . . . Yes No

Part I Income 1 Gross receipts or sales. See instructions for line 1 and check the box if this income was reported to you on

Form W-2 and the “Statutory employee” box on that form was checked . . . . . . . . . ▶ 1

2 Returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . . 2

3 Subtract line 2 from line 1 . . . . . . . . . . . . . . . . . . . . . . . . 3

4 Cost of goods sold (from line 42) . . . . . . . . . . . . . . . . . . . . . . 4

5 Gross profit. Subtract line 4 from line 3 . . . . . . . . . . . . . . . . . . . . 5

6 Other income, including federal and state gasoline or fuel tax credit or refund (see instructions) . . . . 6

7 Gross income. Add lines 5 and 6 . . . . . . . . . . . . . . . . . . . . . ▶ 7 Part II Expenses. Enter expenses for business use of your home only on line 30.

8 Advertising . . . . . 8

9 Car and truck expenses (see instructions) . . . . . 9

10 Commissions and fees . 10

11 Contract labor (see instructions) 11

12 Depletion . . . . . 12 13 Depreciation and section 179

expense deduction (not included in Part III) (see instructions) . . . . . 13

14 Employee benefit programs (other than on line 19) . . 14

15 Insurance (other than health) 15

16 Interest:

a Mortgage (paid to banks, etc.) 16a

b Other . . . . . . 16b17 Legal and professional services 17

18 Office expense (see instructions) 18

19 Pension and profit-sharing plans . 19

20 Rent or lease (see instructions):

a Vehicles, machinery, and equipment 20a

b Other business property . . . 20b

21 Repairs and maintenance . . . 21

22 Supplies (not included in Part III) . 22

23 Taxes and licenses . . . . . 23

24 Travel, meals, and entertainment:

a Travel . . . . . . . . . 24a

b Deductible meals and entertainment (see instructions) . 24b

25 Utilities . . . . . . . . 25

26 Wages (less employment credits) . 26

27 a Other expenses (from line 48) . . 27a

b Reserved for future use . . . 27b

28 Total expenses before expenses for business use of home. Add lines 8 through 27a . . . . . . ▶ 28

29 Tentative profit or (loss). Subtract line 28 from line 7 . . . . . . . . . . . . . . . . . 29

30 Expenses for business use of your home. Do not report these expenses elsewhere. Attach Form 8829 unless using the simplified method (see instructions). Simplified method filers only: enter the total square footage of: (a) your home:

and (b) the part of your home used for business: . Use the Simplified

Method Worksheet in the instructions to figure the amount to enter on line 30 . . . . . . . . . 30

31 Net profit or (loss). Subtract line 30 from line 29.

• If a profit, enter on both Form 1040, line 12 (or Form 1040NR, line 13) and on Schedule SE, line 2. (If you checked the box on line 1, see instructions). Estates and trusts, enter on Form 1041, line 3.

• If a loss, you must go to line 32.} 31

32 If you have a loss, check the box that describes your investment in this activity (see instructions).

• If you checked 32a, enter the loss on both Form 1040, line 12, (or Form 1040NR, line 13) and on Schedule SE, line 2. (If you checked the box on line 1, see the line 31 instructions). Estates and trusts, enter on Form 1041, line 3. • If you checked 32b, you must attach Form 6198. Your loss may be limited.

} 32a All investment is at risk.

32b Some investment is not at risk.

For Paperwork Reduction Act Notice, see the separate instructions. Cat. No. 11334P Schedule C (Form 1040) 2015

Thomas Andrews

Andrews Accounting Services

111–11–1111

×

279 Mountain ViewOgden, UT 84201

×

192,000

192,000

192,000

192,000

4,000

3,00016,000

2,000

172,00020,000

20,000

142,000

5,000


The amortization election for startup expenditures allows the taxpayer to deductthe lesser of (1) the amount of startup expenditures with respect to the trade or businessor (2) $5,000, reduced, but not below zero, by the amount by which the startup expen-ditures exceed $50,000. Any startup expenditures not deducted are amortized ratablyover a 180-month period, beginning in the month in which the trade or businessbegins.37

Amortizable startup expenditures generally must satisfy two requirements.38 First, theexpenditures must be paid or incurred in connection with:

• The creation of an active trade or business,

• The investigation of the creation or acquisition of an active trade or business, or

• Any activity engaged in for profit in anticipation of it becoming an active trade orbusiness.

Second, the expenses must reflect those that could be deducted in an existing tradeor business in the same field (see Investigation of a Business, Chapter 6).

The startup costs of creating a new active trade or business could include advertising;salaries and wages; travel and other expenses incurred in lining up prospective distribu-tors, suppliers, or customers; and salaries and fees for executives, consultants, and profes-sional services. Costs that relate to either created or acquired businesses could includeexpenses incurred for the analysis or survey of potential markets, products, labor supply,transportation facilities, and the like. Startup expenditures do not include allowabledeductions for interest, taxes, and research and experimental costs.39

Amortization deductions also can be claimed for organizational expenses (see Chapter 17)and research and experimental expenditures (see Chapter 7).

8-6 DEPLETIONNatural resources (e.g., oil, gas, coal, gravel, and timber) are subject to depletion , whichcan be seen as a form of depreciation applicable to natural resources. Land generallycannot be depleted.

The owner of an interest in the natural resource is entitled to deduct depletion. Anowner is one who has an economic interest in the property.40 An economic interest

E XAMP L E

33

Assume the same facts as in Example 32, except that the startup expenditures total $53,000.The 2016 deduction is computed as follows.

Deductible amount [$5,000 � ($53,000 � $50,000)] $2,000

Amortizable amount {[($53,000 � $2,000)/180] � 5 months} 1,417

Total deduction $3,417

E XAMP L E

32

Startup Expenditures

Green Corporation begins business on August 1, 2016. The corporation incurs startup expenditures of$47,000. If Green elects amortization under § 195, the total startup expenditures that Green maydeduct in 2016 is computed as follows.

Deductible amount $5,000

Amortizable amount {[($47,000 � $5,000)/180] � 5 months} 1,167

Total deduction $6,167

37§§ 195(b)(1)(A) and (B).38§§ 195(c)(1)(A) and (B).

39§ 195(c).40Reg. § 1.611–1(b).

LO.8

Determine the amount ofdepletion expense, includingbeing able to apply thealternative tax treatmentsfor intangible drilling anddevelopment costs.


requires the acquisition of an interest in the resource in place and the receipt of incomefrom the extraction or severance of that resource. Like depreciation, depletion is a tradeor business deduction for adjusted gross income.

Although all natural resources are subject to depletion, oil and gas wells are used as anexample in the following paragraphs to illustrate the related costs and issues.

In developing an oil or gas well, the producer typically makes four types ofexpenditures.

• Natural resource costs.

• Intangible drilling and development costs.

• Tangible asset costs.

• Operating costs.

Natural resources are physically limited, and the costs to acquire them (e.g., oil under theground) are, therefore, recovered through depletion. Costs incurred in making the prop-erty ready for drilling, such as the cost of labor in clearing the property, erecting derricks,and drilling the hole, are intangible drilling and development costs (IDCs) . These costs gen-erally have no salvage value and are a lost cost if the well is dry.

