Federal Income Taxation Chapter 15 Capital Cost Recovery

Transcription

1 Presentation: Federal Income Taxation Chapter 15 Capital Cost Recovery Professors Wells October 24, 2017

2 Antiques p.870 Richard L. Simon Simon acquired two Tourte bows for $30,000 and $21,000, respectively. Simons claimed tax depreciation for the two bows, and the IRS disallowed the deductions. Bows will be played out with continued use, but evidence showed that the bows increased in value as antiques. Second Circuit upheld deduction. Tourte bow was tangible property that was placed in service in taxpayer s business and were of a character that is subject to depreciation because their frequent use subjects them to wear and tear and eventually causes them to lose their ability to be used in performances. IRS argument that bows had appreciated in value was reason to not allow deprecation was rejected. Why? 2

3 Land & Improvements p.878 World Publishing Co. v. Commissioner Taxpayer purchases land with building constructed by lessee for $700,000. The taxpayer allocated $300,000 of the purchase price to the lease and depreciated that $300,000 over the life of the lease. IRS asserted that the taxpayer had no interest in the building as it would be fully depreciated by the time the lease expired. Court allowed taxpayer to claim a depreciation deduction. It was irrelevant who built the building. In any event, the purchaser bought a land with a building that provided rent, so the purchase price should be allocated. 3

4 Amortization of Intangibles p.885 Newark Morning Ledger Allocation of part of the purchase price for newspapers was allocated to the subscribers lists. How demonstrate the useful lives? Apply a mass asset rule? Treat as separate from goodwill? Response: Code 197 (p.897) - permitting (or requiring) 15 year amortization for intangibles (subject to certain exceptions). 4

5 Recovery of Capital Expenditures p.902 Depreciation Code 167 & 168. Adjusted Tax Basis = Original Tax Basis - Depreciation Objective: allocate the cost of a depreciating item over its period of productivity. Concept of matching income with the expenses associated with that income over the asset s useful life (as prescribed in the Code). This assumes useful life is determinable. For federal income tax purposes how should the cost (i.e., tax basis) for equipment, buildings, and intangibles (other than financial instruments) be recovered (prior to disposition)? 5

6 Economic Depreciation p.909 Value of property is equal to the present value of the remaining cash flows expected over the assets remaining useful life. This is called economic depreciation. Theoretically correct depreciation would be to allow depreciation equal to amount asset declines in value. Example: $34,441 $34,441 $34,441 $34,441 $34,441 $34,441 $150,000 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 $130,559 $109,174 $85,649 $59,774 $31,310 Yr 6 $0 Economic Depreciation $19,441 $21,385 $23,525 $25,875 $28,464 $31,310 6

7 What Assets Are Depreciable? Code 167(a) prescribes the statutory allowance for depreciation: 1) property must be used in the trade or business or held for the production of income, and 2) must be subject to exhaustion, wear and tear (including obsolescence). Raw land and corporate stock are not depreciable assets (cf., economic value). 7

8 Effect of The Depreciation Deduction on Tax Basis Depreciation reduces tax basis, but not if disallowed as a deduction. Personal use property does not cause a reduction in tax basis. Similar if a Code 280F(a) disallowance. 8

9 Code 168 Depreciation Deduction Issues p.902 Tangible property depreciation rules. What amount is deductible? Consider: 1) Property classification - 168(e). 2) Recovery period - 168(c). 3) Depreciation method - 168(b). 4) Applicable convention - 168(d). Note: no salvage value is required - 168(b)(4). 5) Bonus Depreciation - 168(k) 9

10 Tangible Personal Property Depreciation Computation See Code 168(b)(3) concerning the classification of property for establishing depreciation lives. Code 168(b)(1)(A) requires the use of the 200% declining balance method (until switch-over to S.L. is preferable). What is a declining balance method? What is a half-year convention? See Code volume preface (Rev. Proc ). 10

