ACCTG410

Introduction | Video (1 of 10)

Introduction | Video

Chapter 2 Overview

Video 2.1. Chapter 2 Overview

In this lesson and the next lesson, you will review the lifecycle of business assets. It begins when a business acquires and begins to use an asset, runs through the time when the asset generates revenues for the business, and ends with the disposition of that asset. The difficult part of this lesson is that you will see some terms that are familiar from financial accounting, such as depreciation. However, the methods used for tax purposes will often differ from those permitted for financial accounting purposes. You will need to keep those different methods straight.

Learning Objectives

After completing this lesson, you should be able to

discuss the various types of property,
explain the ways of determining basis of business property,
determine the applicable cost recovery method for a type of property and how to determine the amount of cost to be recovered,
explain the special cost recovery rules of immediate expensing and listed property, and
show the appropriate usage and calculations for amortization and depletion.

Lesson 2 Readings and Activities

By the end of this lesson, make sure you have completed the readings and activities found in the Lesson 2 Course Schedule.

Classes of Property (2 of 10)

Classes of Property

You will begin this lesson with a discussion of the four main classes of property: personal property, real property, intangible property, and personal use property. Businesses handle each in different ways. Click on the buttons below to learn more about the main classes of property.

Personal Property

Personal property is tangible business property that is not real estate. Personal property is also known as personalty. Being tangible means it has a physical presence. Personalty can include many different varieties of assets, including machinery, automobiles and trucks, computers, and desks.

Real Property

Real property is any land or building/structure used in a business. Real property is also known as realty. During the time it is used in a business, land is handled differently from a structure or building. Land is land, no matter what is on top of it, whether that is a building or forest, or an opening to a mineshaft. A building is any manmade structure sitting on land.

Intangible Property

Intangible property is any business property that does not have any physical substance, such as trademarks, copyrights, or goodwill. These assets derive their value from the rights they convey to the owner. For example, a copyright gives the owner and their descendants exclusive rights to benefit from a work of art or literature. A trademark will protect the owner from the use of a logo without their permission.

Personal Use Property

Personal use property is any property that is not used for business. That is, it is for the personal use of the owner. Neither this lesson nor the next discusses personal use property. It's presented here only for comparison with the types of business assets.

Acquisition (3 of 10)

Acquisition

Next, you will discuss acquisition by purchase, multiple asset purchase, purchase of another business, and acquisition by conversion from personal use. Click below to learn more about each of these concepts.

Adjusted Basis Computation

The first step to integrating an asset into a business is to figure out the asset’s adjusted basis. Essentially, adjusted basis is the amount invested in the asset and is usually the same for financial accounting and tax purposes. You will need this to figure out the cost allocated to each year of use (a.k.a. depreciation) and the gain or loss on disposition of the asset.

Acquisition by Purchase

The most common way for a business to acquire an asset is by buying it. In this case, the adjusted basis consists of all costs incurred to make the asset usable by the business. For example, a machine is not usable until it is installed on the factory floor. Clearly, the cost includes the purchase price and all taxes paid. It should also include delivery and installation costs, because if a factory in Harrisburg buys a machine from a firm in Japan, the machine doesn’t do any good until it gets from Japan to Harrisburg.

Another way of calculating the adjusted basis is as

Adjusted basis calculation
	Cash paid for the asset
Plus	fair market value (FMV) of other property given to acquire the asset
Plus	increase in the buyer’s liabilities as a result of the purchase.

Acquisition by Multiple Asset Purchase

A multiple asset purchase occurs when a business buys more than one asset for a single price.

Example of Multiple Asset Purchase

For example, a business may buy a building and all of its contents (including desks, machinery, etc.) for $1 million. To figure out the adjusted basis of each asset acquired, the preferred method is to use relative FMV. Relative FMV involves estimating the FMV of each asset acquired. For example, if you acquire a building (FMV $800,000), a machine (FMV $200,000), and 20 desks (FMV $100,000) for $1 million, the total FMV of the items acquired is $1.1 million, but you only need to allocate the $1 million spent to their adjusted basis. That is done by taking the percentage that each asset is of the total FMV, then allocating the cost by those percentages, as follows:

Example of multiple asset purchase calculation for the building
	Building = $800,000
Divided by	$1.1 million FMV
Equals	72.7272% adjusted basis
Multiplied by	$1 million acquisition cost
Equals	$727,272 adjusted basis

Example of multiple asset purchase calculation for the machine
	Machine = $200,000
Divided by	$1.1 million FMV
Equals	18.1818% adjusted basis
Multiplied by	$1 million acquisition cost
Equals	$181,818 adjusted basis

Example of multiple asset purchase calculation for the desks
	Desks = $100,000
Divided by	$1.1 million FMV
Equals	9.0909% adjusted basis
Multiplied by	$1 million acquisition cost
Equals	$90,909 adjusted basis

If it is not possible to get the FMV of the acquired assets, then the buyer should base the adjusted basis on either an appraisal by an independent third party or on an agreement between the buyer and seller as to their values, assuming it is an arm’s-length transaction.

