Chapter 15 p.869
Capital Cost Recovery
Code §167(a) allows a depreciation deduction for a reasonable allowance for the exhaustion, wear and tear (including for obsolescence) of property: (1) used in a trade or business, or
(2) held for the production of income.
No depreciation deduction for personal assets.
Depreciation amount based on cost (§1012) for asset. Basis adjustment is then required - §1016.
Similar “cost recovery” treatment applies upon the depletion of hard minerals & oil and gas.
What property is depreciable? P.870
No tax depreciation deduction is available for an asset that has an indefinite life. Examples include: land, corporate stock and bonds.
Tax depreciation is available for buildings and improvements to real estate; machinery & equipment; and other tangible wasting assets.
Amortization (§197, 15 year straight line cost recovery) is available for certain intangible property (e.g., a patent; but, not a bond - since full repayment of bond anticipated at maturity).
Musician buys antique violin bow used in his profession and seeks to depreciate it for tax.
Bow actually appreciating in fair market value.
Holding: Bow is “recovery property” under §168 for which depreciation may be claimed.
It is “of a character subject to the allowance for
depreciation.” This property will suffer exhaustion, wear and tear or
The bow is not to be treated as a non-depreciable collectible asset. continued
Simon case, continued
What if valuable antiques are acquired as “office furniture”? Or, an antique oriental rug is acquired for the floor? Is tax depreciation available for these assets?
What if an Old Masters painting is acquired as “decoration” on the wall of the office?
Was the Simon violin both (1) trade or business property and (2) a non-wasting antique? If so, should only part of the tax basis be depreciable?
P purchases for 700x improved real estate with the building subject to a lease to tenant (who built the building on the property). Allocation of 300x to the building and 400x to the land.
Life of building was shorter than the lease term.
Is P entitled to depreciate the 300x building?
Did P have a depreciable interest in building?
Held: P could depreciate excess cost over land value (over the remaining term of the lease).
What actually was “depreciable asset”? Cont.
World Publishing, cont.
What is a “premium lease”? How does it arise? Can property
be acquired subject to a premium lease (with payment made for the value of the
Can this premium be amortized for tax purposes (over its “useful life”)?
Cf., §171 re amortization of bond premium (noted on p. 884). The “premium” is the excess of the purchase price over the bond’s value at maturity.
Newark Morning Ledger
NML purchases assets of other newspapers and seeks to allocate purchase price, including to a “paid subscribers” list (& exclusive of any allocation to “goodwill”). Statistical info is provided re the useful life of these lists.
IRS says no asset exists separate from goodwill & an indeterminate life applies for goodwill.
Sup.Ct. says fact burden satisfied by taxpayer & an intangible asset exists with (1) ascertainable value and (2) a limited useful life. continued
Newark Morning Ledger
Dissent (p.893): Failure of proof by the taxpayer. Confusion of subscription duration with goodwill on the date of the assets acquisition. Continued support for the concept that goodwill is not depreciable.
Note: Houston Chronicle – acquisition of a customer list from a defunct business (the prior Houston Press) & depreciation for this list.
Intangibles & Cost Recovery p.897
§167 enable straight line amortization of intangibles – e.g., patents, trademarks.
§197 provides special 15 year amortization rules for goodwill and purchased intangibles, including customer lists, skilled work force, & non-compete covenant, etc.
Does the value of these items actually decline?
§197 is the response to the Newark Morning Ledger case (p. 885). Did the enactment of Code §197 produce a tax increase? Why/how?
What is a non-compete agreement?
In making a noncompete deal the actual term is often five years (or shorter). When/why is a non-compete deal made?
Code §197 mandates a 15 year amortization of the payor’s cost of this noncompete agreement (even though gross income inclusion occurs over the shorter period to the recipient of payment). Why? Result: Current income to recipient but delayed deduction to payor.
How allocate the purchase price when acquisition of a going concern occurs - assuming an asset rather than stock purchase.
See Williams v. McGowan case, p.1116.
Allocation on basis of the residual method – easiest assets to value are first in order in the valuation process, with the remaining value to the (residual) goodwill.
Depreciation Deductions p.901
Cost for “wasting assets” should be recovered over time – associating the cost of the assets with income productivity from the particular asset.
Tax choices: 1) Deduction for the entire cost in the acquisition year.
No deduction until disposition of the asset.
Determine actual value decline during year.
4) Allocate some amount of the acquisition cost to each year of the asset’s anticipated usage (& possibly overstate the annual deemed cost?).
