Depreciation, Amortization and Depletion

Cost Recovery

What is cost recovery? For accounting purposes, businesses must capitalize the cost of assets, if the asset’s useful life is more than one year. Capitalization means that the cost of the asset purchase must show up on the balance sheet rather than as an expense on the income statement. What happens later is that the asset’s cost is recovered by using depreciation deductions, which means spreading the cost across the next few years, there is a deduction in each year, until the value of the asset becomes zero.

There are actually three different methods to recover the cost of assets:

Depreciation	Deducting the cost of *tangible* personal and real property (other than land) over a specific period of time.
Amortization	Deducting the cost of *intangible* personal and real property (other than land) over a specific period of time.
Depletion	Deducting the cost of *natural resources* over a specific period of time.

Basis is essentially the cost (the dollar value) that you report on your balance sheet of the asset you’re using. Cost basis is reduced when costs are recovered through cost recovery deductions. The basis reduced by cost recovery deductions is called adjusted basis or tax basis of the asset. The term accumulated depreciation simply denotes the sum of the annual depreciation deductions that have been claimed over the life of the asset.

Basis = Accumulated depreciation + Adjusted basis

Basis is established and then reduced through cost recovery if we purchase a business-use asset or extend its useful life. Routine maintenance is immediately deductible and does not establish a basis. There are actually a number of ways to establish basis:

assets acquired through normal exchanges (taxable). Basis is generally fair market value.
assets converted from personal use to business use. Basis is lesser of
- cost basis, or
- fair market value on the date of conversion
assets acquired through non-taxable exchanges.
- Carryover basis, which is the basis of the asset you gave up becomes the basis of the asset you acquire.
assets acquired through inheritance. Basis is generally fair market value.

Basis must be reduced by cost recovery deductions allowed or allowable, even if the taxpayer fails to deduct the depreciation on his or her tax return. That is, even if the taxpayer does not claim depreciation deductions on his or her tax return, the IRS will assume the depreciation was taken and basically adjust the basis for you. Remember, in tax, deductions reduce income that would otherwise be taxed.

There are basically two kinds of property:

realty (real property)	land and buildings that are permanently affixed to the land
personalty (personal property)	any assets that are not realty

Note that personalty does not suggest that the asset is used for personal purposes. Personal-use property is any property whether realty or personalty, that has held for personal use rather than for use in a trade or business, or in an income producing activity.

These distinctions are important because there is no depreciation, amortization or depletion allowed for personal-use assets. If you use an asset for personal purposes, then the personal use portion is not eligible for cost recovery deductions. For business-use property, you can depreciate business-use personalty and business-use realty, although business use land is not technically depreciable because it is not subject to wear and tear or obsolescence.

For a business owner, the depreciation deductions are For-AGI deductions, meaning calculated before arriving at Adjusted Gross Income (AGI).

Depreciation

Depreciation of Personalty

Recall that depreciation is a cost recovery method related to business-use tangible personalty or realty, except for land. Before 1981, tax depreciation methods resembled the depreciation methods allowed for financial accounting purposes. Companies were able to calculate depreciation deductions using the straight line method:

(Cost of the asset - Salvage value) / Useful life

In 1981, Congress introduced the Accelerated Cost Recovery System (ACRS) to allow for accelerated depreciation. That is, companies could depreciate more of the value of the asset in the earlier years of the asse, providing for bigger tax deductions and thus, bigger tax benefits sooner relative to the straight line method.

Today, we use what’s known as the Modified Accelerated Cost Recovery System (MACRS), which has very rigid rules and schedules in terms of how quickly assets can be depreciated and over what time period. Also the way the asset is depreciated (the type of accelerated depreciation allowed) is also dictated by regulation.

You need to know four pieces of information to calculate these MACRS depreciation deductions for each of the business-use assets:

Original basis
Applicable depreciation method
Applicable convention: how much of the asset value can be deducted in the first year and the last year of use
Applicable recovery period (class life)

Conventions

Conventions is an assumption that the IRS is making about how much depreciation deductions you are allowed to claim in the first and the last year you place your asset into service. Taxpayers must select between two types of conventions:

Half-year

Assume that the business-use asset is placed into service on July 1st of the first year, which affords you one half of a year’s worth of depreciation in the first year you’re using the asset. Because you’re only recovering half a year’s worth of depreciation in the first year, then this means in the last year you use the asset, you will also get a half-year’s worth of depreciation, as if you disposed the asset on June 30th of the last year of use.
In tax, a five-year asset is depreciated over six years. If you dispose of the asset before the class life hits its final year, you can only take one half of that year’s worth of depreciation in the year you dispose of the asset. You will need to adjust the calculation for such a midstream disposal.