Costs for tangible assets such as tools, pipes, and engines are capitalized and recov-ered through depreciation (cost recovery). Costs incurred after the well is producing areoperating costs. These costs include expenditures for such items as labor, fuel, and sup-plies. Operating costs are deductible as trade or business expenses. Depletable costsand intangible drilling and development costs receive different treatment.

8-6a Intangible Drilling and Development Costs (IDCs)Intangible drilling and development costs can be handled in one of two ways at theoption of the taxpayer. They can be either charged off as an expense in the year inwhich they are incurred or capitalized and written off through depletion. The taxpayermakes the election in the first year such expenditures are incurred, either by taking adeduction on the return or by adding them to the depletable basis.

Once made, the election is binding on both the taxpayer and the IRS for all suchexpenditures in the future. If the taxpayer fails to elect to expense IDCs on the originaltimely filed return for the first year in which such expenditures are incurred, an irrevo-cable election to capitalize them has been made.

As a general rule, it is more advantageous to expense IDCs. The obvious benefit ofan immediate write-off (as opposed to a deferred write-off through depletion) is not theonly advantage. Because a taxpayer can use percentage depletion, which is calculatedwithout reference to basis (see Example 35), the IDCs may be completely lost as adeduction if they are capitalized.

8-6b Depletion MethodsThere are two methods of calculating depletion. Cost depletion can be used on any wast-ing asset (and is the only method allowed for timber). Percentage depletion is subject to anumber of limitations, particularly for oil and gas deposits. Depletion should be calculatedboth ways, and the method that results in the larger deduction should be used. Thechoice between cost depletion and percentage depletion is an annual decision; the tax-payer can use cost depletion in one year and percentage depletion in the following year.

Cost DepletionCost depletion is determined by using the adjusted basis of the asset.41 The basis isdivided by the estimated recoverable units of the asset (e.g., barrels and tons) to arrive atthe depletion per unit. This amount then is multiplied by the number of units sold (not theunits produced) during the year to arrive at the cost depletion allowed. Cost depletion,therefore, resembles the units-of-production method of calculating depreciation.

41§ 612.


If the taxpayer later discovers that the original estimate was incorrect, the depletionper unit for future calculations is redetermined, using the revised estimate.42

Percentage DepletionPercentage depletion (also referred to as statutory depletion) uses a specified percent-age provided by the Code. The percentage varies according to the type of mineralinterest involved. A sample of these percentages is shown in Exhibit 8.2. The rate isapplied to the gross income from the property, but in no event may percentage deple-tion exceed 50 percent of the taxable income from the property before the allowancefor depletion.43

Note that percentage depletion is based on a percentage of the gross income from theproperty and makes no reference to cost. All other deductions detailed in this chapter are

E XAMP L E

34

On January 1, 2016, Pablo purchases the rights to a mineral interest for $1 million. At that time,the remaining recoverable units in the mineral interest are estimated to be 200,000. The deple-tion per unit is $5 ($1,000,000 adjusted basis � 200,000 estimated recoverable units).

If 60,000 units are mined and 25,000 are sold this year, the cost depletion is $125,000 ($5 deple-tion per unit � 25,000 units sold).

E XAMP L E

35

Assume the same facts as in Example 34. In 2017, Pablo realizes that an incorrect estimate wasmade as to the capacity of the mine. The remaining recoverable units now are determined to be400,000. Based on this new information, the revised depletion per unit is $2.1875 ($875,000adjusted basis � 400,000 estimated recoverable units). The $875,000 adjusted basis is the originalcost ($1,000,000) reduced by the depletion claimed in 2016 ($125,000).

If 30,000 units are sold in 2017, the depletion for the year is $65,625 ($2.1875 depletion perunit � 30,000 units sold).

E XAMP L E

36

CarrollCo reports gross income of $100,000 and other property-related expenses of $60,000 and usesa depletion rate of 22%. CarrollCo’s depletion allowance is determined as follows.

Gross income $100,000

Less: Other expenses (60,000)

Taxable income before depletion $ 40,000

Depletion allowance [the lesser of $22,000 (22% � $100,000)or $20,000 (50% � $40,000)] (20,000)

Taxable income after depletion $ 20,000

The adjusted basis of CarrollCo’s property is reduced by $20,000, the depletion deduction allowed.If the other expenses had been only $55,000, the full $22,000 could have been deducted, and theadjusted basis would have been reduced by $22,000.

TAX IN THE NEWS Depletion of Air Space

Landfill operators are allowed a depletion allow-ance, which is a deduction in computing Federal taxableincome. The depletion deduction is the value of the air space

that is being filled up. The value of the air space is the productof some of the goodwill costs; some of the land costs; and all ofthe engineering, siting, and construction costs.

42§ 611(a).43§ 613(a). Special rules apply for certain oil and gas wells (e.g., the 50% ceil-

ing is replaced with a 100% ceiling, and the percentage depletion may not

exceed 65% of the taxpayer’s taxable income from all sources before theallowance for depletion). § 613A.


a function of the adjusted basis (cost) of the property. Thus, when percentage depletionis used, it is possible to claim aggregate depletion deductions that exceed the original costof the property. If percentage depletion is used, however, the adjusted basis of the prop-erty (for computing cost depletion in a future tax year) is reduced by any depletiondeducted, until the basis reaches zero. See Example 40.

8-7 TAX PLANNING

8-7a Cost RecoveryCost recovery schedules should be reviewed annually for possible retirements, aban-donments, and obsolescence.

Because of the deductions for cost recovery, interest, and ad valorem property taxes,investments in real estate can be highly attractive. In examining the economics of suchinvestments, one should take into account any tax savings that result.

E X H I B I T 8.2 Sample of Percentage Depletion Rates

22% Depletion

Cobalt Sulfur

Lead Tin

15% Depletion

Copper Oil, gas, oil shale

Gold Silver

14% Depletion

Granite Marble

Limestone Potash

10% Depletion

Coal Sodium chloride

5% Depletion

Gravel Sand

E XAMP L E

37

An examination of the cost recovery schedule of Eagle Company reveals:

• Asset A was abandoned when it was discovered that the cost of repairs would be in excess ofthe cost of replacement. Asset A had an adjusted basis of $3,000.

• Asset J became obsolete this year, at which point its adjusted basis was $8,000.

Assets A and J should be written off, resulting in deductions of $11,000.

E XAMP L E

The Big Picture

38

Return to the facts of The Big Picture on p. 8-1. In early January 2015, Dr. Payne purchased residen-tial rental property for $170,000 (of which $20,000 was allocated to the land and $150,000 to thebuilding). He made a down payment of $25,000 and assumed the seller’s mortgage for the bal-ance. Under the mortgage agreement, monthly payments of $1,000 are required and are appliedtoward interest, taxes, insurance, and principal.

Because the property was already occupied, Dr. Payne continued to receive rent income of$1,200 per month from the tenant. He actively participates in this activity and so comes under thespecial rule for a rental real estate activity with respect to the limitation on passive activity losses(refer to Chapter 11). He is in the 28% tax bracket.

continued

LO.9

Identify tax planningopportunities for costrecovery, amortization,and depletion.


