Navigating The Depreciation Maze

Navigating the Depreciation Maze

ICPAS Chicago Metro Chapter

August 19, 2009

Brian T. Whitlock, CPA, JD, LLM

Special Thanks to

• Michael Calahan, CPA• Christopher Imperiale • Andrew Popielec• Melanie Tomczyk• Simina Tyiran

This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

Topics to Be Covered

• History of General depreciation rules• Deprecation recapture

– IRC§1231 property



• Federal Bonus Depreciation Rules• Stimulus package elections• Illinois depreciation modifications

Key Terms

• “Depreciation” is a reasonable allowance given for the exhaustion, wear and tear, and normal obsolescence of tangible property used in a trade or business for the production of income. [IRC§167(a)].

• “Amortization” applies to intangible property.

• “Depletion” is the using up of natural resources by mining, quarrying, drilling or felling (i.e., mineral deposits and timber).

Fundamental Issues

• Characteristics of depreciation property– Used in a Trade or Business or held for production of income– Useful life of more than one year– Loses value from use or natural causes

• Problem Assets– Artwork– Musical Instruments– Show cars

• Problem Owners – Trusts (allocation between income and remainder)– Purchasers of Life Estate– Landlord vs. Tenant

“Placed in Service”

• When does life begin?When in a condition or state of readiness and available for a specifically assigned function and nothing in the taxpayer’s control prevents its actual use. Prop Reg. Sec 1.168-2(l)(2).

• When does life end? Once begun depreciation must continue even if idle, until permanently withdrawn through

– Sale – Abandonment– Retirement or other disposition

• Special Rules or Limitations – Use cannot predate beginning of business– Buildings can be place in service by floors– Leased property in service when first “held out” of lease– Spare parts may be in service to avoid downtime

Methods of Allocating Depreciation

• Section 167(a) permits a “reasonable allowance”

The allowance is that amount which should be set aside for the taxable year… so that the aggregate of the amounts set aside, plus the salvage value, equal the cost or other basis of the property…Treas. Reg. 1.167(a)(1), T.D. 6182 (1956), last amended 1972.

• Manner of determining allowance - 1.167(a)(11)(c)• Straight line (SL), which allocates depreciation to each period

equally• Sum of the years digits, Declining Balance (DB), and Double DB

(DDB), which allocate more depreciation to earlier years• Machine hour, Operating Day, and Unit-of-Production, which

allocate depreciation to each unit of output• Income Forecast Method, which allocates depreciation at the same

rate that the income is recognized. (Taxpayer Relief Act of 1997).

History of Depreciation

• The Struggle over Useful Lives– Prior to Great Depression great freedom

– TD 4422 (1934) – Treasury requires proof

– Bulletin F (1942) lengths useful life, Congress grants capital gain treatment for entire gain

– 1954 Code authorizes DDB and Sum of Years Digits. Accelerated depreciation lead to boom in late 1950s

– Rev. Proc. 62-21 creates Depreciation Guidelines for assets by SIC. Congress taxes depreciation recapture as ordinary

– Rev. Proc. 71-25 creates Class Life Depreciation Range System (1971) broad classes of assets (updated).

• Rev. Proc. 87-56 is foundational base for MACRS

General Rules for Current Assets

• ACRS was generally required for asset Placed in Service from 1981 until 1986 unless one elected out.

• MACRS is generally used after 1986 unless specifically required by law or one elects to use the Alternative Depreciation System (ADS).

• ADS is used to track earnings and profits (E&P).

MACRS

• Generally applies to tangible property placed in service after 1986

• Salvage value is ignored.• Recovery period is based on the property’s class life.