Acquisition by Purchase of Another Business

One business can buy another business, either by buying the stock of the business (assuming it’s incorporated), or by buying the assets of the business. When buying the stock of a business, the buyer’s adjusted basis in the included assets is carried over from the seller’s basis in those assets. The basis of the shares of stock acquired is the price paid.

When one business buys the assets of another business, the adjusted basis calculation depends on the purchase price relative to the FMV of the assets. If the purchase price is greater than or equal to the assets’ FMV, the adjusted basis of each asset is its FMV, and any excess is allocated to goodwill, which is not deductible for taxes.

Example of Acquisition by Purchase of Another Business

For example, if a building (FMV $800,000), a machine (FMV $200,000), and 20 desks (FMV $100,000) are acquired for $1.5 million, the adjusted basis of each asset would be as follows:

Adjusted basis calculation
	$1,500,000 acquisition cost
Minus	$800,000 building adjusted basis
Minus	$200,000 machine adjusted basis
Minus	$100,000 desks adjusted basis
Equals	$400,000 goodwill.

If the purchase price is less than the assets’ FMV, use the Relative FMV method to allocate the purchase price, as was done in the example under the "Acquisition by Multiple Asset Purchase" section above. There would be no goodwill from this transaction.

Acquisition by Conversion from Personal Use

If an asset has been a personal use asset, but a business is now converting it for use, most of the time you will use the lower of the adjusted basis of the personal use asset, or its FMV, on the date of the conversion.

If FMV is greater than the adjusted basis, use the adjusted basis for depreciation and for calculating gain or loss on disposition of the asset. For example, if 10% of a home is being converted from personal use to a home office (business use), and the home was purchased for $200,000 but is worth $250,000, the business’s adjusted basis for the office would be 10% of the lower $200,000 adjusted basis, or $20,000.

If the FMV is less than the adjusted basis, you use a split basis for the asset. Under the split basis method, you determine the adjusted basis only when disposition of the asset occurs. There are two bases under the split basis method, gain basis and loss basis. If the asset is sold at a gain, you would use gain basis, and it is equal to the asset’s higher adjusted basis. If the asset is sold at a loss, you would use loss basis, and it would be equal to the asset’s lower FMV on the date of the conversion. The loss basis is also the adjusted basis for depreciation purposes, while the asset is in business use. If the asset is sold for a price between adjusted basis and FMV on the date of conversion, there is no gain or loss reported on the tax return when it is sold.

Example of Conversion From Personal Use

For example, assume a taxpayer bought a home 5 years ago for $200,000. Due to an economic downturn and a declining neighborhood, the home is now worth <$150,000>.

The taxpayer decides to start a business. To save money, they set up an office for the business in their home, converting a room exclusively to a business office. The square footage of the converted room is 10% of the square footage of the home.

The first step is to calculate the gain basis and loss basis of the home office. In this case, the gain basis would be 10% of $200,000, or $20,000, and the loss basis would be 10% of $150,000, or $15,000. To simplify, you will ignore depreciation for now.

Three years after starting the successful business, the taxpayer decides to sell this home. In most cases, any gain on the sale would not be taxable, and any loss would not be deductible. However, the portion of the home used for a home office would be treated just like the sale of any business asset, with the possibility of gain or loss to be taxed. You will make three independent assumptions about the sale and show the resulting amount to be reported on the tax return. For simplicity, you are assuming no improvements to the home and no depreciation deducted for the home office.

Gain Basis

Assume the home sold for $220,000. In this case, you would use the gain basis, since the sale price is greater than the gain basis. There would be a gain of $20,000 ($220,000 − $200,000) of which 10%, or $2,000, would be from the home office. The taxpayer would report a $2,000 gain for the business from the sale of the home office.

Loss Basis

Instead, assume the home sold for $140,000. In this case, you would use the loss basis because the sale price is below the loss basis. There would be a loss of <$10,000> ($150,000 − $140,000) of which 10%, or $1,000, would be from the home office. The taxpayer would report a $1,000 loss for the business from the sale of the home office.

