Capital Recovery: Depreciation, Amortization, and Depletion

CHAPTER 9: CAPITAL RECOVERY: DEPRECIATION, AMORTIZATION, AND DEPLETION.

1. Depreciation and Amortization for Tax Purposes.

1. General Rules for Depreciation Deductions: apply only for property is used in a trade or business or held for the production of income. This rule makes it clear that not all capital expenditures for property are automatically eligible for depreciation.

1. Exhaustion, wear, tear, and obsolescence:

• Depreciation is allowed only for property that has a determinable life.
• Ex: lands, works of art cannot be amortized or depreciated since they normally have an indefinite life.
• Intangible assets with definite lives (patents, copyrights, licenses) that cover a fixed term, can be amortized.

1. Business or Income-Producing Property:

• Property is used in a trade or business or held for the production of income -> deductible.
• Land and inventory are not depreciable.
• If a single asset may be used for both personal purposes and profit-seeking activities, the taxpayer is permitted to deduct depreciation on the portion of the asset used for business or production of income.
• Property held for the production of income, even though not currently producing income, may still be depreciated. (ex: rental house may still be depreciated for the period during which it is not rented.)

1. Depreciable basis:

• The basic for depreciation is the adjusted basis of the property as used for computing gain or loss on a sale or other disposition. -> this is usually the property’s cost.
• Where property used for personal purposes IS CONVERTED to use in business or the production of income, the basis for depreciation purposes is the lesser of the fair market value or the adjusted basis at the time of conversion.

1. Commencement of depreciation:

• Depreciation may not begin until an asset is placed in service.

1. Historical perspective

1. Modified accelerated cost recovery system.

1. Overview MACRS (Section 168)

Caution: here, and in tax practice, the terms ACRS and MACRS tend to be used interchangeably, although technically ACRS refers to 1981-1986, and MACRS refers to 1987 – forward78

• To actually compute depreciation, taxpayers must first determine when the asset is placed in service, whether the property is subject to MACRS, then-based on the property’s classification-determine the applicable method, recovery period, and accounting convention.

1. Property subject to MACRS

• most tangible depreciable property (realty and personalty)
• MACRS is not used to:

• amortize intangible assets such as patents or copyrights which are amortized using the straight-line method.
• Property depreciated using a method that is not based on years. (the units-of production or income forecast methods)
• Automobiles if the taxpayer has elected to use the standard mileage rate (such as election precludes a depreciation deduction)
• Property for which special amortization is provided and elected by the taxpayer in lieu of depreciation (ex: amortization of pollution control facilities)
• Certain motion picture films, video tapes, sound recordings, and public utility property.
• Any property that taxpayer- or a party related to the taxpayer-owned or used (ex:least) prior to 1987  

1. Classes of property & calculating depreciation

Personalty:  Recovery Periods and Methods

1. Classes of property

• 5 year property - cars and light duty trucks, computers, typewriters, copiers, heavy general purpose trucks
• 7 year property - almost all other personalty (including office furniture and fixtures)
• There are several other classifications

1. Depreciation methods (see Exhibit 9-1 in text and IRS Publication 946)

• for MACRS (GDS), personalty may be depreciated using 200%DB or straight-line

(GDS = General Depreciation System, the most commonly used option of MACRS)

1. Conventions used for personalty (Sec. 168(d))

• Half year convention -> general rule: Deduct 1/2 year of depreciation in the year the asset is placed in service (the depreciation tables do this part for you!) and deduct 1/2 year of depreciation in the year the asset is retired or disposed of
• Mid-quarter convention -> must use this convention for ALL personalty placed in service that year if more than 40% of the value of personalty is placed in service during the last quarter of the year

Answer this question to determine which convention applies:

Was more than 40% (of the value) of personalty placed in service during the last quarter of the year?