– Rev. Proc. 87-56

• MACRS tables.– Tables calculate 200% DDB w/ switch to SL to maximize

• Add’l Bonus depreciation might be available.– Depends on Place and time

MACRS Recovery Periods

• Tangible Personal Property– 3-Year Property (Class life of < 4 years)

– 5-Year Property (Class life of > 4 and < 10 years)

– 7-Year Property (Class life of > 10 and < 16 years)

– 10-Year Property (Class life of >16 and < 20 years)

– 15-Year Property (Class life of >20 and < 25 years)

– 20-Year Property (Class life of >25 years)

• Real Property– Residential (27.5 Years)

– Non-Residential (31.5 years < 1994 > 39 years

MACRS Conventions

• Half-year convention• Midmonth convention• Midquarter convention

Half-Year Convention

• Property is deemed as placed in service or disposed of in the middle of the year, regardless of actual date

• Depreciation tables are adjusted.– One half of depreciation for the first year is allowed in the

year the property is placed in service.

• Tables do not take into account disposals– Only one half of the depreciation computed using the table

percentage is allowed.

Half-Year Convention Example

• Five-year property with a depreciable basis of $10,000 and subject to the half-year convention is placed in service in 2005 and sold in 2007. What is the depreciation expense for the following:– 2005

– 2006

– 2007

Half-Year Convention Example

• Five-year property with a depreciable basis of $10,000 and subject to the half-year convention is placed in service in 2005 and sold in 2007. Using the tables (Exhibit 3):– 2005 $2,000 ($10,000 * 20%)

• proof (10,000/5) = 2,000 * 200% = 4,000 / half-year = 2,000

– 2006 $3,200 ($10,000 * 32%)

– 2007 $ 960 ($10,000 * 19.20% * 50%)

Midmonth Convention

• Applies to residential rental property and nonresidential real property

• Deemed placed in service or disposed of during the middle of the month

• Deduction is based on the number of months the property was placed in service

Midmonth Convention Example

• A commercial building with a depreciable basis of $100,000 is purchased in February 2006 and sold in August 2007. Using handout 3, what is the depreciation expense for the following:– 2006

– 2007

Midmonth Convention Example

• A commercial building with a depreciable basis of $100,000 is purchased in February 2006 and sold in August 2007. Using handout 3, what is the depreciation expense for the following:– 2006 $2,247 ($100,000 * 2.247%)

– 2007 $1,603 ($100,000 * 2.564% * 7.5/12)• Proof $100,000/39 = 2,564

Midquarter Convention

• Applies to all property, other than nonresidential real property and residential rental property, if more than 40% of the total basis of such property is placed in service during the last three months of the tax year

• All property placed in service and/or disposed of during any quarter of the year is treated as placed in service at the midpoint of the quarter


• Application of the midquarter convention is computed regardless of the length of the tax year– Note: If it’s a short year consisting of three months or less,

the midquarter convention automatically applies.

• Any amount expensed under§179 reduces the basis of the property for purposes of determining whether or not the midquarter convention applies.– Tax planning tip: Taxpayer might be able to avoid

midquarter convention by allocating§179 deduction to property placed in service in the last quarter.


• IRS has adapted tables for Mid-Quarter• If a table is not used, depreciation for the first year is

determined by computing the depreciation for the full year and then multiplying it by the following:– 1st Quarter: 87.5%

– 2nd Quarter: 62.5%

– 3rd Quarter: 37.5%

– 4th Quarter: 12.5%

MACRS AMT Depreciation

• AMT adjustment – Applies to years three, five, seven and 10 property using

200% DB.

– Applies to§1250 property using other than straight line (SL) depreciation

• Key AMT exceptions– §179 allowed in full for AMT

– Does not apply if bonus depreciation is claimed

Alternative Depreciation System

• ADS must be used for the following properties: – Listed property used 50% or less in qualified business use

– Any tangible property used predominantly outside the United States during the year

– Any tax-exempt use property

– Any tax-exempt bond-financed property

– All property used predominantly in a farming business and placed in service in any tax year during which an election not to apply the uniform capitalization rules to certain farming costs is in effect

– Any property imported from a foreign country for which an executive order is in effect because the country maintains trade restrictions or engages in other discriminatory acts

ADS

• Computed by applying the straight line method, the applicable convention and the applicable recovery period

• Under ADS, you cannot claim any special depreciation allowance for the property, and once you make the election, it covers all property in the same property class that you placed in service during the year.