Another consideration when making decisions with respect to cost recovery iswhether fast or slow cost recovery will be more beneficial for the taxpayer. If the tax-payer’s goal is to recover the cost of fixed assets as quickly as possible, the followingstrategies should be used.

• When constructing a facility, keep in mind any resulting property tax implications.Refer to the discussion in Chapter 1 (text Section 1-5a).

• When electing § 179 expensing, choose assets with longer lives.

• Choose accelerated cost recovery methods where available.

If a taxpayer has a new business with little income or a business with a net operatingloss carryover, the taxpayer’s goal may be to slow down cost recovery. In such a situa-tion, the taxpayer should:

• Elect not to take additional first-year depreciation, if available.

• Choose the straight-line cost recovery method.

• Make no election under § 179.

• Defer placing assets in service in the current tax year or postpone capital outlaysuntil future tax years.

Section 179 and the Mid-Quarter ConventionThe mid-quarter convention generally results in smaller depreciation deductions in theasset’s acquisition year. However, the basis of property used to determine whether themid-quarter convention applies is derived after any § 179 immediate expense election.44

As a result, a taxpayer may be able to avoid the mid-quarter convention by designating§ 179 treatment for assets placed in service during the last quarter of the taxable year.

For 2016, Dr. Payne’s expenses were determined to include:

Interest $10,000

Taxes 800

Insurance 1,000

Repairs and maintenance 2,200

Depreciation ($150,000 � .03636) 5,454

Total expenses $19,454

The deductible loss from the rental property is:

Rent income ($1,200 � 12 months) $ 14,400

Less total expenses (see above) (19,454)

Net loss ($ 5,054)

But what is Dr. Payne’s net cash position for the year when the tax benefit of the loss is taken intoaccount?

Intake—

Rent income $14,400

Tax savings [28% (income tax bracket) � $5,054(loss from the property)] 1,415 $ 15,815

Outlay—

Mortgage payments ($1,000 � 12 months) $12,000

Repairs and maintenance 2,200 (14,200)

Net cash benefit $ 1,615

Should Dr. Payne cease to be an active participant in the rental activity, the passive activity lossrules would apply and he could lose the current period benefit of the loss.

44Reg. § 1.168(d)–1(b)(4).


8-7b AmortizationWhen a business is purchased, goodwill and covenants not to compete are both subjectto a statutory amortization period of 15 years. Therefore, the purchaser does not deriveany tax benefits when part of the purchase price is assigned to a covenant rather thanto goodwill.

Thus, from the purchaser’s perspective, bargaining for a covenant should be basedon legal rather than tax reasons. Note, however, that from the seller’s perspective, good-will is a capital asset, and the covenant is an ordinary income asset.

Because the amortization period for both goodwill and a covenant is 15 years, thepurchaser may want to attempt to minimize these amounts if the purchase price can beassigned to assets with shorter lives (e.g., inventory, receivables, and personalty). Con-versely, the purchaser may want to attempt to maximize these amounts if part of thepurchase price will otherwise be assigned to assets with longer recovery periods(e.g., realty) or to assets not eligible for cost recovery (e.g., land).

8-7c DepletionAs long as the basis of a depletable asset remains above zero, cost depletion or percent-age depletion, whichever method produces the larger deduction, will be used. Whenthe basis of the asset is exhausted, percentage depletion still can be taken.

E XAMP L E

39

Dimond Manufacturing places the following assets in service during 2016. All are 5-year classassets, and they are the only assets that Dimond placed in service during the year.

Asset 1 (April 3, 2016) $ 438,000

Asset 2 (July 17, 2016) 232,000

Asset 3 (October 22, 2016) 580,000

Total $1,250,000

As Dimond has placed more than 40% of the assets in service during the last quarter of the tax-able year, the mid-quarter convention applies ($580,000/$1,250,000 ¼ 46.4%). As a result,Dimond’s MACRS deduction for the year is computed as follows (see Exhibit 8.4).

Asset 1 $438,000 � .25 $109,500

Asset 2 $232,000 � .15 34,800

Asset 3 $580,000 � .05 29,000

Total $173,300

However, if Dimond elects to expense $500,000 of the October 22 acquisition under § 179, themid-quarter convention would not apply.

Asset 1 (April 3, 2016) $438,000

Asset 2 (July 17, 2016) 232,000

Asset 3 (October 22, 2016; $580,000 – $500,000) 80,000

Total $750,000

Now Dimond has placed only 10.7% ($80,000/$750,000) of the assets in service during the lastquarter of the taxable year. As a result, the mid-quarter convention does not apply, and Dimond’sMACRS deduction for the year (including the § 179 expense election) is:

MACRS depreciation ($750,000 � .20; Exhibit 8.3) $150,000

Section 179 expense (Asset 3) 500,000

Total $650,000

As a result of its effective use of § 179, Dimond has increased its 2016 MACRS deduction andsimplified its reporting and record keeping related to these assets.


8-7d Cost Recovery Tables

Summary of Tables

Exhibit 8.3 Modified ACRS statutory percentage table for personalty.Applicable depreciation methods: 200 or 150 percent declining-balance

switching to straight-line.Applicable recovery periods: 3, 5, 7, 10, 15, 20 years.Applicable convention: half-year.

Exhibit 8.4 Modified ACRS statutory percentage table for personalty.Applicable depreciation method: 200 percent declining-balance

switching to straight-line.Applicable recovery periods: 3, 5, 7 years.Applicable convention: mid-quarter.

Exhibit 8.5 Modified ACRS optional straight-line table for personalty.Applicable depreciation method: straight-line.Applicable recovery periods: 3, 5, 7, 10, 15, 20 years.Applicable convention: half-year.

Exhibit 8.6 Alternative minimum tax declining-balance table for personalty.Applicable depreciation method: 150 percent declining-balance

switching to straight-line.Applicable recovery periods: 3, 5, 7, 9.5, 10, 12 years.Applicable convention: half-year.

Exhibit 8.7 Alternative depreciation system straight-line table for personalty.Applicable depreciation method: straight-line.Applicable recovery periods: 5, 10, 12 years.Applicable convention: half-year.

Exhibit 8.8 Modified ACRS straight-line table for realty.Applicable depreciation method: straight-line.Applicable recovery periods: 27.5, 31.5, 39 years.Applicable convention: mid-month.

Exhibit 8.9 Alternative depreciation system straight-line table for realty.Applicable depreciation method: straight-line.Applicable recovery period: 40 years.Applicable convention: mid-month.

E XAMP L E

40

Melissa reports the following related to her sulfur mine.

Remaining depletable basis $ 11,000

Gross income (10,000 units) 100,000

Expenses (other than depletion) 30,000

Because cost depletion is limited to the remaining depletable basis of $11,000, Melissa wouldchoose percentage depletion of $22,000 (a 22% depletion rate is used for sulfur). Her basis inthe mine then becomes zero. In future years, however, she can continue to take percentagedepletion; percentage depletion is computed without reference to the remaining basis.