Neither Gain Basis nor Loss Basis

In the third case, assume the home sold for $180,000. This sale price is between the gain basis and the loss basis, so the business would not report a gain or loss from the sale of the home office. Instead, the business would report the sale price as $18,000 ($180,000 × 10%), and the basis as $18,000, resulting in no gain or loss.

Cost Recovery (4 of 10)

Cost Recovery

For both financial accounting and tax purposes, the cost of any asset with a useful life of more than 1 year must be capitalized. Those costs are then recovered over time through depreciation, amortization, or depletion (hereafter depreciation, except when discussing specifics), depending on the type of asset whose costs are being recovered. Depreciation, amortization, and depletion are cost recovery methods that are tax-deductible business expenses. So, they will reduce the business’s taxes. The reduction in taxes will increase the present value of the asset, making it more likely that the business will invest in the asset. This is especially true when the depreciation is taken quicker.

The method used for depreciation depends on when the business begins to use the asset. In 1981, the effort to accelerate depreciation and the resulting deductions began with the passage of the accelerated cost recovery system (ACRS). ACRS sought to stimulate the economy by accelerating depreciation. It also reduced the complexity and inconsistencies in the application of depreciation by standardizing an asset’s useful life and salvage value. The passage of the IRC of 1986 included the approval of the modified accelerated cost recovery system (MACRS), which extended the useful life of most assets. The continued usage of MACRS, with changes through the years, is for personalty and realty, but not for land or personal use assets that are not depreciated.

Depreciation (5 of 10)

Depreciation

The information needed to calculate depreciation of an asset includes the asset’s original basis, the appropriate length of time for recovering the cost of the asset, the appropriate depreciation method, and the depreciation convention. The IRS form used to report depreciation is Form 4562. Click below to learn more and see examples.

Personalty

Personalty is tangible property other than real estate, such as furniture, machinery and equipment, and automobiles. These are relatively short-lived assets, subject to obsolescence. There are three acceptable methods for depreciating personalty:

double (200%) declining balance,
150% declining balance, and
straight line.

Double declining balance is the default method with the quickest cost recovery. Most personalty is depreciated over 3, 5, or 7 years.

The IRS determines the recovery period for business assets in Rev. Proc. 87–56, which is updated periodically as new assets and technologies are created (summarized in the tables on the next page). Businesses classify new assets and use the information in Rev. Proc. 87–56 to assign recovery periods to the costs of those assets.

There are conventions applied to depreciation calculations. For personalty, a business must use either the half-year convention or the mid-quarter convention. Under the half-year convention, which is the default convention, a business takes a half-year of depreciation in the first year and the last year of an asset’s useful life. This is independent of the date the business actually put an asset to use. No matter whether it was in January or December, the business gets a half-year of depreciation in the first year and the last year. To simplify the calculations, the depreciation tables supplied by the government automatically include this half-year adjustment.

Double Declining Balance and the Half-Year Convention

The table for personalty using double declining balance and the half-year convention is found in Table A-1 and in "Table 1 MACRS Half-Year Convention" in the appendix to Chapter 2 in your text. Once you know the basis of the asset and classify it by useful life, the calculation of annual depreciation is simple multiplication.

Example of Double Declining Balance and the Half-Year Convention

For example, if you have established the basis of a machine as $1 million and that the appropriate life is 7 years, then you calculate the first year’s depreciation as $1 million × 0.1429 = $142,900. Remember, the adjustment for the half-year convention in years 1 and 8 is already built into that percentage, so there is no need to adjust it. The second year’s depreciation would be $1 million × 0.2449 = $244,900. If the business disposes of the asset anytime during years 2–7, you would need to adjust the depreciation for the half-year convention by multiplying it by ½.

For example, if the business disposed of the asset anytime in year 3, the depreciation for that year would be $1 million × 0.1749 × ½ = $87,450. It's important to note that the basis used to calculate annual depreciation, $1 million in this example, does not change, even as the adjusted basis of the asset (original basis minus depreciation) is declining.

Personalty Subject to the Mid-Quarter Convention

Tables A-2 to A-5 are for personalty, subject to the mid-quarter convention. These tables are also found in the appendix to Chapter 2 as "Tables 2a–2d MACRS Mid-Quarter Convention." Note that there are four tables, one for each quarter in the year, so be careful to use the correct one as noted in the title to each table. A business is required to use the mid-quarter convention when more than 40% of the value of the business’s personalty that has been placed in service during the year was placed during the fourth quarter.