Current Depreciation Deduction System p.902-3
Determine the useful life (e.g., machinery &
equipment; office and industrial buildings).
Determine anticipated salvage value (but,
not relevant under current system, MACRS).
Determine the method of allocation to each
year (e.g., does a greater decline in value occur during earlier years)? Straight line, declining balance (e.g., DDB); some other system (e.g., income forecast)?
§168 – Statutory Depreciation Rules p.902
Recovery period – depends on the class of
property. See §168(c)&(e). Real property?
Recovery method - §168(b). Choices include
DDB, 150% DB and straight line.
With salvage value at zero. §168(b)(4).
3) “Placed in service” conventions - §168(d) re half-year convention, except for real property.
Limited expensing – without regard to rules
above - §179. $500,000 (§179(b)) – made permanent in PATH (2015)..
Additional depreciation Issues p.904
1) First year – full year’s depreciation? Allocated? Or, use an accounting convention (see prior screen)?
2) “Component” depreciation – divide parts of a building (e.g., elevators & escalators) into its various components to allocate useful lives?
3) Available depreciation necessitates a reduction in income tax basis (under §1016) – so as to avoid using tax basis twice for tax reduction purposes.
Stimulating Capital Investment p.905
Tax systems for stimulating capital investment:
Immediate deduction/expensing (equivalent to a consumption tax).
Accelerated depreciation, including:
a) Shorter lives than economic life.
b) Accelerated depreciation deduction.
c) No allocation to any salvage value.
3) Investment tax credit (tangible personal property only?) – make a tax basis adjustment if this credit is claimed? P.912
Additional depreciation Issues p.914
Possible “recapture” of depreciation deduction?
If claiming too much tax depreciation (when contrasted with economic depreciation): recapture the excess depreciation at disposition? Characterization: Ordinary income? See §1245.
What about “market gain? Example: buy at 100x, depreciate by 60x, basis is then 40x; then sell at 110x. What tax result(s)?
Impose an interest charge for excess deduction?
Real property – limited recapture under §1250.
Oil & Gas & Hard Minerals Issues: p.916
What federal income tax treatment for:
Development costs? IDCs.
Production costs, including costs for (a) tangible personal property and (b) depletion of the natural resource deposit itself (cost or percentage depletion)?
Dry hole expense – loss deduction?
5) Disposition – and possible recapture?
Hard Mineral Costs
§617 – exploration expenditures are currently deductible, at the election of the taxpayer. These are costs incurred to identify the existence and location of the mineral deposit.
Recapture of the deducted amount when reaching the production stage.
§616 – development expenditures can be currently deducted – when incurred after proving the existence of the deposit.
Intangible Drilling Costs & G&G Costs p.918
1) Oil & gas exploration costs. Deduction?
2) §263(c) authorizes regulations to enable current expensing for “intangible drilling and development” costs. What are IDCs?
What percentage of the total drilling costs? Why permit this deduction? Cf, capitalization.
Consider the tax benefit of the combination of (1) IDC deduction (no cost basis is established), and (2) the percentage depletion deduction (no cost basis is necessary). (next slide)
Depletion for Oil & Gas and Minerals p.916
Cost depletion for (1) oil & gas, and (2) hard minerals properties is allowed under §611.
How determine? Tax basis is allocated over the estimated recoverable units for the property.
Alternative method: §613/§613A - Percentage depletion enables deduction for percentage of gross income derived from production (except for major, integrated oil companies). But, no limitation on the deduction amount even after cost basis equivalent is recovered. Why?
Defining an “Economic Interest” p.917
To qualify for a depletion deduction the taxpayer must have an “economic interest” in the property being depleted.
What is the purpose of this concept? I.e., looking for an investment return from the production of the oil or mineral itself.
An “economic interest” can include a royalty interest, a working interest, a carved-out interest, etc.
Percentage Depletion Limit? p.916
What limits on the % depletion deduction?
- Percentage limit for 50 percent of the “taxable
income” from the property. What relevance of the tax basis of the property?
- What is the “cutoff point” for determining
the “gross income” from production?
See Cannelton Sewer Pipe Co. -when clay comes from mine or when clay pipe is finally sold?
Cf., oil & gas production – the “cutoff point” is at the wellhead for determining gross income.
Timber Tax Treatment
Possible election to treat timber income as capital gain. §631(a).
Possible alternative for §1231 treatment for timber royalties.