Unit11.

Depreciation, Cost Recovery,

1
Amortization, & Depletion [PAK Ch. 10-1 to 10-21]
We will cover only pages 10-1 to 10-21 (objectives
1 and 2 in the text). We will omit the sections on
depletion, intangible drilling and development costs,
tax planning considerations, and compliance and
procedural considerations. You are welcome to read
these sections, but will not be tested on the
information in them.
 Overview
2

The concept of cost recovery is simple. The IRS allows those

conducting trade or business or those investing for a profit to
recover the cost of invested capital via tax deductions. The
cost recovery process encourages business and investment
activity, and thereby can stimulate economic growth.

Rules related to cost recovery for assets used in trade or
business or for production of income are complex. Before
reading the chapter, I would recommend that you read
through the chapter outline a few times to help grasp the
broad structure and classification of cost recovery rules
before focusing on detailed rules. This chapter is definitely
one to read one small section at a time, taking notes on
each section regarding specific rules and exceptions. You
may find the chapter Topic Reviews helpful summaries of
various rules.
 Concepts
3

Capital goods used in trade or business can suffer from

wear and tear or become obsolete (e.g. when’s the last
time that you saw a typewriter?). A stock of natural
resources can be depleted. Intangible assets such as a
trademark or copyright can lose value over time.
Under the ‘recovery of capital doctrine’ the IRS code
allows taxpayers to recover the cost of an asset.
Depending on the type of asset, the process of cost
recovery is called:

Depreciation – deductions related to most tangible property

Amortization – deductions related to intangible property

Depletion – deductions related to natural resources
 Depreciation / Cost Recovery
4

1. General considerations
2. Depreciation methods
3. Calculation of
depreciation
4. MACRS restrictions
 1. General Considerations
1) Three systems
5

Tax law changes have created three different sets

of rule related to depreciation and cost recovery:

Modified Accelerated Cost Recovery System (MACRS) –
for property placed in service after Dec. 31, 1986

Accelerated Cost Recovery System (ACRS) – for
property placed in service after Dec. 31, 1980 and
before Jan 1 1987

Sec. 167 – for property placed in service before 1981

Most property in service today follows MACRS.

 1. General Considerations
2) Rules common to all three systems (Ex. 10-1)
6

Depreciation can only be claimed on property used

in trade or business or for production of income

Assets with indefinite life cannot be depreciated
(e.g. land, works of art)

Depreciation begins when the asset is put in service,
regardless of when purchased

Must continue use of same method of depreciation
selected when asset placed in service

Property basis must be reduced by amount of
allowable depreciation each taxable year
 1. General Considerations
3) Property types
7

For both property law and income tax purposes,

there are two basic types of property

Tangible – has physical substance, e.g. buildings
 Real – land and permanently attached structures
 Personal – tangible property not classified as real, e.g.
vehicles, furniture

Intangible –has value, but no physical substance, e.g. a
patent
 1. General Considerations
4) Capitalization vs. expense
8

Expenditures that improve efficiency of asset or

extend the life of the asset beyond the end of the
year should be capitalized. In practice, however,
relatively small expenditures are often expensed
rather than capitalized
 1. General Considerations
5) Conversion of personal-use property (Ex. 10-2)
9

When property is converted from personal use to

business use or held for production of income (e.g.,
a principal residence converted to a rental house),
property basis for depreciation is lesser of adjusted
basis or FMV on date of conversion.
 2. Depreciation Methods (Ex. 10-3,
10
10-4, 10-5)

We will focus on MACRS for assets placed in service
after 1986.

Does not consider salvage value

Uses specific asset classes, i.e., 5-year property, 7-year
property

Depreciation methods built into MACRS tables (Page C-1)

MACRS convention for dates of acquisitions or dispositions

 Half-year convention: mid point of tax year
 Mid-quarter convention: mid point of a quarter
 Mid-month convention: mid point of a month
 3. Calculation of Depreciation
1) Tangible personal property (Ex. 10-6)
11

Depreciable if used for trade or business

Property must be classified into one of six asset classes:

3-year (life <= 4 years, e.g. tractor units)

5-year (life 4-10 years, e.g. computers, cars)

7-year (life 10-16 years, e.g. office furniture)

10-year (life 16-20 years, e.g. barges, food processing
equipment)

15-year (life 20-25 years, e.g. billboards

20-year (life >25 years, e.g., utilities, sewers).

Table 10-1 shows some examples of depreciation rates

Depreciation deduction = costs * depreciation rate
 3. Calculation of Depreciation
2) Section 179 expensing election (Ex. 10-7, 10-8)
12

In lieu of depreciating under the regular MACRS

methods, taxpayer may elect to expense up to
$250,000 (in 2009) of the acquisition cost as an
ordinary deduction in the year the property is
placed in service. Two limitations:

Taxpayers purchasing qualifying property with a cost
exceeding $800,000 will lose $1 of potential Sec. 179
expensing for every dollar of qualifying property acquired
over $800,000.

Sec. 179 reduction cannot exceed the taxpayer’s taxable
income from trade or business.
 3. Calculation of Depreciation
3) Bonus depreciation (Ex. 10-9, 10-10)
13

Bonus depreciation is for qualifying personal property

placed in service during particular periods of time after
9/11/2001.