Depreciation Recapture Rules

Depreciation Recapture Rules

• General rules– When business property is disposed of, the resulting taxable

gain or loss is usually a§1231 transaction.

– When depreciable property is disposed of as§1245 property or§1250 property, at a gain, you might have to recognize all or part of the gain as ordinary income. Any remaining gain is§1231 gain.

§1231 Property Defined

• Sales and exchanges of property held longer than one year and used in a trade or business

• Also includes certain involuntary conversions (e.g., fire) of business or investment property, including capital assets

• Provides special tax benefits– Net gains are treated as capital gains

– Net losses are treated as ordinary losses

Examples of §1231 Transactions

• Sales or exchanges of real property or depreciable personal property

• Sales or exchanges of leaseholds • Sales or exchanges of cattle and horses • Sales or exchanges of other livestock • Sales or exchanges of unharvested crops • Cutting of timber or disposal of timber, coal or iron ore • Condemnations • Casualties and thefts

§1231—Ordinary vs. Capital Treatment

• Combine all §1231 gains and losses for the year, and if the result is:– Net §1231 loss

• Ordinary loss

– Net §1231 gain• Ordinary income up to the amount of nonrecaptured§1231

losses from prior years• The rest, if any, are long-term capital gains

§1231– Nonrecaptured Losses

• Net §1231 losses for the previous five years that have not been applied against net §1231 gains

• These losses are applied against net §1231 gains beginning with the earliest loss in the five-year period

§1231 Example

• XYZ, Inc. is a calendar year corporation. In 2004, it had a net §1231 loss of $8,000. For tax years 2006 and 2007, the company had net §1231 gains of $5,250 and $4,600, respectively. 1.) How should the 2006 gain of $5,250 be treated?

2.) How should the 2007 gain of $4,600 be treated?

§1231 Example

• XYZ, Inc. is a calendar year corporation. In 2004, it had a net §1231 loss of $8,000. For tax years 2006 and 2007, the company had net §1231 gains of $5,250 and $4,600, respectively. 1.) How should the 2006 gain of $5,250 be treated?

The net§1231 gain of $5,250 should be treated as ordinary income by recapturing $5,250 of its

$8,000 net section 1231 loss from 2004. 2.) How should the 2007 gain of $4,600 be treated?

In 2007, it applies its remaining net§1231 loss, $2,750 ($8,000–$5,250) against its net§1231 gain, $4,600. For 2007, the company reports

$2,750 as ordinary income and $1,850 ($4,600–$2,750) as long- term capital gain.


• Property subject to an allowance for depreciation or amortization that is any of the following:– Personal property (either tangible or intangible)

– Other tangible property (except buildings and their structural components)

– That part of real property not included above

– Single-purpose agricultural (livestock) or horticultural structures

– Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum

– Any railroad grading or tunnel bore

§1245 Gain/Loss Treatment

• Loss– Netted with§1231 losses

• Gain– Ordinary income to the extent of all accumulated

depreciation

– Remaining gain is treated as§1231 gain

– Use Part III of Form 4797 to calculate the ordinary income part of the gain.

§1245 Example

• ABC Co. bought, and placed in service, a five-year 100% business use asset that cost $10,000. The company used the half-year convention, and their MACRS deduction for the equipment was $2,000 in 2005 and $3,200 in 2006. They did not take the§179 deduction. The equipment was sold in May 2007 for $7,000. The MACRS deduction in 2007, the year of sale, was $960 (half of $1,920). What is the gain/loss recognized by the company?

