Taxchapter9.docx

Taxchapter9.docx

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Taxchapter9

Chapter9

PropertyAcquisitionandCostRecovery

SOLUTIONSMANUAL

DiscussionQuestions:

1.[LO1]Explainthereasoningwhythetaxlawsrequirethecostofcertainassetstobecapitalizedandrecoveredovertimeratherthanimmediatelyexpensed.

Assetswithanexpectedlifeofmorethanoneyearmustbecapitalizedandrecoveredthroughdepreciation,amortization,ordepletiondeductions—dependingonthetypeofunderlyingasset.Thepolicyattemptstomatchtherevenuesandexpensesfortheseassetsbecausetheassetshaveausefullifeofmorethanoneyear.

2.[LO1]Explainthedifferencesandsimilaritiesbetweenpersonalproperty,realproperty,intangibleproperty,andnaturalresources.Also,provideanexampleofeachtypeofasset.

Personalproperty,realproperty,andnaturalresourcesarealltangiblepropertythancanbeseenandtouched.Naturalresourcesareassetsthatoccurnaturally（e.g.timberorcoal）.Realpropertyislandandallpropertythatisattachedtoland（e.g.buildings）.Personalpropertyisalltangiblepropertythatisnotanaturalresourceorrealproperty.Intangiblesareallintellectualpropertyrights（e.g.patentsandcopyrights）andanyothervaluenotassignedasatangibleassetsduringapurchase（e.g.goodwill）.Eachofthesehasanexpectedusefullifeofmorethanoneyear.

AssetType

Examples

Personalproperty

Automobiles,equipment,furniture,andmachinery

Realproperty

Landanditemsattachedtolandsuchasbuildings（warehouse,officebuilding,andresidentialdwellings）

Intangibles

Start-upandorganizationalcosts,copyrights,patents,covenantsnottocompeteandgoodwill

NaturalResources

Commoditiessuchasoil,coal,copper,timber,andgold

3.[LO1]Explainthesimilaritiesanddissimilaritiesbetweendepreciation,amortization,anddepletion.Describethecostrecoverymethodusedforeachofthefourassettypes（personalproperty,realproperty,intangibleproperty,andnaturalresources）.

Therearethreetypesofcostrecovery:

depreciation,amortization,anddepletion.Eachissimilarinthattheyrecoverthecostbasisoflong-lived

assets.Depreciationforrealproperty,amortization,andcostdepletionareonastraight-linebasis.（Taxpayersmayelectstraight-lineontangiblepersonalpropertyaswell.）Theprimarydifferenceisthattheyareusedforpropertywithuniquecharacteristics.Depreciationoftangiblepersonalpropertyisdoneonanaccelerated（mostoftendouble-decliningbalance）method.Percentagedepletionassignsastatutoryratethatmayrecovermorethantheoriginalcostoftheasset.

AssetType

CostRecoveryType,Characteristics

Personalproperty

MACRSdepreciation,characterizedbydoubledecliningbalancemethod（although150%DBorstraight-linemaybeelected）,half-yearconvention（althoughmid-quartermayberequired）,andshorterrecoveryperiods.

Realproperty

MACRSdepreciation,characterizedbystraight-linemethod,mid-monthconvention,andlongerrecoveryperiods.

Intangibles

Amortization,characterizedbystraight-linemethod,full-monthconvention,variousrecoveryperiods（usuallynotbasedonactuallife）dependingonintangibletype.

NaturalResources

Depletion（costorpercentage）,costdepletionallocatesthecostofanaturalresourcebasedonresourceestimates（tons,ounces,barrels,etc.）,straight-linemethod,basedonactualextractionquantities,percentagedepletionallocatesastatutoryexpense（dependingonresourcetype）basedongrossincome,butlimitedto50%ofnetincome,andistheonlycostrecoverymethodthatallowsataxpayertorecovermorethantheoriginalbasisofanasset.

4.[LO1]Isanasset’sinitialorcostbasissimplyitspurchaseprice?

Explain.

Theinitialbasisofanypurchasedbusinessassetishistoricalcost.Thisisgenerallythepurchaseprice,plusanyotherexpenses（e.g.salestaxandinstallationcosts）incurredtogettheassetinworkingcondition.Thisdoesnotincludecostswhichsubstantiallyimproveorextendthelifeofanassetsuchasabuildingaddition.

5.[LO1]Compareandcontrastthebasisofpropertyacquiredviapurchase,conversionfrompersonalusetobusinessorrentaluse,anontaxableexchange,gift,andinheritance.

Thebasisofpurchasedassetsishistoricalcost.Thebasisrulesforotheracquisitionsdependonwhetherthetransactionwastaxableornot.For

taxabletransactionsthereisusuallyastep-upinbasistofairmarketvalue.Fornon-taxabletransactions,thereisusuallyacarryoverbasis.Conversionofassetsfrompersonalusegetsthelesserofthetwovalues.Thespecificrulesareasfollows:

AcquisitionType

BasisRules

Purchase

Theinitialbasisishistoricalcost,plusallcostsincurredtogettheassettoitsdestinationandinworkingorder.

Conversionfrompersonaluse

Thedepreciablebasiswouldbethelesserofthefairmarketvalueoftheassetonthedateofconversionortheadjustedbasisofthetransferor.