9/10/2001-3/5/2003, additional 30% first-year bonus depreciation

3/5/2003 – 1/1/2005, additional 50% first-year bonus depreciation

2008 and 2009 Additional 50% first-year bonus depreciation
reinstated

Depreciation order for first year:

Section 179 depreciate first if so elected

Additional first year bonus depreciation

Regular MACRS depreciation

After first year regular MACRS depreciation under normal rules.
 3. Calculation of Depreciation
4) Year of disposition (Ex. 10-13, 10-14)
14

The MACRS system requires that depreciation be

taken in the year of disposition using the same
convention that applied on acquisition (e.g. half-
year, mid-quarter, or mid-month).
 3. Calculation of Depreciation
5) Real property classification and recovery rates (Ex. 10-15)
15

The MACRS recovery periods that apply to real

property placed in service after 1986 are:

Residential
rental property: 27.5 years

Nonresidential real property: 39 years

Straight-line depreciation must be used (reflected in

Tables 7, 8, and 9 in Appendix C)

Straight-line
depreciation method means constant
depreciation rate over time.

A mid-month convention is used in the year of
acquisition and in the year of deposition.
 3. Calculation of Depreciation
6) Straight-Line method election under MACRS
16

For tangible personal property,

taxpayers may elect to use the
straight-line method instead of
the accelerated method.

Using straight-line method
makes sense if the taxpayer has
substantial Net Operating Loss
(NOL) carryovers.
 3. Calculation of Depreciation
7) Alterative Depreciation System (ADS) (Ex. 10-18, Topic Review 10-1)
17

MACRS provides an alternative depreciation system

(ADS) that is required mostly for tangible property
used predominantly outside the U.S.

ADS is also available for all other depreciable
assets if the taxpayer so elects.

ADS requires the use of the straight-line method.

ADS election is generally made by taxpayers who
have net operating losses (NOL) or subject to the
alternative minimum tax.
 4. MACRS Restrictions
1) Personal use assets
18

Personal use assets: the personal use portion of an

asset’s cost is not depreciable.

Ex.Live in one duplex unit and rent the other one out.
Only the rental unit is depreciable.
 4. MACRS Restrictions
2) Listed property rules (Ex. 10-19, 10-20, 10-21)
19

Listed property rules apply to certain assets that

are conducive to mixed business/personal use.

Listed property includes (but not limited to)
automobiles, computers, peripheral equipment, and
cell phones.

Listed property restrictions:

If business use <50%
 Cannot elect Sec. 179 expense
 Must use ADS
 May not use bonus depreciation
 4. MACRS Restrictions
3) Recapture of excess cost recovery deductions (Ex. 10-22 )
20

Taxpayers are subject to depreciation recapture on

listed property if MARCS rules were used originally
but the business use portion falls below 50%
subsequently.

Excess depreciation is recaptured as ordinary income in
gross income in the year of the change.

Once business use falls under 50%, ADS must be used
for current year and all subsequent years, even if the
% is back to >50% later on.
 4. MACRS Restrictions
4) Additional rules on automobiles
21

Luxury cars

Must be depreciated over longer than the normal 5-year period.
(PAK Ex. 10-23, 10-24)

Mixed-use automobiles

PAK Ex. 10-25 – Table 10-3.

Trucks, vans, and SUVs

PAK Ex. 10-26

Leased vehicles

PAK Ex. 10-27

You won’t be tested on the details of these rules. You just
need to know that there are special rules regarding
automobiles but I don’t expect you to remember all the
details.
 5. Amortization
22

Amortization is the process of accounting for an

amount over a period of time.

Intangibles are amortized using the straight-line
method.

Major intangible assets that may be amortized are

Good will and other purchased intangibles

Computer software

Startup expenditures

Organizational expenditures

Pollution control facilities

 5. Amortization
1) Definition of Sec. 197 Intangible Asset
23

Section 197 allows a deduction for the amortization

of certain acquired intangible assets over a 15-
year period. These include

Goodwill

Intangible assets relating to the workforce

Licenses, permits

Franchises, trademarks, and trade names

Internally-created patents and copyrights are not

Sec. 197.
 5. Amortization
2) Research and experimental (R&E) expenditures (Ex. 10-32)
24

Sec. 174 deals with the income tax treatment of R&E

expenditures. A taxpayer can elect to

Expense in the year R&E expenses incurred

Deter and amortize over 60 months

Capitalize and write off only when the research project is
abandoned or is worthless

A taxpayer must make an election to either expense or
to amortize in the initial year the R&E expenditures are
incurred. These are the considerations:

Most taxpayers elect the expense to get immediate tax
benefits

Deferral and amortization is desirable if there is NOL
carryover.
 5. Amortization
3) Computer software (Ex. 10-33, 10-34)
25

Development software – treated as R&E, can be either

expensed in the year the costs incurred or capitalized
and amortized over 60 months at the taxpayer’s
election.

Purchased software – may be depreciated in serveal
alternative ways

If part of the computer hardware, no special treatment –
depreciated with the computer under MACRS with the
computer

If purchased separately, depreciated on a straight-line
basis over 36 months.

If acquired in connection with a number of assets of an
existing trade or business, it is considered Sec. 197 and must
be amortized over 15 years.