§1245 Example

• Amount realized __________• Cost __________• Depreciation allowed/allowable__________• Adjusted basis __________• Gain realized __________• Gain treated as ordinary __________• Gain treated as capital income __________• Loss treated as ordinary __________

§1245 Example 1

• Amount realized $ 7,000• Cost $ 10,000• Depreciation allowed/allowable $ (6,160)• Adjusted basis $ 3,840• Gain realized $ 3,160• Gain treated as ordinary $ 3,160• Gain treated as§1231 $ 0• Loss treated as§1231 $ 0

§1245 Example 2

• Same facts as the previous example, except cash received from the sale of the equipment is $15,000

§1245 Example 2

• Amount realized _________• Cost _________ • Depreciation allowed/allowable _________• Adjusted basis _________• Gain realized _________• Gain treated as ordinary _________ • Gain treated as§1231 _________• Loss treated as§1231 _________

§1245 Example 2

• Amount realized $ 15,000• Cost $ 10,000• Depreciation allowed/allowable $ (6,160)• Adjusted basis $ 3,840• Gain realized $ 11,160• Gain treated as ordinary $ 6,160• Gain treated as§1231 $ 5,000• Loss treated as§1231 $ 0


• Includes all real property that is subject to an allowance for depreciation and that is not, and never has been,§1245 property

• Includes a leasehold of land or§1250 property subject to an allowance for deprecation

• If section 1250 property becomes section 1245 property (because its use changes), it cannot be treated as 1250 property ever again

§1250 Tax Treatment

• Gain on the disposition of§1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable on the property

• The applicable percentage used to figure the ordinary income because of additional depreciation depends on whether the real property you disposed of is, – Nonresidential real property,

– Residential rental property or

– Low-income housing

Additional Depreciation Under §1250 Property

• If §1250 property is held longer than one year, the additional depreciation is the actual depreciation taken minus the depreciation using the straight line method

• If §1250 property is held less than one year, all of the depreciation taken is additional depreciation

• Also includes all depreciation adjustments to the basis of §1250 property whether allowed to you or another person (as carry-over basis property)

Additional Depreciation Under §1250 Doesn’t Apply When

• Depreciation for the property using the straight line method does not result in depreciation that is more than the amount figured by the straight line method

• The property was residential low-income rental property you held for 16⅔ years or longer

• You chose the alternate ACRS method for the property, which was a type of 15-, 18- or 19-year real property covered by §1250 rules

Additional Depreciation Under §1250 Doesn’t Apply When

• The property was residential rental property or nonresidential real property placed in service after 1986; was held longer than one year; and, if the property was qualified New York Liberty Zone property, a timely election not to claim any special depreciation allowance was made. (All these properties are depreciated using the straight line method)

Applicable Percentage Under§1250

• Nonresidential real property– 100% for periods after 1969

– 0% for periods before 1970• No ordinary income of additional depreciation before 1970 will

result from the property’s disposition.

• Residential real property (80% or more of the gross income is from dwelling units)– 100% for periods after 1975

– 0% for periods before 1976• No ordinary income of additional depreciation before 1976 will

result from the residential rental property’s disposition.

§1250 Ordinary Gain Treatment

• Use the following steps to calculate the portion of §1250 property treated as ordinary income.1.) Compute the realized gain on the property.2.) Calculate the additional depreciation for the periods after 1975.3.) Multiply the lesser of (1) or (2) by the applicable percentage.

• If this is residential rental property, stop here. This is the gain treated as ordinary income.

• If (2) is equal to or more than (1), stop here. This is the gain treated as ordinary income.

4.) Subtract (2) from (1).5.) Calculate the additional depreciation for periods after 1969 but

before 1976.6.) Add the lesser of (4) or (5) to the result in (3). This is the gain

treated as ordinary income because of additional depreciation.