Non-taxableexchange

Thebasisisacarryoverbasisofthetransferorsincethereisnorecognitionofgainorlossonthetransfer（notataxabletransaction）.

Gift

Thebasisisgenerallyacarryoverbasis,becausethesetransactionsusuallyaren’ttaxable.Ifgifttaxispaid,thebasismaybeincreasedbyaportionofthegifttaxpaid.

Inheritance

Thebasisisthefairmarketvalueonthedateofdeathorthealternatevaluationdatesixmonthslater（ifelectedbytheestate）.Thefairmarketvalueisusedbecausethetransferarisesfromataxabletransaction.

6.[LO1]Explainwhytheexpensesincurredtogetanassetinplaceandoperableshouldbeincludedintheasset’sbasis.

Additionalexpenses,includingsalestax,shipping,installationcosts,andthelikearecapitalizedintoanasset’sbasisbecauseallcostsrequiredtoplaceanassetintoservicearerequiredtobeincludedintoitsbasis.Thatis,withoutthesecosts,thetaxpayerwouldnotbeabletoplaceinserviceorusetheassetinabusiness.

7.[LO1]GraberCorporationrunsalong-haultruckingbusiness.Graberincursthefollowingexpenses:

replacementtires,oilchanges,andatransmissionoverhaul.Whichoftheseexpendituresmaybedeductedcurrentlyandwhichmustbecapitalized?

Explain.

Anexpensethatextendstheusefullifeofanassetwillbecapitalizedasanewasset—depreciatedoverthesameMACRSrecoveryperiodoftheoriginalassetratherthantheremaininglifeoftheexistingasset.Alternatively,expensesthatconstituteroutinemaintenanceshouldbeexpensedimmediately.Anengineoverhaulislikelytobeacapitalizedexpense.Tiresandoilchangesarelikelytobeexpensedcurrently.However,allexpensesaresubjecttoafactsandcircumstancestest.

8.[LO2]MACRSdepreciationrequirestheuseofarecoveryperiod,method,andconventiontodepreciatetangiblepersonalpropertyassets.Brieflyexplainwhyeachisimportanttothecalculation.

MACRSdepreciationcalculationsarestraightforwardonceyouknowtherecoveryperiod（life）,method,andconventionfortheasset.Recoveryperiodisthestatutorylifeortheperiodoverwhichataxpayerwillallocatethedepreciationexpense.Profitabletaxpayersprefertherecoveryperiodtobeasshortaspossiblesothattheymayrecoupthebasisasquicklyaspossible.Themethodisgenerallythedouble-declining（200%DB）method.However,taxpayersmayelecttouseeitherthe150%DBmethod（usefuliftheyaresubjecttoAMT,toavoidcalculatingbothregularandAMTdepreciation）orstraight-linemethod（tolengthendepreciationexpensefortaxpayersinanexpiringNOLsituation）.Theconventiondetermineshowmuchdepreciationistakeninboththeyearofacquisitionandtheyearofdisposition.Thehalf-yearconventionisusedtosimplifycalculatingdepreciationbasedonthenumberofdaysanassetwasownedduringtheyear,butthemid-quarterconventionisrequiredifmorethan40%ofthetangiblepersonalpropertyplacedinserviceduringtheyearwasplacedinserviceduringthefourthquarter.

9.[LO2]Canataxpayerwithverylittlecurrentyearincomechoosetonotclaimanydepreciationexpenseforthecurrentyearandthussavedepreciationdeductionsforthefuturewhenthetaxpayerexpectstobemoreprofitable?

Taxpayersmustreducethebasisofdepreciablepropertybythedepreciationallowedorallowable（§1011）.Therefore,taxpayersmustreducetheirbasiswhetherornottheyclaimthedepreciationexpense.Asaresult,taxpayersarebetterofftakingthedepreciationexpenseevenifitcreatesanetoperatinglossoristaxedatarelativelylowmarginaltaxrate.

10.[LO2][Planning]Whatdepreciationmethodsareavailablefortangiblepersonalproperty?

Explainthecharacteristicsofabusinesslikelytoadopteachmethod.

Taxpayersmayelecttousethe200%DB,150%DB,orthestraight-linemethodfortangiblepersonalproperty.Itisimportanttonotethatallthreemethodsallowthesamedepreciationexpenseoverthesamerecoveryperiod.Nevertheless,profitabletaxpayerswillelecttousethe200%DBmethodbecauseitminimizestheafter-taxcostoftheassetbymaximizingthepresentvalueofthedepreciationexpenses—throughacceleratingthedepreciationexpenses.TaxpayerstraditionallysubjecttotheAMTmayelecttousethe150%DBmethodbecauseitsavesthemtheadministrativeinconvenienceofcalculatingdepreciationunderbothmethodswhentheresultingexpenseunderthe150%DBmethodrequiredbyAMT.Taxpayersmayelecttousethestraight-linemethodiftheywanttoslowdowndepreciationexpense—

whichiscounterintuitivebutoftenoccursforcompaniesthatregularlyincurNOLsandwouldliketopreservetheselossesforatimewhentheyexpectprofitabilityorwillbeacquiredbyanothertaxpaye