E X H I B I T 8.3 MACRS Accelerated Depreciation for Personal PropertyAssuming Half-Year Convention

For Property Placed in Service after December 31, 1986

RecoveryYear

3-Year(200% DB)

5-Year(200% DB)

7-Year(200% DB)

10-Year(200% DB)

15-Year(150% DB)

20-Year(150% DB)

1 33.33 20.00 14.29 10.00 5.00 3.750

2 44.45 32.00 24.49 18.00 9.50 7.219

3 14.81* 19.20 17.49 14.40 8.55 6.677

4 7.41 11.52* 12.49 11.52 7.70 6.177

5 11.52 8.93* 9.22 6.93 5.713

6 5.76 8.92 7.37 6.23 5.285

7 8.93 6.55* 5.90* 4.888

8 4.46 6.55 5.90 4.522

9 6.56 5.91 4.462*

10 6.55 5.90 4.461

11 3.28 5.91 4.462

12 5.90 4.461

13 5.91 4.462

14 5.90 4.461

15 5.91 4.462

16 2.95 4.461

17 4.462

18 4.461

19 4.462

20 4.461

21 2.231

*Switchover to straight-line depreciation.

E X H I B I T 8.4 MACRS Accelerated Depreciation for Personal PropertyAssuming Mid-Quarter Convention

For Property Placed in Service after December 31, 1986 (Partial Table*)

3-YearRecoveryYear

FirstQuarter

SecondQuarter

ThirdQuarter

FourthQuarter

1 58.33 41.67 25.00 8.33

2 27.78 38.89 50.00 61.11

5-YearRecoveryYear

FirstQuarter

SecondQuarter

ThirdQuarter

FourthQuarter

1 35.00 25.00 15.00 5.00

2 26.00 30.00 34.00 38.00

7-YearRecoveryYear

FirstQuarter

SecondQuarter

ThirdQuarter

FourthQuarter

1 25.00 17.85 10.71 3.57

2 21.43 23.47 25.51 27.55

*The figures in this table are taken from the official tables that appear in Rev.Proc. 87–57, 1987–2 C.B. 687. Because oftheir length, the complete tables are not presented.


E X H I B I T 8.5 MACRS Straight-Line Depreciation for Personal PropertyAssuming Half-Year Convention*


MACRSClass

% FirstRecovery Year

Other Recovery Years Last Recovery Year

Years % Year %

3-year 16.67 2–3 33.33 4 16.67

5-year 10.00 2–5 20.00 6 10.00

7-year 7.14 2–7 14.29 8 7.14

10-year 5.00 2–10 10.00 11 5.00

15-year 3.33 2–15 6.67 16 3.33

20-year 2.50 2–20 5.00 21 2.50*The official table contains a separate row for each year. For ease of presentation, certain years are grouped in this table.

In some instances, this will produce a difference of .01 for the last digit when compared with the official table.

E X H I B I T 8.6 Alternative Minimum Tax: 150% Declining-BalanceAssuming Half-Year Convention

For Property Placed in Service after December 31, 1986 (Partial Table*)

RecoveryYear

3-Year150%

5-Year150%

7-Year150%

9.5-Year150%

10-Year150%

12-Year150%

1 25.00 15.00 10.71 7.89 7.50 6.25

2 37.50 25.50 19.13 14.54 13.88 11.72

3 25.00** 17.85 15.03 12.25 11.79 10.25

4 12.50 16.66** 12.25** 10.31 10.02 8.97

5 16.66 12.25 9.17** 8.74** 7.85

6 8.33 12.25 9.17 8.74 7.33**

7 12.25 9.17 8.74 7.33

8 6.13 9.17 8.74 7.33

9 9.17 8.74 7.33

10 9.16 8.74 7.33

11 4.37 7.32

12 7.33

13 3.66

*The figures in this table are taken from the official table that appears in Rev.Proc. 87–57, 1987–2 C.B. 687. Because ofits length, the complete table is not presented.

**Switchover to straight-line depreciation.


E X H I B I T 8.7 ADS Straight-Line for Personal Property AssumingHalf-Year Convention

For Property Placed in Service after December 31, 1986 (Partial Table)*

Recovery Year 5-Year Class 10-Year Class 12-Year Class

1 10.00 5.00 4.17

2 20.00 10.00 8.33

3 20.00 10.00 8.33

4 20.00 10.00 8.33

5 20.00 10.00 8.33

6 10.00 10.00 8.33

7 10.00 8.34

8 10.00 8.33

9 10.00 8.34

10 10.00 8.33

11 5.00 8.34

12 8.33

13 4.17

*The figures in this table are taken from the official table that appears in Rev.Proc. 87–57, 1987–2 C.B. 687. Because of itslength, the complete table is not presented. The tables for the mid-quarter convention also appear in Rev.Proc. 87–57.

E X H I B I T 8.8 MACRS Straight-Line Depreciation for Real Property Assuming Mid-Month Convention*

For Property Placed in Service after December 31, 1986: 27.5-Year Residential Real Property

RecoveryYear(s)

The Applicable Percentage Is (Use the Column for the Month in the First Year the Property Is Placed in Service):1 2 3 4 5 6 7 8 9 10 11 12

1 3.485 3.182 2.879 2.576 2.273 1.970 1.667 1.364 1.061 0.758 0.455 0.152

2–18 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636

19–27 3.637 3.637 3.637 3.637 3.637 3.637 3.637 3.637 3.637 3.637 3.637 3.637

28 1.970 2.273 2.576 2.879 3.182 3.485 3.636 3.636 3.636 3.636 3.636 3.636

29 0.000 0.000 0.000 0.000 0.000 0.000 0.152 0.455 0.758 1.061 1.364 1.667

For Property Placed in Service after December 31, 1986, and before May 13, 1993: 31.5-Year Nonresidential Real Property

RecoveryYear(s)


1 3.042 2.778 2.513 2.249 1.984 1.720 1.455 1.190 0.926 0.661 0.397 0.132

2–19 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175

20–31 3.174 3.174 3.174 3.174 3.174 3.174 3.174 3.174 3.174 3.174 3.174 3.174

32 1.720 1.984 2.249 2.513 2.778 3.042 3.175 3.175 3.175 3.175 3.175 3.175

33 0.000 0.000 0.000 0.000 0.000 0.000 0.132 0.397 0.661 0.926 1.190 1.455

For Property Placed in Service after May 12, 1993: 39-Year Nonresidential Real Property

RecoveryYear(s)


1 2.461 2.247 2.033 1.819 1.605 1.391 1.177 0.963 0.749 0.535 0.321 0.107

2–39 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564

40 0.107 0.321 0.535 0.749 0.963 1.177 1.391 1.605 1.819 2.033 2.247 2.461

*The official tables contain a separate row for each year. For ease of presentation, certain years are grouped in these tables. In some instances, this will produce adifference of .001 for the last digit when compared with the official tables.


