Tax Test 3 Study Guide Chapter 8 Depreciation Cost Recovery Amortization and Depletion The Code allows depreciation cost recovery amortization or depletion deduction based on an asset s cost Cost recovery deductions are based on the premise that the asset acquired or improvement made benefits more than one accounting period Taxpayers may write off deduct the cost of certain assets that are used in a trade or business or held for the production of income o Tangible assets are depreciated o Natural resources oil gas coal and timber are depleted o Intangible assets copyrights and patents are amortized Generally no write off is allowed for an asset that does not have a determinable useful life Depreciation and Cost Recovery Nature of Property Property includes both realty real property and personalty personal o Realty land and buildings permanently affixed to the land o Personalty any asset that is not realty furniture machinery equipment and many other types of assets Personalty or personal property should not be confused with personal use property property o 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 Both realty and personalty can be either business use income producing assets property or personal use property o Examples A residence realty that is personal use An office building realty that is business use A dump truck personalty that is business use Common wearing apparel personalty that is personal use Assets used in trade or business or for the production of income are eligible for cost recovery if they are subject to wear and tear decay or decline from natural causes or obsolescence e g an automobile that the taxpayer rents to third parties Assets that do not 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 Placed in Service Requirement Commencement of depreciation is the date an asset is placed in service NOT the purchase date of the asset Cost Recovery Allowed or Allowable Allowed the cost recovery actually deducted Allowable the amount that could have been taken under the applicable cost recovery method The basis of cost recovery property is reduced by the cost recovery allowed but NOT by less than the allowable amount If no cost recover is claimed on property the basis of the property is still reduced by the amount of cost recovery that should have been deducted allowable cost recovery Cost Recovery Basis for Personal Use Assets Converted to Business or Income Producing Use If personal use assets are converted to business or income producing use the basis for cost recovery and for loss is the lower of o The adjusted basis cost of asset cost recovery of asset or o The fair market value Lower of basis rule losses that occurred while the property was personal use property or before conversion are not recognized for tax purposes through cost recovery of the property Modified Accelerated Cost Recovery System MACRS General Rules Under the modified accelerated cost recovery system MACRS the cost of an asset is recovered over a predetermined period that generally is shorter than the useful life of the asset or the period that the asset is used to produce income Personalty Recovery Periods and Methods Classification of Property MACRS provides that the cost recovery basis of eligible personalty is recovered over 3 5 7 10 15 or 20 years o 200 declining balance is used for 3 5 7 and 10 year classes o 150 declining balance is allowed for the 15 and 20 year classes To determine the amount of the cost recovery allowances simply identify the asset by class and go to the appropriate table for the percentage Taxpayer may elect the straight line method to compute cost recovery allowances for each of these classes of property Class of Property 3 Year Cost Recovery Periods MACRS Personalty Examples Tractor units for use over the road Any horse that is not a racehorse and is more than 12 years old at the time it is placed in service Any racehorse that is more than 2 years old at the time it is placed in service Breeding hogs Special tools used in the manufacturing of motor vehicles such as dies fixtures molds and patterns 5 Year 7 Year 10 Year 15 Year 20 Year Automobiles and taxis Light and heavy general purpose trucks Buses Trailers and trailer mounted containers Typewriters calculators and copiers Computers and peripheral equipment Breeding and dairy cattle Rental appliances furniture and carpets Office furniture fixtures and equipment Breeding and work horses Agricultural machinery and equipment Railroad tracks Vessels barges tugs and similar water transportation equipment Assets used for petroleum refining or for the manufacture of grain and grain mill products sugar and sugar products or vegetable oils and vegetable oil products Single purpose agricultural or horticultural structures Land improvements Assets used for industrial steam and electric generation and or distribution systems Assets used in the manufacture of cement Assets used in pipeline transportation Municipal wastewater treatment plant Farm buildings except single purpose agricultural and horticultural structures Gas utility distribution facilities Water utilities Municipal sewer Half year convention MACRS views property as placed in service in the middle of the asset s first year o Example the statutory recovery period for the property with a life of three years begins in the middle of the year an asset is placed in service and ends three years later o Means taxpayers must wait and extra year to recover the full cost of MACRS also allows for a half year of cost recovery in the year of disposition depreciable assets or retirement o Example Kareem acquired a 5 year class asset on April 10 2014 for 30 000 Kareem s cost recovery deduction for 2014 is computed as follows MACRS cost recovery 30 000 x 20 table 8 1 6 000 Now assume Kareem disposes of the asset on March 5 2016 Kareem s cost recovery deduction for 2016 is computed as follows 30 000 x x 192 table 8 1 2 880 Mid Quarter Convention Mid Quarter Convention applies if more than 40 percent of the value of property other than eligible real estate is placed in service during the last quarter of the year o Property acquisitions are grouped by the quarter they were acquired for cost recovery purposes