Chapter 7

Property Acquisitions
and
Cost Recovery
Deductions

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 Capital Expenditures

 Cost of a business asset with a useful life

extending beyond the current year may be
Deducted currently
Capitalized until disposal or
Capitalized with the cost allocated to the years
the asset’s use benefits the taxpayer (cost
recovery period)

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 Capitalize or Expense

 Incidental materials & supplies that cost $200

or less can be deducted at time of purchase
 Safe harbor provision allowing expensing of items
costing up to $2,500
 Repairs & maintenance costs
 Capitalized if they are for permanent
improvements that increase the value of the
property, restore its value, substantially prolong its
useful life or adapt it to a different use
 Expense incidental repair costs that only maintain
current functionality
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 Basis of Property

 Basis is the taxpayer’s unrecovered

investment in an asset that can be recovered
without tax cost
 As the asset’s basis is recovered (through
depreciation, depletion or amortization
deductions), basis is reduced and is called
adjusted basis

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 Basis of Property

 The original basis of an asset includes

Cash plus fair market value of property given
up by the purchaser
Money borrowed and used to pay for the
property acquired
Liabilities of the seller assumed by the
purchaser
Expenses of making the purchase, such as
attorney fees or brokerage commissions

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 Multiple Asset Purchase

 If more than one asset is acquired in a single

transaction, the cost is apportioned to each
using their relative fair market values (FMV)
 Original basis of specific asset =
Total purchase price x (FMV of specific asset /
FMV of all assets)
 If the purchase price exceeds the value of the
assets, the excess is goodwill
 Alternatively, buyer and seller can agree to a
written allocation of the purchase price to
individual assets
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 Adjusted Basis

 The original basis of an asset is

Increased for nondeductible capital
expenditures that prolong its useful life or
enhance its usefulness
Decreased by cost recoveries (depreciation,
depletion, or amortization)
Decreased by other recoveries (casualty
losses)

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 Basis of Converted Property

 If the property is converted from personal use

to business use, the basis for depreciation is
the lesser of the property’s fair market value
(FMV) or adjusted basis at the date of
conversion
 This prevents taxpayers from depreciating
any decline in value while used for personal
purposes

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 Acquisition Through a
Taxable Exchange
 Basis of acquired asset equals the FMV of
the property given up or the services
performed
 Gain or loss is recognized on any property
surrendered as if cash had been received in
the exchange

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 Acquisition by Gift

 Donee’s basis = donor’s basis + portion of gift

taxes due to appreciation (but total cannot
exceed FMV at date of gift)
 This addition is gift tax paid multiplied by
FMV at gift date – Donor’s Basis
FMV at gift date
 If FMV is less than donor’s basis, basis may
be limited to lower FMV on subsequent sale

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 Acquisition by Gift

 If FMV at gift date is less than donor’s basis

FMV used as basis only for loss
determination (if sold at less than FMV)
Donor’s basis used for gain determination
(if sold for more than donor’s basis)
No gain or loss if sold for price between
FMV at gift date and donor’s basis
 Holding period determined by basis used for
gain or loss
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 Acquisition by Inheritance

 Use date-of-death fair market value as

basis for inherited property (or alternate
valuation date, if elected)
 Inherited property always has a long-term
holding period

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 Categories of Assets

 Realty includes land and buildings

 Personalty is any asset that is not realty and
includes machinery and equipment
 Personal-use property is any property used
for personal purposes

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 MACRS

 Modified Accelerated Cost Recovery System

(MACRS, pronounced “makers”) assigns
assets to a class with a pre-determined
recovery period (ignores salvage value)
Recovery periods for personalty are 5 years
(autos and computers) or 7 years (machinery,
equipment, and furniture)
Recovery periods for realty are 27½ years
(residential rental property) or 39 years
(commercial and industrial buildings)

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 MACRS

 Depreciation for personalty uses

200% declining-balance method (with a switch
to straight-line to maximize deductions) or
Straight-line method
 Realty must use the straight-line method
 IRS provides tables with annual allowable
depreciation expressed as a percentage
Annual deduction equals the asset’s original
basis multiplied by % from table

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MACRS Tables

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 Averaging Conventions

 Mid-quarter convention is required if more

than 40% of the personalty (not buildings) is
placed in service during the last quarter of the
tax year
This usually results in smaller deductions than
the half-year convention and is intended to
discourage taxpayers from waiting until the
end of the year to make their purchases