E X H I B I T 8.9 ADS Straight-Line for Real Property Assuming Mid-Month Convention


RecoveryYear

Month Placed in Service1 2 3 4 5 6 7 8 9 10 11 12

1 2.396 2.188 1.979 1.771 1.563 1.354 1.146 0.938 0.729 0.521 0.313 0.104

2–40 2.500 2.500 2.500 2.500 2.500 2.500 2.500 2.500 2.500 2.500 2.500 2.500

41 0.104 0.312 0.521 0.729 0.937 1.146 1.354 1.562 1.771 1.979 2.187 2.396

REFOCUS ON THE BIG PICTURE

CALCULATING COST RECOVERY DEDUCTIONS

Regardless of whether the accrual method or the cash method of accounting is used,MACRS must be used in calculating the depreciation expense for fixed assets for taxpurposes. Evidently, Dr. Payne’s financial reporting system uses MACRS, because$91,298 is the correct amount of depreciation expense. The computers and periph-eral equipment are 5-year property. The office furniture and fixtures and the dentalequipment are 7-year property.

Based on the IRS cost recovery tables, the following percentages are used in cal-culating depreciation expense for the first year of each asset’s life.

5-year property 20.00%

7-year property 14.29%

Dr. Payne can deduct depreciation on the house he converted from personal useto rental use and on the rental house he purchased.

What If?From a tax planning perspective, what can Dr. Payne do to increase the depreciationdeductions associated with the purchase of these fixed assets and thereby reduce theamount of the business net income reported on Schedule C of Form 1040 for hisdental practice?

In addition to the standard MACRS deduction using the percentages for 2016, § 179provides for the limited expensing of fixed assets. This provision applies to personalty,but does not apply to realty (e.g., buildings). In 2016, the maximum amount that can bededucted under this limited expensing provision is subject to several overall limits. First,the total amount deducted cannot exceed $500,000. Second, the $500,000 amount isreduced dollar for dollar for § 179 asset purchases placed in service during the tax yearonce such purchases exceed $2,010,000. Finally, the § 179 deduction for a tax year can-not exceed the taxable income from the trade or business.

If Dr. Payne elects § 179 treatment for some of the fixed asset purchases of hisdental practice, he can reduce the Schedule C net income of his dental practicebeyond the $91,298 of depreciation expense computed using MACRS to a maximumof $500,000 § 179 expense for 2016.

The remaining amount of the $612,085 purchases of § 179 assets not deducted in thecurrent year are eligible for additional first-year depreciation and MACRS cost recovery.

For future reference associated with similar fixed asset purchases for his business,the sequence of calculating the deduction is as follows.

• § 179 limited expensing.

• Additional first-year depreciation.

• Standard MACRS cost recovery.ªER

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M8-32 PART 3 Deductions and Credits

Key Terms

Accelerated cost recoverysystem (ACRS), 8-2

Additional first-year depreciation, 8-10

Alternative depreciationsystem (ADS), 8-17

Amortization, 8-19

Cost depletion, 8-23

Cost recovery, 8-2

Depletion, 8-22

Depreciation, 8-2

Half-year convention, 8-6

Intangible drilling and development costs(IDCs), 8-23

Listed property, 8-13

Mid-month convention, 8-8

Mid-quarter convention, 8-7

Modified accelerated cost recoverysystem (MACRS), 8-2

Percentage depletion, 8-24

Residential rental real estate, 8-8

Section 179 expensing, 8-11

Startup expenditures, 8-19

Discussion Questions

1. LO.1 Discuss whether property that is classified as personal use is subject tocost recovery.

2. LO.1 Discuss the difference between personal property and personal use property.

3. LO.1 Discuss whether land improvements are eligible for cost recovery.

4. LO.2 At the beginning of the current year, Henry purchased a ski resort for $10 mil-lion. Henry does not own the land on which the resort is located. The Federal

government owns the land, and Henry has the right to operate the resort on the landpursuant to Special Use Permits, which are terminable at will by the Federal govern-ment, and Term Special Use Permits, which allow the land to be used for a fixednumber of years.

In preparing the income tax return for the current year, Henry properly allocated$2 million of the purchase price to the costs of constructing mountain roads, slopes,and trails. Since the acquisition, Henry has spent an additional $1 million on main-taining the mountain roads, slopes, and trails. Identify the relevant tax issues forHenry.

5. LO.2 Identify the three factors reflected in the MACRS tables when the amount ofcost recovery is determined.

6. LO.2 Discuss the computation of cost recovery in the year an asset is placed inservice when the mid-quarter convention is being used.

7. LO.2 Discuss the computation of cost recovery in the year of sale of an asset whenthe mid-quarter convention is being used.

8. LO.2 Robert purchased and placed in service $100,000 of 7-year class assets onAugust 10 of the current year. He also purchased and placed in service

$500,000 of 5-year class assets on November 15 of the current year. He does notclaim any available additional first-year depreciation. If Robert elects to use theMACRS straight-line method of cost recovery on the 7-year class assets, discuss thecalculation of cost recovery for the 5-year class assets.

9. LO.2 Jim owns a very large ranch. A large part of his business is the productionand raising of breeding cattle. Jim understands that he is entitled to use

MACRS cost recovery on breeding cattle. Identify the relevant tax issues for Jim withrespect to taking cost recovery on his self-produced breeding cattle.

10. LO.3 Discuss when § 179 expense must be recaptured.

11. LO.3 Explain how the § 179 limited expensing deduction affects the computationof MACRS cost recovery.

Issue ID

Issue ID


For the latest in changes to tax legislation, visit www.cengagebrain.com.

12. LO.3 Discuss the treatment of a § 179 expensing carryforward.

13. LO.3 Discuss the definition of taxable income as it is used in limiting the § 179expensing amount.

14. LO.2, 3 A professional consulting business sells professional tools and equipment andprovides associated services, such as repair and maintenance, to its customer

base. The company’s employees include technicians, who are required to provide andmaintain their own tools and equipment for performing the repairs and maintenancework. The company will reimburse a technician for amounts spent to purchase toolsand equipment eligible for a § 179 deduction up to a set amount each year. Any costsfor tools and equipment that exceed the set amount will not be reimbursed.

John is a technician for the company. During the current year, he purchasedequipment that qualifies for the § 179 deduction. John paid $50,000 for the equip-ment and was reimbursed the set amount of $40,000. Identify the relevant tax issuesfor John with respect to § 179 and the computation of his taxable income.

15. LO.4 Discuss how the limits on cost recovery apply to listed property.

16. LO.4 Discuss the tax consequences if the business use percentage of listed prop-erty falls to 50% or lower after the year the property is placed in service.

17. LO.7 Explain the amortization period of a § 197 intangible if the actual useful life isless than 15 years.

18. LO.7 Harold and Bart own 75% of the stock of Orange Motors. The other 25% ofthe stock is owned by Jeb. Orange Motors entered into an agreement with

Harold and Bart to acquire all of their Orange stock.In addition, Harold and Bart signed a noncompete agreement with Orange Motors.

Under the terms of the noncompete agreement, Orange will pay Harold and Bart$15,000 each per year for four years. Identify the relevant tax issues for Orange Motors.