Mid-quarter

Apply when more than 40% of the value of business-use personalty assets are placed into service during the last quarter (last three months) of the tax year. The assets are treated as if they are placed into service in the middle of the quarter Nov 15th, which effectively translates into a much smaller tax benefit in the first year of placing an asset into service.
IRS wants to disincentivize taxpayers from back loading all of their asset use decisions just to manufacture half a year’s worth of depreciation, when they barely even used those assets during that first tax year.
Well to the extent there were other assets placed into service during the year but not in the fourth quarter, then they may still be subject to the mid-quarter convention.

How to determine which convention to use:

Sum the total basis A of all the tangible business-use personal property that you placed into service during the year.
Sum the total basis B of all the tangible business-use personal property that you placed into service in just the fourth quarter.
Compute the ratio of B / A. If the ratio is > 40%, must apply Mid-quarter convention to all the assets placed into service that year, otherwise apply Half-year convention.

Depreciation of Realty

Depreciation of realty does not use the same convention as a depreciation of personalty. Instead, realty (real property) is depreciated using the Mid-month convention, the taxpayer is allowed to deduct:

one half of one month’s worth of depreciation in the month the realty is placed into service

one half of one month’s worth of depreciation in the month the realty is disposed of

If you place realty into service on August 4th, it’s assumed that you placed the realty into service on August 15th, that is the middle of the month.

Also the realty asset is depreciated straight line (i.e. depreciated evenly over time). An important distinction with realty is whether the realty is residential (apartments) or nonresidential (office buildings, warehouses, hotels) because the class life period is different.

A real property is considered residential if 80% or more of the gross rental revenues are from non-transient dwelling units (meaning very short-term living). Residential real property can be depreciated straight line over a shorter period (27.5 years) than non-residential (39 years). Therefore the cost recovery is quicker for residential real properties.

The land itself is never depreciated. Only the buildings on the land are depreciated. In the year an asset is disposed of, if it still has depreciable basis remaining, a taxpayer will compute both:

depreciation in the year of disposition, and
gain or loss on the disposition of the asset

Depreciation in Year of Disposition

Often a taxpayer will dispose of an asset (usually by selling it) prior to the asset being fully depreciated. In these situations we still need to compute depreciation for the asset in the year of the disposition. If an asset is disposed during the tax year, the taxpayer shouldn’t be entitled to that full depreciation rate from the table. Instead, the taxpayer should only be allowed a portion of that full depreciation rate.

No depreciation deduction is allowed for assets acquired and disposed of in the same tax year.

For the assets using the half-year convention, the depreciation in the year of disposition is:

Depreciation expense = Basis × Depreciation rate × 50%

For the assets using the mid-quarter convention, it is considered to be disposed of in the middle of the quarter of disposition. Assume you are a calendar year taxpayer, if you dispose of the mid-quarter asset anytime in the first quarter (from January 1st through March 31st), it’s treated as if they dispose of that asset in the middle of the first quarter (1.5 months into the tax year). So the percentage of the full depreciation rate you would have been entitled is 1.5 divided by 12 months, i.e. 12.5%.

Depreciation expense = Basis × Depreciation rate × Percentage

Remember that the applicable table for mid-quarter assets depends on when the asset was originally placed in service. To calculate the Depreciation expense, find the depreciation rate from the table you would otherwise use if you didn’t dispose of the asset, then multiply that number by the Percentage.

A mid-month asset is treated as if it were disposed of in the middle of the month in which it was actually disposed of. If a taxpayer disposes of a mid month asset in June, they would be entitled to a depreciation deduction of 5.5 months (Jan, Feb, Mar, Apr, May, and half of June). So the percentage of the full depreciation rate they would have been entitled is 5.5 divided by 12 months, i.e. roughly 45.8%.

Depreciation expense = Basis × Depreciation rate × (Month of disposal - 0.5) / 12

Accelerated First-Year Depreciation

In additional to depreciation calculated from IRS tables, eligible taxpayers may be able to claim additional first year depreciation through:

“Bonus” depreciation
Section 179 depreciation

Bonus Depreciation

Bonus depreciation is a fixed percentage of an asset’s adjusted basis that is deductible as a depreciation expense in the year the asset is placed into service. It is an addition to MACRS and section 179 depreciation. By default, bonus depreciation is going to be included in the depreciation calculations. However, taxpayers can elect out of bonus on an asset class by asset class basis.

