TOPIC 64: COST RECOVERY CONCEPTS in VS .NET

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TOPIC 64: COST RECOVERY CONCEPTS
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1 De nition of depreciable property A Property used in a trade or business or held to produce income B Property must lose its value over time C Property must have a determinable life of greater than one year 2 What cannot be depreciated A Property placed in service and disposed of in the same year B Land C Inventory D Equipment used to build capital improvements 3 Modi ed accelerated cost recovery system (MACRS) A Depreciation rules that apply to assets placed in service between 1981 and 1986 are often referred to as the accelerated cost recovery system (ACRS) Assets that are placed in service after 1986 fall under a modi ed cost recovery system, which is called the modi ed accelerated cost recovery system (MACRS) B ACRS generally provided faster recovery than MACRS, but only certain property placed in service under ACRS is still in service for tax purposes C The term accelerated means any cost recovery method that provides a higher deduction in the earlier years of the asset s recovery period than would have been provided in a straightline recovery method D The estimated useful life of an asset is irrelevant in the computation of tax depreciation with MACRS This often results in different numbers relative to what a rm reports as taxable income and what it reports as tax expense on its nancial statements E MACRS is used for most tangible assets in a business or in the production of income after 1986 Eight cost recovery periods are used for property: 3, 5, 7, 10, 15, 20, 271 2, and 39 years The most important recovery periods to know are those for computer software, at 3 years; cars and computer hardware, at 5 years; of ce furniture and xtures, at 7 years; residential real estate, at 271 2 years; and nonresidential rental property, at 39 years F Assets with a 3-, 5-, 7-, or 10-year recovery period are depreciated using a 200 percent declining-balance method Assets with a 15-year or 20-year recovery period are depreciated using a 150 percent declining-balance method The depreciation method switches to straight-line when a straight-line computation over the remaining recovery period results in a greater reduction There is no salvage value below 200 percent and 150 percent decliningbalance For property with a life of 271 2 or 39 years, straight-line depreciation must be used MACRS is an accelerated cost recovery system in name only for these assets G Cost basis (1) Depreciation allows for the recovery of the cost of assets purchased for use in a trade or business (a) Reduces the cost basis of an asset, thus increasing future gains (b) Reduces current income by providing a deduction in calculating net income for a business
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204 - Income Tax Planning (2) Example: Rental property cost $50,000, sold for $90,000, and had $15,000 in depreciation The amount of gain is Step 1 Step 2 Adjusted basis = Basis ($50,000) Depreciation ($15,000) Gain = Proceeds ($90,000) Adjusted basis ($35,000) = $55,000
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(3) Allowed or allowable rule Even if depreciation was not deducted on the taxpayer s return, the basis must be reduced by the depreciation that was allowable for that year H Half-year convention (1) The half-year convention means that in the rst year of the recovery period, six months of depreciation is allowed regardless of when the asset was purchased The rm later claims six months of depreciation in the year in which the asset is disposed of (2) This applies to all assets with a recovery period of 3 to 20 years (3) Exception: If more than 40 percent of the depreciable assets acquired during a taxable year are placed in service during the last three months of the year, the rm must use the midquarter convention I Midquarter convention (1) If the midquarter convention is used, then it must be used for all assets (recovery period of 3 to 20 years) placed in service during the year (2) Assets placed in service or disposed of in any quarter are assumed to be placed in service, or disposed of, at the midpoint of the quarter 4 Repairs A When a cost incurred in regard to an asset will lengthen its useful life or increase its market value, the cost is considered a betterment and must be added to the cost of the asset and depreciated over the life of the associated asset B If the cost is incurred only to bring the asset back to its normal use, then it will be considered a repair and can be expensed to reduce current income 5 Special elections (Section 179 deduction) A A special election is an election to deduct all or part of the cost of certain qualifying property in the year it is placed in service, instead of taking depreciation deductions over a speci ed recovery period B Taking the deduction on Form 4562 makes the election Election can be revoked only with IRS consent C Limitations (1) The aggregate cost that may be taken into account for any taxable year cannot exceed the following applicable amount: $25,000 (2003 or later) (2) The applicable maximum deduction for any year is reduced (but not below zero) by the amount of qualifying property placed in service during the tax year that exceeds $200,000 (3) The total cost that can be deducted is limited to taxable income from the active conduct of any trade or business during the tax year No loss can be created or increased by Section 179 The limit applies at both the business entity level and the individual level (4) If a deduction is fully used for the year, amounts above the limit can be considered for depreciation D Property that quali es (1) Certain tangible property (except most buildings and their structural components), including luxury autos having a gross weight of more than 6,000 pounds
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Topic 65: Tax Consequences of Like-Kind Exchanges - 205 (2) Leased property usually does not qualify, with exceptions for (a) Property manufactured or produced by the lessor (b) Certain property that is subject to a short-term lease E Section 179 is not permitted if business use is 50 percent or less F Section 179 recapture is required if business use drops to 50 percent or less G For partnerships and S Corporations, the Section 179 deduction passes through to the owners but is limited by the Section 179 dollar limitation regardless of how many businesses the individual owns 6 Amortization A Amortization is used for intangible assets that have a de nite life for example, a patent or copyright B There is a 15-year amortization for intangibles beginning in the month of acquisition C Certain intangibles are speci cally excluded: (1) Interests in corporations, partnerships, trusts, and estates (2) Interests in land (3) Computer software not acquired in connection with the purchase of a business or which is readily available to the general public (4) Sports franchises (5) Professional fees and transportation costs incurred in a corporate organization or reorganization
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