19. LO.7 In May 2016, George began searching for a trade or business to acquire. Inanticipation of finding a suitable aquisition, George hired an investment

banker to evaluate three potential businesses. He also hired a law firm to begindrafting regulatory approval documents for a target company. Eventually, Georgedecided to purchase all of the assets of Brash Corporation. Brash and Georgeentered into an acquisition agreement on December 1, 2016. Identify the relevanttax issues for George.

20. LO.8 Discuss how the cost of mineral rights enters into the calculation of cost depletion.

Computational Exercises

21. LO.2 Euclid acquires a 7-year class asset on May 9, 2016, for $80,000. Euclid doesnot elect immediate expensing under § 179. She does not claim any available

additional first-year depreciation. Calculate Euclid’s cost recovery deduction for2016 and 2017.

22. LO.2 Hamlet acquires a 7-year class asset on November 23, 2016, for $100,000.Hamlet does not elect immediate expensing under § 179. He does not claim

any available additional first-year depreciation. Calculate Hamlet’s cost recoverydeductions for 2016 and 2017.

23. LO.2 Lopez acquired a building on June 1, 2011, for $1 million. Calculate Lopez’scost recovery deduction for 2016 if the building is:

a. Classified as residential rental real estate.

b. Classified as nonresidential real estate.

Issue ID

Issue ID

Issue ID


24. LO.2 Andre acquired a computer on March 3, 2016, for $2,800. He elects thestraight-line method for cost recovery. Andre does not elect immediate expens-

ing under § 179. He does not claim any available additional first-year depreciation.Calculate Andre’s cost recovery deduction for the computer in 2016 and 2017.

25. LO.2 Diana acquires, for $65,000, and places in service a 5-year class asset onDecember 19, 2016. It is the only asset that Diana acquires during 2016.

Diana does not elect immediate expensing under § 179. She elects additionalfirst-year deprecation. Calculate Diana’s total cost recovery deduction for 2016.

26. LO.3 McKenzie purchased qualifying equipment for his business that cost $212,000in 2016. The taxable income of the business for the year is $5,600 before con-

sideration of any § 179 deduction. Calculate McKenzie’s § 179 expense deduction for2016 and any carryover to 2017.

27. LO.4 On April 5, 2016, Kinsey places in service a new automobile that cost$36,000. He does not elect § 179 expensing, and he elects not to take any

available additional first-year depreciation. The car is used 70% for business and30% for personal use in each tax year.

Kinsey chooses the MACRS 200% declining-balance method of cost recovery (theauto is a 5-year asset). Assume the following luxury automobile limitations: year 1:$3,160; year 2: $5,100. Compute the total depreciation allowed for 2016 and 2017.

28. LO.7 On September 30, 2016, Priscilla purchased a business. Of the purchase price,$60,000 is allocated to a patent and $375,000 is allocated to goodwill. Calcu-

late Priscilla’s 2016 § 197 amortization deduction.

29. LO.8 On March 25, 2016, Parscale Company purchases the rights to a mineral inter-est for $8 million. At that time, the remaining recoverable units in the mineral

interest are estimated to be 500,000 tons. If 80,000 tons are mined and 75,000 tonsare sold this year, calculate Parscale’s cost depletion for 2016.

30. LO.8 Jebali Company reports gross income of $340,000 and other property-relatedexpenses of $229,000 and uses a depletion rate of 14%. Calculate Jebali’s

depletion allowance for the current year.

Problems

31. LO.1, 2 On November 4, 2014, Blue Company acquired an asset (27.5-year residentialreal property) for $200,000 for use in its business. In 2014 and 2015, respec-

tively, Blue took $642 and $5,128 of cost recovery. These amounts were incorrect;Blue applied the wrong percentages (i.e., those for 39-year rather than 27.5-year assets).Blue should have taken $910 and $7,272 cost recovery in 2014 and 2015, respectively.

On January 1, 2016, the asset was sold for $180,000. Calculate the gain or loss onthe sale of the asset for that year.

32. LO.1, 2 Jos�e purchased a house for $300,000 in 2013. He used the house as hispersonal residence. In March 2016, when the fair market value of the

house was $400,000, he converted the house to rental property. What is Jos�e’scost recovery for 2016?

33. LO.2 Orange Corporation acquired new office furniture on August 15, 2016, for$130,000. Orange does not elect immediate expensing under § 179. Orange

claims any available additional first-year depreciation. Determine Orange’s costrecovery for 2016.

34. LO.2 Weston acquires a new office machine (7-year class asset) on November 2,2015, for $75,000. This is the only asset Weston acquired during the year.



He does not elect immediate expensing under § 179. He claims the maximum addi-tional first-year depreciation deduction. On September 15, 2016, Weston sells themachine.

a. Determine Weston’s cost recovery for 2015.

b. Determine Weston’s cost recovery for 2016.

35. LO.2 Juan acquires a new 5-year class asset on March 14, 2016, for $200,000. Thisis the only asset Juan acquired during the year. He does not elect immediate

expensing under § 179. He does not claim any available additional first-year depre-ciation. On July 15, 2017, Juan sells the asset.

a. Determine Juan’s cost recovery for 2016.

b. Determine Juan’s cost recovery for 2017.

36. LO.2 Debra acquired the following new assets during 2016.

Date Asset Cost

April 11 Furniture $40,000

July 28 Trucks 40,000

November 3 Computers 70,000

Determine Debra’s cost recovery deductions for the current year. Debra does notelect immediate expensing under § 179. She does not claim any available additionalfirst-year depreciation.

37. LO.2 On August 2, 2016, Wendy purchased a new office building for $3.8 million.On October 1, 2016, she began to rent out office space in the building. On

July 15, 2020, Wendy sold the office building.

a. Determine Wendy’s cost recovery deduction for 2016.

b. Determine Wendy’s cost recovery deduction for 2020.

38. LO.2 On April 3, 2016, Terry purchased and placed in service a building that cost$2 million. An appraisal determined that 25% of the total cost was attributed

to the value of the land. The bottom floor of the building is leased to a retail busi-ness for $32,000. The other floors of the building are rental apartments with anannual rent of $160,000. Determine Terry’s cost recovery deduction for 2016.

39. LO.2 On May 5, 2016, Christy purchased and placed in service a hotel. The hotelcost $10.8 million. Calculate Christy’s cost recovery deductions for 2016 and

for 2026.

40. LO.2 Janice acquired an apartment building on June 4, 2016, for $1.6 million. Thevalue of the land is $300,000. Janice sold the apartment building on Novem-

ber 29, 2022.

a. Determine Janice’s cost recovery deduction for 2016.

b. Determine Janice’s cost recovery deduction for 2022.

41. LO.2, 3, 9 Lori, who is single, purchased 5-year class property for $200,000 and 7-yearclass property for $400,000 on May 20, 2016. Lori expects the taxable income

derived from her business (without regard to the amount expensed under § 179) to beabout $800,000. Lori wants to elect immediate § 179 expensing, but she doesn’t knowwhich asset she should expense under § 179. She does not claim any available additionalfirst-year depreciation.

a. Determine Lori’s total deduction if the § 179 expense is first taken with respectto the 5-year class asset.

b. Determine Lori’s total deduction if the § 179 expense is first taken with respectto the 7-year class asset.

c. What is your advice to Lori?

