McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Principles of Taxation

Chapter 6Property Acquisitions and Cost Recovery

Deductions

Slide 6-2

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Objectives Expense versus capitalize. Define tax basis and adjusted basis. Show how leverage reduces the after-tax

cost of assets. Compute cost of goods sold. Use recovery period, method and

convention to compute MACRS depreciation.

Explain the limited expensing election. Understand role of depreciation in NPV of

after-tax cash flows. Amortize intangibles, deplete resources.

Slide 6-3

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Expense vs. Capitalize

Deduction permitted for all “ORDINARY AND NECESSARY” business expenses.

Deduction prohibited for “PERMANENT improvements to increase the value of property.”

Some types of capitalized costs can be recovered through amortization or depreciation.

Slide 6-4

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Expense vs. Capitalize

Repairs and maintenance? Source of IRS dispute due to facts.

Are environment cleanup and prevention costs expensed or capitalized?

Capitalize expenditures that increase the _________ or _______ ______ of an asset.

Slide 6-5

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Tax Subsidies Permit Expensing

R&D expenses (this is BIG). Allowing deduction for R&D is a tax

subsidy. What is the GAAP rationale for requiring expense under SFAS 2?

Y2K costs - IRS has ruled these can be expensed.

Various oil and gas: IDC, depletion The IRS allows deductions for

advertising. Why might this be considered an asset in the absence of specific allowance?

Slide 6-6

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Tax Basis Tax basis = unrecovered cost. Starting basis generally equals COST basis:

original purchase price, or _________ of asset if cost more difficult to

measure. When do you recover the cost?

Depreciation or sale. Example: For depreciable equipment, adjusted basis is the original basis reduced by depreciation. You can think of adjusted basis as being the tax equivalent of “net book value” of the asset, but with tax depreciation instead of book depreciation.

Slide 6-7

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Tax Basis and Leverage If you buy an asset with $500 cash and

$4500 debt, what is the cost basis? Deductions for interest and cost recovery

(depreciation) can improve NPV of after-tax cash flows. AP1, 2 Study example in text regarding After-Tax Cost of

Leveraged Purchase. Note especially the footnote describing the effect of borrowing rate versus internal discount rate.

Tax deductions made some leveraged tax shelters in early 1980’s had positive NPV even when pre-tax flows were breakeven or negative. Chapters 9 and 15 will discuss limits on such tax shelter losses.

Slide 6-8

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Cost Recovery

Cost of goods sold Depreciation Amortization Depletion

Slide 6-9

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Cost of goods sold

Similar to GAAP1) Beginning inventory2) PLUS_____________3) = inventory available for sale4) MINUS_________ ____________5) = CGS

Tax versus GAAP differences may occur in capitalization of indirect costs. Tax requires “uniform capitalization” under Section 263. AP4

Slide 6-10

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Cost of Goods Sold Uniform capitalization rules (IRC Section

263)What indirect costs must be capitalized?

Examples? Officers’ comp (VP Mfg.), employee benefits, building rent, insurance, depreciation.Why might there be book-tax differences in indirect costs being capitalized?

Slide 6-11

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Cost of Goods Sold

What are permissible inventory methods? Which ones require book-tax conformity?123Which method requires book-tax

conformity? In times of inflation, LIFO reduces

book and taxable income.

Slide 6-12

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Depreciation

Depreciation applies to tangible assets (things you can touch, versus intangibles like patents, goodwill) that: lose value over time due to wear and

tear, obsolescence.Does this rule make sense for real

estate?have a reasonably

ascertainable__________ _________.What do you think about artwork?

Slide 6-13

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Depreciation

MACRS - Modified Accelerated Cost Recovery SystemFixed recovery methods and periods

Personalty and other short-lived property:

DDB: 3, 5, 7, 10 150% DB:15, 20

Realty: SL method: _____ years residential, _____ years non-residential (specialty realty 20, 25, 50).

Slide 6-14

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Depreciation Conventions - Personalty

Table 6-2 incorporates a half-year convention - provides only 1/2 of the regular rate in the year the property is put in service.

When dispose of asset, multiply table amount by 1/2 in the year of sale.

Buy $10,000 of 7-year property in 1997. Sell the property in 1999. What is 1997, 1998 and 1999 depreciation?

Slide 6-15

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Depreciation Conventions - Personalty

Exception to mid-year convention: IF > _____ % personalty is acquired

during the last quarter of the year, THEN

Compute depreciation separately for EACH quarter’s acquisition.

See the MID-QUARTER tables. (Instructor hand out in class.) ONLY adjust table amounts in year of disposition.

AP6, TPC 1.

Slide 6-16

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Depreciation Conventions - Realty

Mid-month convention. Get 1/2 of a month in month acquired. Built into Table 6-3. Choose column for month put in service. Use this same column throughout the asset life. AP10.

Like personalty, you have to adjust table amount in year of disposition. Get _____ of a month for the month of disposition.

Buy apartment building for $1,000,000 in August 1995. Sell in March 1999. What is depreciation in 1995 - 1999?

Slide 6-17

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Depreciation Conventions

What is the purpose of the half-year, midquarter and midmonth conventions?Balance 1) prevent taxpayer from

claiming a full year of depreciation if hold only for a portion of the year against

2) Easier rules than computing actual days held.

Slide 6-18

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Expensing Election

Applies to tangible personalty. 2001 amount = $_________. See AP8. Limits:

Expense cannot create a__________ .Expense reduced $ for $ if purchases

> $__________. AP9. Reduces record keeping, benefit for small

businesses. Planning - if buy a 3-year, 5-year and 7-

year asset, which one should you expense?

Slide 6-19

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Other Depreciation Details Not in Text

Combination business and personal use property - “listed property” - such as computers, phones, cars. Only use accelerated depreciation if business use > 50%.

Cars have additional depreciation limits per year.

Different depreciation methods apply for Alternative Minimum Tax purposes (Chapter 10, 14).

Slide 6-20

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Lease versus Buy Example in text compares purchasing for cash

up-front to an operating lease. Tax rules are similar to financial rules for

determining whether a lease is capital or ordinary. A capital lease is treated like a purchase by the lessee.

A lessee who obtains assets through an operating lease:gives up interest and depreciation

deductions (because lessor still owns the asset), but

doesn’t have deemed debt on financial balance sheet.

Slide 6-21

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Amortization of Intangibles

Generally requires a determinable useful life.

Organizational costs are amortizable straight line method over ____ months.

Start-up costs are also amortizable straight line method over ____ months - some exceptions.

Expansion costs may be currently deductible.

Slide 6-22

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Leasehold Costs and Improvements

Cost of acquiring lease is amortized over the period of _______ .

Improvements to leased property are capitalized and depreciated according to type of property. What do you suppose happens when lease ends?

Slide 6-23

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Purchased Intangibles

Allocate lump-sum price to assets by relative FMVs.

Residual = goodwill. Tax = ____ years SL, GAAP = ____ years

SL. Book-tax difference is temporary under current tax laws.

Slide 6-24

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Depletion

Cost depletion = ___________ * __________ / ___________________.

Percentage depletionstatutory % of gross income. See

Q18. Deduct the greater of cost or

percentage depletion.

Slide 6-25

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Review - Book-Tax Differences

Temporary differences due to: Depreciation, inventory methods, goodwill amortization. (This used to be permanent before 1992 when goodwill was not amortizable for tax.)

AP11. Permanent differences due to %

depletion (in excess of cost).