Chapter 9

Property Acquisition and Cost

Recovery

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Learning Objectives
1.

2.

3.

4.

5.

Explain the concept of basis and adjusted basis and

describe the cost recovery methods used under the tax
law to recover the cost of personal property, real
property, intangible assets, and natural resources
Determine the applicable cost recovery (depreciation)
life, method, and convention for tangible personal and
real property and calculate the deduction allowable
under basic MACRS
Explain the additional special cost recovery rules (179,
bonus, listed property) and calculate the deduction
allowable under these rules.
Explain the rationale behind amortization, describe the
four categories of amortizable intangible assets, and
calculate amortization expense
Explain cost recovery of natural resources and the
allowable depletion methods
9-2

Cost Recovery
Businesses must capitalize the cost of assets
with a useful life of more than one year on the
balance sheet rather than expense the cost
immediately
Also known as depreciation, amortization, or
depletion depending upon the underlying
nature of asset
Businesses use these methods to recover cost
of assets due to wear, tear and obsolescence of
assets

9-3

Cost Recovery

9-4

Cost Recovery

Basis for Cost Recovery

An assets cost basis includes all the expenses to

purchase, prepare it for use, and begin using the asset.
Once the use of purchased assets is started, recouping
the cost of assets also starts
Cost basis reduces when cost is recovered through Cost
Recovery Deductions which is called Assets Adjusted
Basis or Tax Basis
Assets Adjusted Basis = Assets Initial Cost or Historical
basis minus Accumulated Depreciation (Amortization or
Depletion)
9-5

Cost Recovery

Basis for Cost Recovery

What about costs incurred after placing an asset in

service?

If the cost is routine maintenance, its expensed

immediately.
If the cost results in a betterment, restoration, or new or
different use for the property, capitalize the cost and
depreciate or amortize it over time

9-6

Basis Example
Neckflix Inc., a necktie subscription service,
purchased an old warehouse for $175,000 for
use in expanding its current operations. An
additional $15,000 was spent remodeling the
building in preparation for its opening.
Two years later, a Neckflix employee discovered
that several leaks in the roof were causing
serious water damage to the neckties in
inventory; the company spent $50,000 to re-roof
the building.
Every six months, Neckflix pays $500 to have
the carpet professionally cleaned.

9-7

Depreciation-Tangible
property

Before 1981, tax depreciation methods closely

resembled financial accounting methods which required
businesses to determine Salvage Values and Useful
Lives.
In 1981, ACRS Accelerated Cost Recovery System
was introduced to depreciate assets over predetermined,
fixed recovery periods.
Today, businesses calculate their tax depreciation using
the MACRS- Modified Accelerated Cost Recovery
System. Simpler than book depreciation.

9-8

Depreciation

To compute MACRS depreciation for an asset, the

business needs to know:

Assets original cost,

Applicable depreciation method (S/L, double declining),
Assets recovery period (or depreciable life),
Applicable depreciation convention (depreciation
deductible in the year of acquisition and the year of
disposition).

Method, recovery period and convention vary based on whether

the asset is personal property or real property.

9-9

Depreciation

Personal Property Depreciation

Personal property is any property that is not real

property, and is not the same thing as personal use
property.

Generally, personal property is not attached to the ground

Includes all tangible property such as computers,

automobiles, furniture, machinery and equipment,
other than real property.

9-10

Depreciation

Depreciation Method

Three acceptable methods for depreciating personal property:

200 percent (double) declining balance.

Default method
Generates the largest depreciation expense in the early years of the assets lives.

150 percent declining balance.

Straight-line.

Depreciation method has to be the same for all similar assets

put into service in a given year, but can change from year to
year.

9-11

Depreciation

Depreciation Recovery Period

For financial accounting purposes an assets recovery period

(depreciable life) is based on its taxpayer-determined estimated
useful life.
For tax purposes, an assets recovery period is predetermined by
IRS in Rev. Proc. 87-56 which helps payers to categorize each of
their assets based upon the propertys description.
Once the business has determined the appropriate categories for
its assets, it can use the Revenue Procedure to identify the
recovery period for all assets in a particular category

9-12

Depreciation

9-13

Depreciation

9-14

Depreciation
Depreciation

conventions

Half-year convention

One-half of a full years depreciation is allowed in the

first and last year of an assets life.
IRS depreciation tables automatically account for the
half-year convention in the year of purchase and
disposition
If an asset is disposed of before it is fully depreciated,
the applicable depreciation amount = Original basis *
MACRS rate in the year of disposition * 1/2