Decision Making


d. Assume that Lori is in the 25% marginal tax bracket and that she uses § 179 onthe 7-year asset. Determine the present value of the tax savings from the depre-ciation deductions for both assets. See Appendix G for present value factors,and assume a 6% discount rate.

e. Assume the same facts as in part (d), except that Lori decides not to use § 179on either asset. What is the present value of the tax savings generated by usingthe § 179 deduction on the 7-year asset?

42. LO.2, 3 Olga is the proprietor of a small business. In 2016, the business’s income,before consideration of any cost recovery or § 179 deduction, is $250,000.

Olga spends $600,000 on new 7-year class assets and elects to take the § 179deduction on them. She does not claim any available additional first-year deprecia-tion. Olga’s cost recovery deduction for 2016, except for the cost recovery withrespect to the new 7-year assets, is $95,000. Determine Olga’s total cost recovery for2016 with respect to the 7-year class assets and the amount of any § 179 carryforward.

43. LO.2, 3, 9 On June 5, 2015, Dan purchased and placed in service a 7-year classasset costing $550,000. Determine the maximum deductions that Dan

can claim with respect to this asset in 2015 and 2016.

44. LO.3, 4 Jabari Johnson is considering acquiring an automobile at the beginning of2016 that he will use 100% of the time as a taxi. The purchase price of the

automobile is $35,000. Johnson has heard of cost recovery limits on automobilesand wants to know how much of the $35,000 he can deduct in the first year.

Write a letter to Jabari in which you present your calculations. Also prepare a memofor the tax files, summarizing your analysis. Johnson’s address is 100 Morningside,Clinton, MS 39058.

45. LO.2, 4 On October 15, 2016, Jon purchased and placed in service a used car. Thepurchase price was $25,000. This was the only business use asset Jon

acquired in 2016. He used the car 80% of the time for business and 20% for personaluse. Jon used the MACRS statutory percentage method. Calculate the total deductionJon may take for 2016 with respect to the car.

46. LO.4 On June 5, 2015, Leo purchased and placed in service a new car that cost$20,000. The business use percentage for the car is always 100%. Leo claims

any available additional first-year depreciation. Compute Leo’s cost recovery deduc-tions for 2015 and 2016.

47. LO.2, 3, 4 On March 15, 2016, Helen purchased and placed in service a new Esca-lade. The purchase price was $62,000, and the vehicle had a rating of

6,500 GVW. The vehicle was used 100% for business. Calculate the maximum totaldepreciation deduction that Helen may take with respect to the vehicle in 2016.

48. LO.2, 4 On May 28, 2016, Mary purchased and placed in service a new $20,000 car.The car was used 60% for business, 20% for production of income, and 20%

for personal use in 2016. In 2017, the usage changed to 40% for business, 30% for pro-duction of income, and 30% for personal use. Mary did not elect immediate expensingunder § 179. She did not claim any available additional first-year depreciation. Com-pute Mary’s cost recovery deduction and any cost recovery recapture in 2017.

49. LO.2, 4, 9 Sally purchased a new computer (5-year property) on June 1, 2016, for$4,000. Sally could use the computer 100% of the time in her business,

or she could allow her family to use the computer as well. Sally estimates that if her fam-ily uses the computer, the business use will be 45% and the personal use will be 55%.

Determine the tax cost to Sally, in the year of acquisition, of allowing her family touse the computer. Assume that Sally would not elect § 179 limited expensing and thather marginal tax rate is 28%. She does not claim any available additional first-yeardepreciation.

Communications

Decision Making



50. LO.2, 4, 9 Dennis Harding is considering acquiring a new automobile that he willuse 100% for business. The purchase price of the automobile would be

$48,500. If Dennis leased the car for five years, the lease payments would be $375 permonth. Dennis will acquire the car on January 1, 2016. The inclusion dollar amountsfrom the IRS table for the next five years are $47, $103, $153, $183, and $210.

Dennis wants to know the effect on his adjusted gross income of purchasing ver-sus leasing the car for the next five years. He does not claim any available additionalfirst-year depreciation. Write a letter to Dennis, and present your calculations. Alsoprepare a memo for the tax files. His address is 150 Avenue I, Memphis, TN 38112.

51. LO.2, 5 In 2016, Muhammad purchased a new computer for $16,000. The computeris used 100% for business. Muhammad did not make a § 179 election with

respect to the computer. He does not claim any available additional first-year deprecia-tion. If Muhammad uses the MACRS statutory percentage method, determine his costrecovery deduction for 2016 for computing taxable income and for computing hisalternative minimum tax.

52. LO.2, 5, 9 Jamie purchased $100,000 of new office furniture for her business inJune of the current year. Jamie understands that if she elects to use ADS

to compute her regular income tax, there will be no difference between the costrecovery for computing the regular income tax and the AMT.

a. Jamie wants to know the present value of the tax cost, after three years, of usingADS rather than MACRS. Assume that Jamie does not elect § 179 expensing, shedoes not claim any additional first-year depreciation, and her marginal tax rate is28%. See Appendix G for present value factors, and assume a 6% discount rate.

b. What is the present value of the tax savings/costs that result over the life of theasset if Jamie uses MACRS rather than ADS?

53. LO.2, 7, 9 Mike Saxon is negotiating the purchase of a business. The final purchaseprice has been agreed upon, but the allocation of the purchase price to

the assets is still being discussed. Appraisals on a warehouse range from $1.2 millionto $1.5 million. If a value of $1.2 million is used for the warehouse, the remainder ofthe purchase price, $800,000, will be allocated to goodwill. If $1.5 million is allo-cated to the warehouse, goodwill will be $500,000.

Mike wants to know what effect each alternative will have on cost recovery andamortization during the first year. Under the agreement, Mike will take over thebusiness on January 1 of next year. Write a letter to Mike in which you present yourcalculations and recommendation. Also prepare a memo for the tax files. Mike’saddress is 200 Rolling Hills Drive, Shavertown, PA 18708.

54. LO.7 Oleander Corporation, a calendar year entity, begins business on March 1, 2016.The corporation incurs startup expenditures of $64,000. If Oleander elects § 195

treatment, determine the total amount of startup expenditures that it may deduct in 2016.

55. LO.7 Martha was considering starting a new business. During her preliminary investi-gations related to the new venture, she incurred the following expenditures.

Salaries $22,000

Travel 18,000

Interest on short-term note 4,000

Professional fees 13,000

Martha begins the business on July 1 of the current year. If Martha elects § 195 treat-ment, determine her startup expenditure deduction for the current year.

56. LO.8 Wes acquired a mineral interest during the year for $10 million. A geologicalsurvey estimated that 250,000 tons of the mineral remained in the deposit.

During the year, 80,000 tons were mined, and 45,000 tons were sold for $12 million.Other related expenses amounted to $5 million. Assuming that the mineral depletionrate is 22%, calculate Wes’s lowest taxable income, after any depletion deductions.