For instance, a business-use computer worth $2000 (a five-year class asset) is placed into service on June 60. Assuming half-year convention, the MACRS depreciation in the first year is 20%. Moreover, the computer’s applicable bonus percentage is 50%. So the total depreciation $1200 in the first year can be calculated like this:

Basis:                 $2000
Bonus depreciation:   -$1000
= Remaining basis:     $1000
MACRS depreciation:   -$ 200
= Adjusted basis:      $ 800

What property is eligible for bonus depreciation?

Property with a recovery period no longer than 20 years (most business-use personalty, but not reality)
Prior to the Tax Cut & Jobs Act, the property must be new. However post-TCJA, the “new” requirement is removed. The property can be used.

Bonus depreciation is not permanent. It does not apply to all assets, either. There are some separate limitations that Congress has placed on automobiles, for instance. Also many states do not allow taxpayers to claim a 100% bonus depreciation. You may still need to calculate depreciation using those tables for state tax. Finally, remember that bonus depreciation is optional, meaning a taxpayer can elect out of it. So, for example, a business may elect out a bonus depreciation so that it has sufficient taxable income as opposed to a taxable loss to utilize certain tax credits.

Section 179 Expense

This election is geared towards smaller to medium size businesses that do not place a huge amount of assets into service during the year. The election allows taxpayers to elect to immediately expense or deduct, a fixed dollar amount of eligible property used in a trade or business. This election applies to depreciate particular eligible assets. Therefore, you would individually select the assets that you wanted to use this accelerated depreciation on.

Like bonus depreciation, Section 179 depreciation is mostly limited to business-use personalty. However, it does allow for an election to treat certain limited categories of non-residential real property improvements as qualifying property, for instance:

a category of assets called qualified improvement property which is non-structural, non elevator interior improvements to an existing building. Qualified improvement property is now 15-year property and is eligible for bonus depreciation in addition to being eligible for Section 179.
nonresidential roofs, heating and cooling systems, and fire and security systems

Unlike bonus depreciation, Section 179 is a permanent feature of the tax code, it is not scheduled to sunset and is adjusted for inflation annually. It has always been allowed on both new and used property. If you don’t wish to or you can’t completely depreciate a particular asset, you can combine Section 179 with both bonus depreciation and regular makers depreciation. Section 179 expense is taken before bonus depreciation and before MACRS:

Basis:                       A
Section 179:                -B (up to limitation)
= Remaining basis 1:         C
Bonus depreciation:         -D (equals to C × x%)
= Remaining basis 2:         E
MACRS depreciation:         -F (from tables)
= Adjusted basis:            G (at the end of year 1)

The total depreciation is B + D + F.

The eligibility requirements for Section 179, there are two main limitations:

Asset acquisition limitation

Determine how much you can elect.
The amount of eligible 179 election is phased out dollar for dollar by the amount of property placed into service that is eligible for Section 179, that exceeds a threshold amount.
In 2018, this threshold acquisition amount was $2.5 million.
– If you place less than $2.5 million of qualifying assets into service, you can elect up to $1 million dollars in Section 179 depreciation, or up to the basis of the qualifying assets if the amount you place in service is less than a million.
– if you go over the threshold with your asset acquisitions, your eligible Section 179
election phases out dollar for dollar. In short, for every dollar above the limitation,
that’s a dollar less of the maximum amount the taxpayer is allowed to elect.

Taxable income limitation

Determine how much you can deduct.
Section 179 deduction cannot create a business taxable loss for the taxpayer. In other words, the amount expense cannot exceed the year’s business taxable income computed without regard to the Section 179 expense.
Any amount of elected 179 depreciation the taxpayer wanted to deduct but could not, is carried forward to a future year and can be deducted in the future, but it’s going to be subject to those same limitations.
The business taxable income limitation plus the total deduction for the year can never exceed the overall dollar limit.
NOTE: however, regular MACRS and bonus depreciation can create a loss.

Take an example: Pam places $2,060,000 qualifying Section 179 property for business use. Her business income before considering the Section 179 deduction is $200,000. Note that the maximum Section 179 expense election in 2017 is $510,000. The threshold acquisition amount in 2017 is $2,030,000. How much of Section 179 expense can she elect and deduct in 2017?