§1250 Additional Ordinary Gain Treatment for Corporations

• Corporations, other than S corporations, have an additional amount to recognize as ordinary income on the sale or other disposition of §1250 property– The additional amount treated as ordinary income is 20% of

the excess of the amount that would have been ordinary income if the property were§1245 property over the amount treated as ordinary income under§1250

Comprehensive Example

• During 2007, EIEIO Co. sold the following assets:

Description Selling Price Cost A/D Recognized Gain/Loss

Office Desk 4,000$ 6,800$ 3,200$ 400$

Photocopier 2,600$ 2,500$ 500$ 600$

Van 500$ 15,000$ 13,000$ (1,500)$


• Calculate depreciation recapture, if any, on the assets.– Printing press

– Photocopier

– Van


• Calculate depreciation recapture, if any, on the assets.– Printing press $ 400

– Photocopier $ 500

– Van $ 0


• Calculate remaining gain/loss, if any.– Printing press

– Photocopier

– Van

• What type of income or loss is this?


• Calculate remaining gain/loss, if any.– Printing press $ 0

– Photocopier $ 100

– Van $ (1,500)

• What type of income or loss is this? §1231


• How is the§1231 gain/loss treated?


• How is the§1231 gain/loss treated?– The net result is a loss of $1,400, which is treated as a§1231

loss and deducted as an ordinary loss.

©2007 Ronald R. Tidd Property – 1231, 1245, 1250

§§1231,1245 and1250 Application—General Procedures

Sales – §1245 Sales – §1250

Calculations§1231

Losses

Gains Gains

§1231

Gains

§1231

Gains

Ordinary Gains Ordinary Gains

Depreciation Developments

Congress has used bonus depreciation to spur on economic recovery or to target disaster areas

• 30% Bonus Depreciation (after Sept 10, 2001)• New York Liberty Zone• The Jobs and Growth Tax Relief Act of 2003 (50% until 2005)• The Gulf Opportunity Zone Act of 2005 (50% for Katrina)• The Tax Relief Act of 2006 (50% for ethanol plants)• The Emergency Economic Stabilization Act (“Disaster Property”)• Economic Stimulus Act of 2008 (50% after 12/31/07)• American Recovery and Reinvestment Act of 2009 (end of 2009)

Bonus Depreciation

Example: Assume that in 2008 a taxpayer purchases new 5-year property and places it in service for $10,000, subject to the half-year convention.

50% - first-year depreciation $5,000

The remaining $5,000 of the cost is deductible under the MACRS rules. 20 percent, or $1,000, is also allowed as a depreciation deduction in 2008.

The total depreciation deduction for 2008 is $6,000.

Bonus Depreciation

Bonus depreciation is permitted only for:

• MACRS property with a recovery period of 20 years or less

• Water utility property

• Non-custom-made computer software

• Qualified leasehold improvement property.

• Original use must begin with the taxpayer after 12/31/2007.

Bonus depreciation is allowed for AMT purposes as well as for regular tax purposes.

Election out of Bonus Depreciation

Section 167(k) permit taxpayers to elect out of bonus:

• Taxpayer can consider making an election-out for one or more classes of property, for tax year ideal where:(1) The taxpayer has about-to-expire net operating losses; and•(2) The taxpayer anticipates being in a higher tax bracket in future years.

•The election is made separately by each person owning qualified property (for example, by each member of a consolidated group, by the partnership or by the S corporation). See Rev. Proc. 2002-33.

Election out of Bonus Depreciation

There is no official form:

Election Out of Special Depreciation Allowance of Code Section 168(k)

Taxpayer's name: __________________

Taxpayer's address: ______________________

Taxpayer's tax identification number: ___________________

Attachment to Form ______, Tax Year Ending ____________

Pursuant to Code Section168(k)(2)(D)(iii), the taxpayer, ______________, hereby elects out of the special depreciation allowance of Code Section 168(k) for all property placed in service by the taxpayer during the taxable year which would otherwise qualify for the special depreciation allowance under Code Section 168(k) and which is in the following classes:

[list classes for which election is made]

Stimulus Package Election

The American Housing Rescue and Foreclosure Prevention Act of 2008 was signed into law on July 30, 2008.