Decision Making

Communications

Decision Making

Decision Making

Communications


Cumulative Problems

57. Janice Morgan, age 24, is single and has no dependents. She is a freelance writer.In January 2015, Janice opened her own office located at 2751 Waldham Road, PleasantHill, NM 88135. She called her business Writers Anonymous. Janice is a cash basis tax-payer. She lives at 132 Stone Avenue, Pleasant Hill, NM 88135. Her Social Security num-ber is 123-45-6789. Janice’s parents continue to provide health insurance for her undertheir policy. Janice wants to contribute to the Presidential Election Campaign Fund.

During 2015, Janice reported the following income and expense items connectedwith her business.

Income from sale of articles $85,000

Rent 16,500

Utilities 7,900

Supplies 1,800

Insurance 5,000

Travel (including meals of $1,200) 3,500

Janice purchased and placed in service the following fixed assets for her business.Janice wants to elect immediate expensing under § 179.

• Furniture and fixtures (new) costing $21,000 on January 10.

• Computer equipment (new) costing $12,400 on July 28.

Janice’s itemized deductions include:

State income tax $3,000

Home mortgage interest paid to First Bank 6,000

Property taxes on home 1,500

Charitable contributions 1,200

Janice did not keep a record of the sales tax she paid. The pertinent amount fromthe sales tax table is $437.

Janice reports interest income of $4,000 on certificates of deposit at Second Bank.Janice makes estimated tax payments of $3,000 for 2015.

Compute Janice Morgan’s 2015 Federal income tax payable (or refund due). Ifyou use tax forms for your computations, you will need Forms 1040 and 4562 andSchedules A, B, and C. Suggested software: H&R BLOCK Tax Software.

58. John Smith, age 31, is single and has no dependents. At the beginning of 2016,John started his own excavation business and named it Earth Movers. John lives at 1045Center Street, Lindon, UT, and his business is located at 381 State Street, Lindon, UT.The ZIP Code for both addresses is 84042. John’s Social Security number is 111-11-1111,and the business identification number is 11-1111111. John is a cash basis taxpayer.During 2016, John reports the following items in connection with his business.

Fee income for services rendered $912,000

Building rental expense 36,000

Office furniture and equipment rental expense 9,000

Office supplies 2,500

Utilities 4,000

Salary for secretary 34,000

Salary for equipment operators 42,000

Payroll taxes 7,000

Fuel and oil for the equipment 21,000

Purchase of three new front-end loaders on January 15, 2016, for $550,000. 550,000

Purchase of a new dump truck on January 18, 2016 80,000

Tax Return Problem

Tax Computation Problem

Decision Making

Communications



During 2016, John recorded the following additional items.

Interest income from First National Bank $10,000

Dividends from ExxonMobil 9,500

Quarterly estimated tax payments 11,500

John makes the election under § 179 on the three front-end loaders purchased inJanuary. John claims any available additional first-year depreciation.

On October 8, 2016, John inherited IBM stock from his Aunt Mildred. John hadbeen her favorite nephew. According to the data provided by the executor of AuntMildred’s estate, the stock was valued for estate tax purposes at $110,000. John isconsidering selling the IBM stock for $125,000 on December 29, 2016, and using$75,000 of the proceeds to purchase an Acura ZDX. He would use the car 100% forbusiness. John wants to know what effect these transactions would have on his2016 adjusted gross income.

Write a letter to John in which you present your calculations, and prepare amemo for the tax files. Ignore any Federal self-employment tax implications.

Research Problems

Student Edition

Note: Solutions to Research Problems can be prepared by using the Checkpoint�

Student Edition online research product, which is available to accompany this text. Itis also possible to prepare solutions to the Research Problems by using tax researchmaterials found in a standard tax library.

Research Problem 1. Your client, Dave’s Sport Shop, sells sports equipment andclothing in three retail outlets in New York City. During 2016, the CFO decided thatkeeping track of inventory using a combination of QuickBooks and Excel was not anefficient way to manage the stores’ inventories. So Dave’s purchased an inventorymanagement system for $9,000 that allowed the entity to keep track of inventory, aswell as automate ordering and purchasing, without replacing QuickBooks for itsaccounting function.

The CFO would like to know whether the cost of the inventory management pro-gram can be expensed in the year of purchase. Write a letter to the CFO, CassandraMartin, that addresses the tax treatment of purchased software. Cassandra’s mailingaddress is 867 Broadway, New York, NY 10003.

Research Problem 2. In 2012, Jed James began planting a vineyard. The costs of theland preparation, labor, rootstock, and planting were capitalized. The land prepara-tion costs do not include any nondepreciable land costs. In 2016, when the plantsbecame viable, Jed placed the vineyard in service. Jed wants to know whether hecan claim a deduction under § 179 on his 2016 income tax return for the 2012 costsfor planting the vineyard.

Research Problem 3. Juan owns a business that acquires exotic automobiles that arehigh-tech, state-of-the-art vehicles with unique design features or equipment. Theexotic automobiles are not licensed or set up to be used on the road. Rather, the carsare used exclusively for car shows or related promotional photography. With respectto the exotic automobiles, Juan would like to know whether he can take a costrecovery deduction on his Federal income tax return.

Partial list of research aids:Bruce Selig, 70 TCM 1125, T.C.Memo. 1995–519.

Communications


Research Problem 4. Locate a financial calculator program that assesses the wisdomof buying versus leasing a new car. Install the program on your computer, andbecome familiar with it. Use the program to work through Problem 50 in thischapter.

Research Problem 5. Changes to depreciation systems often are discussed by policy-makers and observers of the tax system. Outline the terms and policy objectives ofone of the changes currently proposed by the Treasury, a member of Congress, or atax policy think tank.

Roger CPA Review Questions

1. Quanti Co., a calendar year taxpayer, purchased small tools for $5,000 on December21, 2016, representing the company’s only purchase of tangible personal propertythat took place during 2016. On its 2016 tax return, how many months of MACRSdepreciation may Quanti Co. claim on the tools?

a. One-and-a-half months

b. One month

c. Six months

d. None

2. Which of the following is correct about depreciation under Federal tax law?

I. The recovery period is longer than the useful life of the asset.II. There are different recovery periods for new and used property.III. Salvage values are ignored.

a. I and II only

b. II only

c. III only

d. I, II, and III

3. Joe purchased a van on February 1, 2016, for use in his business, Crew AirportTransport. The van was purchased for $30,000, has an estimated useful life of 10years, and has a salvage value of $2,000. No other assets were put into service thatyear. What is Joe’s MACRS depreciation for the van in 2016?

a. $2,567

b. $6,000

c. $10,500

d. $10,267

4. Dolly purchased and placed into service qualifying depreciable property in 2016 ata total cost of $2,250,000. Dolly has elected to take the § 179 deduction. What isDolly’s § 179 deduction for 2016?

a. $0

b. $260,000

c. $500,000

d. $1,750,000

5. In 2016, Christa purchased and placed into service five-year assets at a total cost of$2,250,000. If Christa elects both the § 179 deduction and additional first-year bonusdepreciation, but does not elect the straight-line method, what is Christa’s deprecia-tion expense for tax purposes for the year, assuming a half-year convention?

a. $260,000

b. $500,000

c. $1,250,000

d. $1,454,000

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