The electable amount is calculated like this:

Election = Max expense election - (Basis - Asset acquisition threshold)
= $510,000 - ($2,060,000 - $2,030,000)
= $480,000

However, because the taxable income limitation, she cannot deduct full $480,000 because her taxable income before Section 179 is only $200,000. So the deductible amount is $200,000. Now she has two options:

Elect up to the deductible amount ($200,000)
Elect more than the deductible amount ($200,000) up to the electable amount ($480,000), and have the remainder carryover to the next tax year.

Section 179 depreciation is applied to specific assets, so you would generally want to elect Section 179 on the longest-lived assets. The cost basis for MACRS and bonus depreciation purposes is reduced by the elected amount even if only a portion of that amount is actually deducted in the current year. The remaining adjusted basis can now be considered for regular MACRS and bonus depreciation.

Section 179 interacts with the mid-quarter convention. When you claim Section 179 on particular asset, the adjusted basis after applying the Section 179 election is used in the mid-quarter calculation. Strategic election or what assets you apply Section 179 to, can actually shift a taxpayer from mid-quarter to half-year in a particular tax year.

Listed Property and Recapture

Generally, for business-use personalty, the accelerated depreciation are quite generous. However, for certain business-use assets, the depreciation deduction amount that a taxpayer can claim may be limited. These kinds of assets are called listed property. Listed property are assets usually used for both business and personal use. The IRS only provides for limited depreciation deductions for them.

If a listed property is predominantly used for business (>50%) the taxpayer may follow the statutory methods of depreciation, namely Section 179, Bonus depreciation and MACRS.
If a listed property is not predominantly used for business (<50%) then the asset is depreciated using straight line.

If an asset’s business-use falls to < 50% after being place into service, the taxpayer must recapture excess cost recovery, in other words, the difference in depreciation between:

the sum of MACRS, bonus depreciation and Section 170 depreciation that the taxpayer has claimed
the straight line depreciation that would have been claimed during the same period

will be included in gross income. It backs out the excess depreciation deductions that were taken over the life of the asset and reclassifies it as income. Therefore, it’s very important for a business taxpayer to keep track of the business use percentage of assets over their lives in order to avoid such a recapture.

Luxury Auto Limitation

In general, the amount of depreciation that can be taken on passenger cars and “light” trucks, vans, and SUVs with the gross vehicle weight of less than 6000 lbs is limited. (Limitations do not apply to certain vehicles like emergency vehicles).

Taxpayer will need to calculate their otherwise allowable depreciation deduction on the automobile and then compare it to the luxury auto limit, and the taxpayer can only deduct the smaller of the two. If the taxpayers does not use the vehicle exclusively for business, then they will have to prorate the eligible depreciation deductions.

First, we’ll need to figure out if the asset qualifies for bonus depreciation or not, since that will determine what table we use. A car is a 5-year property for MACRS purposes, it is less than 20 years, and will qualify for bonus.

If this wasn’t a car, we’d just take the acquisition cost multiplied by the applicable bonus depreciation percentage and we’d have our deduction. But this is a car, so we have to look at the table.
If the limitation number from the table is less than the depreciation we calculated, the limitation is going to apply.
If the taxpayer had elected out of bonus depreciation for this class of assets, we would’ve used the non-bonus table.

And in future years, for the rest of this car’s depreciable life, depreciation deductions will continue to be limited by the same column from the same table we just used to determine year one depreciation.

Hummer Loophole

For vehicles weighing more than 6,000 pounds, the annual depreciation limitations do not apply. This weight cut off for luxury auto limitation spurred what was affectionately known as the Hummer Loophole, where taxpayers would buy really expensive cars that also happen to be really heavy, thus avoiding the yearly depreciation limitations. It’s not uncommon to see the manufacturers of these heavy vehicles note there are tax-advantage status to consumers seeking vehicles for business usage.

But while the annual depreciation limitations don’t apply to these heavier vehicles, there is a limitation on how much Section 179 expense you can claim on vehicles weighing between 6,000 pounds and 14,000 pounds. There is no limitation on bonus depreciation for these heavy vehicles. So buy a heavy and expensive truck or SUV and your business could be able to deduct 100% of the cost in year one starting in 2018, that’s a pretty good deal.

Another way some taxpayers have thought of getting around the listed property rules for autos was to not by the automobile but to lease it instead. Therefore, by leasing, the taxpayer isn’t worrying about limitations on depreciation, because now instead of depreciation deductions, they have a rental deduction for the lease.

Amortization

Amortization is used to recover the cost of business use intangible assets. Internal Revenue Code Section 197 identifies the types of intangible assets eligible for amortization, and Section 195 discusses the amortization of startup expenditures.