Half-year Convention (Example

9/3 and 9/5)
Teton is using the 200 percent declining balance method and
half-year convention to compute depreciation expense on its
current year personal property additions. What is Teton's
depreciation expense for these assets?
Date Placed in
Asset
Service
(1) Original Basis
Office furniture
February 3
$ 10,000
Machinery
July 22
510,000
Used delivery truck
August 17
15,000
Total

(2) Rate
14.29%
14.29
20.00

Assume that Teton sells all of its office furniture in year 2 (the
year after it buys it). What is Teton's depreciation for the office
furniture in the year of disposition (year 2)?

Depreciation

MidQuarter Convention

Steps to determine whether the midquarter convention

applies:

Sum the total basis of tangible personal property that was

placed in service during the year.
Sum the total basis of tangible personal property that was
placed in service during the fourth quarter (Oct-Dec).
Divide step (2) by step (1). If the result is more than 40%, then
the business must use mid-quarter method for all personal
property placed in service during the year.

9-17

Mid-Quarter convention
(Example 9-7/9-8)
Under this scenario, is Teton required to use the
mid-quarter convention? If so, what is the
depreciation amount in 2014 (year 1)?
Asset
Office furniture
Delivery truck
Machinery
Total personal
property

Date Acquired
2/3/14
8/17/14
10/25/14

Quarter Acquired Cost Basis

First
$ 10,000
Third
15,000
Fourth
510,000
$535,000

9-18

Mid-Quarter convention

9-19

Mid-Quarter convention
(Example 9-10)
Under this scenario, is Teton required to use the mid-quarter
convention? If so, what is the depreciation amount in 2014?
Asset
Office furniture
Delivery truck
Machinery
Total personal
property

Date Acquired
2/3/14
8/17/14
10/25/14

Quarter Acquired Cost Basis

First
$ 10,000
Third
15,000
Fourth
510,000
$535,000

Assume that Teton depreciates its personal property under the midquarter convention and that it sells its office furniture in the third quarter
of year 2. The office furniture ($10,000 original basis) was placed into
service during the first quarter of year 1 and has a seven-year recovery
period. What depreciation expense can Teton deduct for the office
furniture in year 2, the year of sale?
9-20

Depreciation

Real Property

Land, residential rental property, or nonresidential

property.

Land is non-depreciable.
All properties are attached to the ground.

Use midmonth convention and depreciate using

straight line method.

9-21

Midmonth convention
(Example 9-11)
Teton's basis in the warehouse it purchased
on May 1 of year 1 is $275,000. What is
Teton's year 1 depreciation on its
warehouse?

9-22

Depreciation

Mid-month convention for year of disposition.

(1) Determine depreciation expense for full year.

(2) Subtract one-half of a month from the month in
which the asset was sold.
(3) Divide the amount in step 2 by 12 months.
(4) Multiply the step 3 outcome by step 1 outcome.

9-23

Midmonth convention
(Example 9-12)
Assume that Teton sells its warehouse on
March 5 in year 2 (the year after Teton buys it).
What is Teton's depreciation for the warehouse
in the year of disposition (year 2)? Teton's basis
in the warehouse it purchased on May 1 of year
1 is $275,000.

Special
Depreciation

Immediate Expensing (179 deduction)

This incentive is commonly referred as 179 expense

or immediate expensing election.
Limits on immediate expensing (up to $500,000 of
tangible personal property and $250,000 of qualified
real property).
Choosing the assets to immediately expense.

9-25

Depreciation - Limits
of
179
deduction

Subject to a dollar for dollar phase-out for the amount of

tangible personal property placed in service over
$2,000,000
If the amount of total property<2,000,000, take the
179 deduction immediately;
If the amount of total property>2,000,000, allowable
179 deduction = the higher of 1) [500,000-(the amount
of total tangible personal property purchased
2,000,000)] or 0.
179 deduction should not create net operating losses

9-26

179 deduction (example 9-13)

Assume Teton is eligible for and elects to
immediately deduct $80,000 of 179 expense
against the basis of the machinery. (The basis
of machinery is 510,000). What is the amount
of Teton's current year depreciation expense,
including regular MACRS depreciation and the
179 expense on its machinery (assuming halfyear convention applies)?