For tax years ending after March 31, 2008, corporations elect to forego bonus depreciation and accelerated depreciation in exchange for being allowed to claim certain unused research tax credits or certain AMT minimum tax credits.

• C corporation taxpayers only

• Guidance issued in Rev Proc 2008-65 (Oct 14, 2008)

Illinois Bonus Depreciation Modification Rules

Let’s Start with Federal

• The Economic Stimulus Act took effect in 2008. – Allows a trade or business to depreciate an additional 50% of

the cost of an asset acquired and placed in service during 2008

– The types of property eligible for bonus depreciation will remain the same as those that are part of previous depreciation packages

Let’s Start with Federal

• Tangible property that had a recovery period of 20 years or less

• Purchased computer software• Water utility property• Qualified leasehold improvement property

So What’s the Problem?

• Like the majority of States, Illinois did not adopt the federal bonus depreciation and additional changes provided in IRC§168(k)

• Therefore, Illinois does not follow the additional changes made by the Economic Stimulus Act or any prior federal bonus depreciation legislation

What Do We Need to Do?

• Add back all bonus depreciation taken– For Illinois purposes, depreciation additions and

subtractions will show up on Form IL-4562

– In Step 2 Line 1, put the total bonus depreciation you claimed on federal Form 4562

There’s a Twist for 30% Bonus

• Illinois did not just disallow the bonus they applied a percentage limitation of 42.9%, which removes not only the bonus but also a portion of the MACRS

• Form IL-4562, Line 3– If an asset for which bonus depreciation has been sold,

traded, abandoned, otherwise disposed of or the asset has reached the end of its depreciable life:

• All prior subtractions related to that asset must be reversed and treated as an addition(s).

– Line 4 is the total of Lines 1, 2 and 3. This is the Illinois special depreciation addition, which will flow to Form IL-1120-ST, Line 2c or Form IL-1065, Line 17.

Illinois Just Has to Be Difficult

• The Illinois special depreciation subtractions are a little more complicated. – The subtraction on the prior add-back is not simply the

difference between the remaining basis after bonus depreciation and the total depreciation taken on that asset for the year.

– You must take the difference and multiply it by 42.9%. This is shown on Form IL-4562, Step 3, Lines 5-8.

There’s Another Twist

• Form IL-4562, Line 9– If an asset for which bonus depreciation has been sold,

traded, abandoned, otherwise disposed of or the asset has reached the end of its depreciable life:

• All prior additions related to that asset must be reversed and treated as a subtraction(s).

– Basically, all prior modifications are eliminated, and you are back at the federal net book value.

And Finally

• The Illinois special depreciation subtraction will flow to Form IL-1120-ST, Line 5e or Form IL-1065, Line 31.

Illinois Bonus Depreciation Example


• In this example, computer equipment was placed in service in 2004 for $6,121. 50% federal bonus depreciation is $6,121/2=$3,061. The $3,061 is disallowed for Illinois purposes and will need to be added back.

• The $3,061 flows to the Form IL-4562, Line 1. Since this is the only asset in 2004 with bonus depreciation, this will be the only Illinois special depreciation addition and will flow to IL 1120-ST, Line 2c.


• The total federal depreciation on the computer equipment for the year is $3,571.

• To calculate the Illinois special depreciation subtraction, we start by taking the difference between total depreciation and the bonus depreciation taken on the asset ($3,571 minus $3,060 = $511).

• We are not allowed to take the entire $511 as a depreciation subtraction.

• The $511 must be multiplied by 42.9% ($511 * .429 = $219). This is shown in Step 3 of Form IL-4562 and flows to IL-1120-ST, Line 5e.

• In years following the initial year with bonus depreciation, a subtraction for the full amount of the depreciation will be allowed.

Questions and Comments

Navigating The Depreciation Maze

Documents

Transcript of Navigating The Depreciation Maze