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Mid-Quarter Rates

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 Averaging Conventions

 Realty is depreciated using a mid-month

convention
 Depreciation is calculated from the midpoint
of the month in which the property is placed
in service
 Table amount for all years determined by
the month of acquisition

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Residential Rental Realty

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Nonresidential Realty

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 Dispositions

 When an asset is disposed of before it is fully

depreciated, the same averaging convention
applies in the year of disposition
An asset that was depreciated under the half-
year convention will be allowed one-half year’s
depreciation in the year of disposal
Taxpayers must adjust the deduction
determined by the table to reflect only a half-
year’s depreciation

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 Dispositions

 For mid-quarter convention property,

depreciation is allowed from the beginning of
the year to the mid-point of the quarter in
which the asset is disposed of
 First quarter dispositions, 1.5 / 12 months
 Second quarter dispositions, 4.5 / 12 months
 Third quarter dispositions, 7.5 / 12 months
 Fourth quarter dispositions, 10.5 / 12 months

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 Dispositions

 For Realty
Depreciation is taken from the beginning of the
year until the midpoint of the month in which
the disposition takes place
Table amount must be adjusted for the month
of disposition: 3rd-month disposition = 2.5/12

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 Section 179 Election

 Taxpayers may elect to expense a portion

of the cost of depreciable personalty in the
year of acquisition (realty is not eligible)
 Applies to both new and used property
 Annual limit
 $1,020,000 per taxpayer in 2019
 $1,000,000 per taxpayer in 2018

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 Section 179 Limits

 When the total cost of eligible property placed

in service for the year exceeds a dollar limit,
the maximum annual expensing limit is
reduced dollar-for-dollar
 2019 phase-out begins at $2,550,000
 If $3,570,000 ($2,550,000 + $1,020,000) or more
of eligible assets placed in service, then no Sec.
179 expensing allowed
 2018 phase-out began at $2,500,000
 If $3,500,000 or more of eligible assets placed in
service, then no Sec. 179 expensing allowed
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 Section 179 Limits

 The expense deduction cannot exceed

taxable income from the business using the
asset
Unused cost (due to this income limitation
only) is carried forward to the next year and
added to the amounts eligible for the expense
deduction in that year

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 Section 179 Strategy

 Expensing the assets with the longest class

lives generally maximizes the value of the
Section 179 deduction
 Section 179 expensing can also alter the
application of the mid-quarter convention
because property expensed under Section
179 is not counted in calculating the 40%
test for the mid-quarter convention

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 Bonus Depreciation
 100% first-year bonus depreciation for new
and used personalty acquired after 9/27/2017
 Realty ineligible for bonus depreciation
 Section 179 expensing claimed before bonus
depreciation (no annual phaseout or income limits
for bonus depreciation)
 Bonus depreciation will be gradually eliminated
beginning in 2023
 For property acquired before 9/28/2017, 50% first-
year bonus depreciation was allowed for new
personalty (used personalty ineligible)
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 Mixed-Use Assets

 If an asset is used for both business and

personal purposes, depreciation is only
permitted for the business-use portion
 If listed property not used more than 50% for
business, ADS must be used and Section
179 cannot be claimed
 Computers purchased in 2018 or later are no
longer considered listed property

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 Mixed-Use Assets

 Once ADS is required, it must be used for

all future years for that asset
 If business use is more than 50% in the first
year, but business use declines to 50% or
less in a future year, a change to ADS must
be made
Any excess depreciation claimed in earlier
years must be recaptured as income in the
year of change to ADS

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 Depletion

 The cost of minerals, other natural

resources, and timber are recovered
through depletion
 Taxpayers can elect to claim the greater
of the two depletion deductions
1) Cost depletion – depletion per unit
calculated by dividing adjusted basis by
estimated recoverable units
2) Percentage depletion – calculated as a
percentage of gross income

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 Intangibles

 Intangible assets are grouped into 3

categories
1. Intangibles with perpetual life that cannot be
amortized
2. 15-year intangibles (including goodwill)
acquired as part of a business purchase
(Section 197 assets)
3. Intangibles amortizable over a life other than
15 years

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 Research and
Experimentation
 Research and experimentation expenditures
are costs incident to obtaining a patent and
costs for development of an experiment or pilot
model, formula or invention
 Choice of three alternatives
1. Expense them in full in the year paid or incurred
2. Amortize them over 60 months or more
3. Capitalize them
Beginning in 2022, R&E expenditures must be
amortized over 15 years

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The End

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