179 deduction
(example 9-14/9-15)
During 2014, Teton placed into service $2,100,000 of
machinery, $10,000 of office furniture, and a $15,000 truck
for a total of $2,125,000 tangible personal property placed
in service for the year. What is Teton's maximum 179
expense after applying the phase-out limitation?
Also assume that Teton elects to claim the entire $375,000
expense and it chooses to apply it against the machinery.
Further assume that Teton reports $296,503 of taxable
income before deducting any 179 expense and
depreciation. What amount of total depreciation (including
179 expense) is Teton able to deduct on the machinery for
the year?
9-28

Depreciation

Bonus Depreciation

To stimulate the economy, policy makers occasionally

implement bonus depreciation.
In 2014, taxpayers can elect to immediately expense 50
percent of qualified property.

Qualified property must have a recover period of 20 years or

less (no real property), and the original use of the property
must commence with the taxpayer (no used property), and the
property must be placed in service during 2014.

The bonus depreciation is calculated after the 179

expense but before regular MACRS depreciation

9-29

Depreciation
Luxury

automobiles

Business deduction is considered to be ordinary,

necessary and reasonable
Ford Focus VS Ferrari
Auto allowable depreciation=Lessor of 1) MACRS
depreciation or 2) IRS statutory limits

9-30

Auto depreciation
(adapted example 9-21)
What is the depreciation schedule for each model (assume mid-year convention)?

Year/Make
Model
Price

2015 Ford Focus

DX 2dr Coupe
$15,750

2015 Porsche 911

Carrera 4S
$97,400

9-31

Amortization

For intangible assets, businesses recover cost of

the asset through amortization.

Amortize assets using the straight-line method

Examples: patents, trademarks, trade names, goodwill,
going-concern value, etc.

Section 197 purchased intangibles

Start-up expenditures and organizational costs
Research and experimentation costs

9-32

Amortization

Section 197 intangibles

Most intangible properties qualify for section 197

According to 197, these assets have a recovery
period of 180 months (15 years), regardless of their
actual life.

Annual depreciation = original basis/15

9-33

Amortization

Organizational Expenditures and Start-up Costs

Organizational expenditures include expenditures to

form and organize a business in the form of a
corporation or a partnership and are incurred prior to
the starting business.

NOT include costs of selling or marketing stock

9-34

Startup cost

Businesses can immediately expense up to $5,000

in organizational expenses or startup costs subject
to a dollar-for-dollar phaseout above $50,000.

If startup cost<50,000, expense 5,000 immediately

and amortize the residual amount over 180 months
If startup cost>50,000, allowable expense
deduction= Higher of 1) [5,000-(startup costs50,000)], or 2) 0.

Amortize the residual amount over 180 months

Amortization (Example 9-24/25)

Teton incurred $53,000 of organizational expenditures in
year 1. How much of the organizational expenditures can
Teton immediately expense in year 1?
Assume Teton amortizes the $51,000 of organizational
expenditures remaining after it immediately expenses
$2,000 of the costs. If Teton began business on February
1 of year 1, how much total cost recovery expense for the
organizational expenditures is Teton able to deduct in year
1?

9-36

Amortization
Research

and Experimentation Expenditures

Businesses may immediately expense these costs

or they may elect to capitalize and amortize these
costs using the straight-line method over a period of
not less than 60 months, beginning in the month
benefits are first derived from the research.

9-37

Depletion

Used to recover capital investments in natural resources.

Businesses compute annual depletion expense under
both the cost and percentage depletion methods and
deduct the larger of the two.

Under cost depletion, taxpayers must estimate or determine the

number of units or reserves that remain at the beginning of the
year and allocate a pro rata share of that basis to each unit that
is extracted during the year.
However, taxpayers could over or under estimate the number
of units extracted in each year
Under percentage depletion, taxpayers multiply the gross income
from the resource extraction activity by a fixed percentage based
on the type of natural resource as indicated in Exhibit 9-15.

9-38

Depletion

9-39

Example 9-28
Ken's cost basis in the gold is the $150,000 he
paid for it. Based on a mining engineer's
estimate that the gold deposit probably holds
1,000 ounces of gold, Ken can determine his
cost depletion. What is Ken's cost depletion for
year 1 and year 2, assuming he extracts 300
and 700 ounces of gold in year 1 and year 2,
respectively?

Practice questions
Problems:
38,

45, 52, 55 (no part b), 59 (only calculate

depreciation expense), 67 (no part e), 70
(only part a)