Section 197 Intangibles

Intangible assets that are acquired or purchased from another party and used in a taxpayer’s trade or business. This category includes assets such as trademarks, trade names, non-compete covenants, copyrights, patents, licenses, goodwill, and the going-concern value of a firm. Importantly, self-created intangibles are generally not amortizable.

Intangibles are amortized using straight-line recovery over 180 months beginning in month the intangible asset is acquired.

There are a couple of exceptions here for patents and copyrights under Section 197:

Purchased patents and copyrights – amortized over 180 months (15 years)
Internally created patents – 20 years
Internally created copyrights – Life of the author plus 70 years

Section 195 Startup Expenditures

Startup expenditures are costs related to investigation and operating expenses, but before the business actually begins operations. That is, their expenses incurred to start-up the business, but before the business has actually started-up officially. Some examples of start-up expenditures that business owners need to keep track of before starting the their business include:

marketing survey costs
advertising related to opening the business
analyzing various facilities
training employees before the business starts
traveling and other expenses related to securing distributors, suppliers, or customers
hiring personnel and outside consultants

Businesses can immediately expense the first $5,000 of start-up expenses. Then, any remaining amount over $5,000 that was spent for start-up purposes can be amortized over 180 months beginning in the month the business begins operations.

However the $5,000 immediate expense is phased out (or reduced) dollar-for-dollar when total start-up expenses exceed $50,000. That is, for every dollar that the total start-up expenses go over $50,000, that’s $1 less of the $5,000 that can be immediately deducted.

To qualify for expenses and amortization treatment, the election must be made on the business’s first tax return. If timely election is not made, start-up expenses can not be deduced, and must be capitalized. It can not deduct when business ceases operations and liquidates.

Depletion

With depletion, we’re simply referring to cost recovery related to natural resources like oil, gas, and minerals, but not simply land itself. The general approach here is to calculate the annual depletion expense under two methods:

The cost depletion method
The percentage depletion method

and then deduct the larger of the two.

Cost Depletion Method	Cost depletion method is basically a straight-line method, but using *units* as the denominator. `Depletion rate per unit = Basis / Estimated recoverable units` then `Deduction = Depletion rate per unit × Units sold in year` continue deducting depletion only until all estimated units are sold.
Percentage Depletion Method	This method computes using statutory percentage rate for resource type. The eligible deduction here is the *lesser* of: `The percentage depletion rate × Gross income from the resource` or `50% (or 100% if oil/gas) × Taxable income before depletion deduction`

The final depletion deduction is the greater of the two.

One major nuance in calculating depletion is for oil and gas producers. In particular the Intangible Drilling Costs (IDC), which are related to making the property ready for drilling, plus costs of drilling for oil, gas, geothermal wells. The Internal Revenue Code allows these taxpayers to elect to either:

capitalize them as an asset, and then recover the cost through depletion over time.
- The amounts are added to the property’s basis for determining cost depletion and costs are expensed through cost depletion deductions.
- Depletion rate per unit = Basis + Capitalized IDCs / Estimated recoverable units
deduct the IDC costs
- Deduction can be either immediate (all expensed in current year) or amortized over 60 months
- 50% (or 100% if oil/gas) × Taxable income before depletion deduction - IDCs expensed

But why should we care about whether the IDCs are capitalized or immediately expensed? Because not taking an immediate deduction will by definition increase the taxable income. Usually, it’s advantageous to simply elect an immediately expense IDCs rather than capitalize them, because it drives down taxable income in the current year.

Taxable income = Revenues - IDCs - Other expenses - Depletion

Capitalization vs Expensing

In general, property with a useful life greater than one year should be capitalized. However, you can imagine the administrative burden placed on taxpayers, if they were forced to capitalize and depreciate every piece of property. The IRS has produced some guidance, providing safe harbors that taxpayers can use to immediately expense as opposed to capitalizing newly acquired property.

De Minimis Safe Harbor – an annual election. If elected, most expenditures are immediately expensed.
- under $2500 without an applicable financial statement, or
- under $5000 with an applicable financial statement
Small Business Safe Harbor – an annual election that applies to improvements on certain buildings that would normally have to be capitalized.
- Small business (average gross receipts up to $10 million) can deduct repairs, maintenance, and improvements up to the lesser of $10000 or 2% of a building’s unadjusted basis.

Amounts paid to improve a unit of property must be capitalized. An improvement is defined as an expenditure that materially betters a unit of property, restores a unit of property, or adapts a unit of property to a new and different use.

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