11 Example: $300,000 Cost Industrial Machine Entire $300,000 cost is deductible. Five year class life; 5 year property. No 179. Bonus depreciation of 50% per 168(k). Regular depreciation uses 200 percent declining balance method. Annual Depreciation Original Cost 300,000 Bonus per 168(k) 50% 150,000* Yr. 1 (Bonus) Adjusted Basis after Bonus Depreciation 150,000 20% 200% ,000 Yr. 1 (Regular) EOY 1 Adjusted Tax Basis 120,000 20% 200% 1 48,000 Yr. 2 EOY 2 Adjusted Tax Basis 72,000 20% 200% 1 28,800 Yr. 3 EOY 3 Adjusted Tax Basis 43,200 20% 200% 1 Yr. 4 EOY 4 Adjusted Tax Basis 25,920 17,280** Yr.5 EOY 5 Adjusted Tax Basis 8,640 8,640 Yr. 6 * Note: Congress has given bonus depreciation on top of regular depreciation for investments through See 168(k). Added by 143(a)(5)(A), P.L , Protecting Americans From Tax Hikes Act of 2015 (Dec. 18, 2015). ** Note: In Year 5, the use of the straight line method provides a larger benefit of $17,280 (i.e., $17,280 x 1 year/1.5 years remaining) compared to the depreciation benefit of $6,912 from using double declining (i.e., $17,280 x 20% x 200%). 11

12 Example: $150,000 Cost Industrial Machine Comparison of Economic Depreciation to Tax Depreciation $60,000 $50,000 $40,000 $30,000 Economic Deprecia-on Tax Deprecia-on $20,000 $10,000 $

13 Depreciation Recapture Personal Property Asset s tax basis is reduced (below FMV?) by tax depreciation. Code 1016(a)(2). p Asset Through depreciation the tax basis is recovered in portions, not all at once. All disposition gain equal to prior tax depreciation deductions is ordinary > 1221(a)(2) > 1231 > 1245 Avoids tax arbitraging (except timing). 13

14 Depreciation Recapture Problem 1 (Sales Price Below Recomputed Basis) p.914 Sale of office equipment: Original Cost 30,000 Depreciation Claimed 8,000 Sales Price 25,000 Amount realized of 25,000 less 22,000 adjusted basis (30-8=22); this 3,000 gain is recaptured as ordinary income (up to the amount of prior depreciation) under

15 Depreciation Recapture Problem 2 (Sales Price Above Recomputed Basis) p.914 Sale of personal property acquired last year. Cost 100,000 Depreciation 9,000 Sales Price 110,000 Amount realized of 110,000 less 91,000 adjusted basis provides gain of $19,000; $9,000 of this gain is recaptured as ordinary income (up to prior depreciation) under By taking the excess of the recomputed basis over adjusted basis ($100,000 - $91,000). 15

16 Real Property Depreciation Computation p.916 No depreciation is available for land (since not a wasting asset). Residential real property or nonresidential property depreciation 27.5 years (residential), or 39 years (nonresidential) recovery periods. Code 168(c) & (e)(2). Straight line depreciation. 168(b)(3). A mid-month convention is applicable for the year the asset is placed into service. 16

17 Depletion p.916 Do oil & gas deposits and hard minerals deposits get depleted? Should cost recovery (of tax basis) be permitted for tax purposes? Wasting asset? How should such depletion be determined? Cost Depletion? Percentage Depletion? Note: Code 611 permits a reasonable allowance for depletion. 17

18 Percentage Depletion -- p.917 % of Revenue This deduction is based on a percentage of the revenue from the minerals extracted. The deduction cannot exceed a specified portion of taxable income. Not available for oil and gas, except for small royalty owners and independent producers (and certain others). 613A. Percentage depletion deduction continues after tax basis has been reduced to zero. 18

19 IDCs & Hard Minerals Exploration Expenses p.918 IDCs for oil & gas wells are deductible. 263(c) & Reg Cf., exploration. 617 permits a current deduction of hard mineral exploration expenses. Deducted expenses must be recaptured when production commences. What is a development expense? Answer: The cost of preparing the site for production or extraction. See