Example of Personalty Subject to the Mid-Quarter Convention

For example, if a calendar year business places $1 million of personalty in service during the year, and more than $400,000 of that was placed in service between October 1 and December 31, the business would have to use the less beneficial mid-quarter convention for all personalty placed in service during that year, and it would have to continue to use the mid-quarter convention throughout the lives of those assets. This is done to prevent the manipulation of loading up on assets and their depreciation, just before the end of the year. The application of the mid-quarter convention is the same as the half-year convention, with the added step of identifying the quarter each asset was placed in service. For example, assume a business is subject to the mid-quarter convention for its personalty placed in service this year. One of the assets was a $1 million, 7-year asset placed in service in the second quarter. The table for the second quarter (Table A-3 online) shows the first-year depreciation to be $1 million × 0.1785 = $178,500. Keep in mind that once the mid-quarter convention is used on an asset, it must continue to be used. So, the third-year depreciation for this asset would be $1 million × 0.1676 = $167,600.

Realty

Realty, except land, is depreciated using the straight-line method and the mid-month convention. The mid-month convention means the business must figure out the month in which the asset is placed in service, and use that column in the appropriate table for the asset’s entire useful life. Residential realty has a depreciation period of 27.5 years, and nonresidential realty has a depreciation period of 39 years if it was placed in service after 1993. Nonresidential realty placed in service before 1993 has a life of 31.5 years. The determination of the type of realty is based on the primary usage of the realty.

Depreciation of Realty

Tables A-6 and A-7a are for depreciation of realty. These tables are also in the appendix to Chapter 2 as "Table 3 Residential Rental Property Mid-Month Convention Straight Line – 27.5 Years" and "Table 5 Residential Rental Property Mid-Month Convention Straight Line – 39 Years." Note that there are 12 columns, one for each month of the year. If a business placed a building in service in the third month of the year, the business would calculate depreciation using the figures in the third column and would continue to use that column for the entire useful life of the building.

Example of Depreciation of Realty

For example, if a calendar year business placed in service a $1 million factory in April (4th month), they would use the table for 39-year realty, since this is a nonresidential building. In year 1, depreciation would be $1 million × 0.01819 = $18,190. As with the tables for personalty, the mid-month adjustment is built into the table in the first and last years. Depreciation in year 4 would be $1 million × 0.02564 = $25,640. If the business sold the building in September of year 5, it would get a partial year of depreciation, calculated as $1 million × 0.02564 × 8.5 / 12 = $18,162. The business disposed of the building in the ninth month of the year, and you’re using the mid-month convention, so the business gets depreciation for half of the last month, meaning they get depreciation for 8½ of the 12 months in the year.

MACRS Asset Life Table (6 of 10)

MACRS Asset Life Table

"The MACRS Asset Life Table" is derived from Revenue Procedure 87-56 1987-2 CB 674. The table specifies asset lives for property subject to depreciation under the general depreciation system provided in section 168(a) of the IRC, or the alternative depreciation system provided in section 168(g). Use Table B-1 in Appendix B - Table of Class Lives and Recovery Periods on the irs.gov website to determine an asset's class based on the asset's activity type or description.

Table B-1. **Table of Class Lives and Recovery Periods**
Asset class	Description of assets included	Class Life (in years)	Recovery Periods (in years) GDS (MACRS)	Recovery Periods (in years) ADS
SPECIFIC DEPRECIABLE ASSETS USED IN ALL BUSINESS ACTIVITIES, EXCEPT AS NOTED:
00.11	Office Furniture, Fixtures, and Equipment: Includes furniture and fixtures that are not a structural component of a building. Includes such assets as desks, files, safes. and communications equipment. Does not include communications equipment that is included in other classes.	10	7	10
00.12	Information Systems: Includes computers and their peripheral equipment used in administering normal business transactions and the maintenance of business records. their retrieval and analysis. Information systems are defined as: 1) Computers: A computer is a programmable electronically activated device capable of accepting information, applying prescribed processes to the information, and supplying the results of these processes with or without human intervention. It usually consists of a central processing unit containing extensive storage, logic, arithmetic, and control capabilities. Excluded from this category are adding machines, electronic desk calculators, etc., and other equipment described in class 00.13. 2) Peripheral equipment consists of the auxiliary machines which are designed to be placed under control of the central processing unit. Nonlimiting examples are: Card readers, card punches, magnetic tape feeds, high speed printers, optical character readers, tape cassettes, mass storage units, paper tape equipment, keypunches, data entry devices, teleprinters, terminals, tape drives, disc drives, disc files, disc packs, visual image projector tubes, card sorters, plotters, and collators. Peripheral equipment may be used online or offline. Does not include equipment that is an integral part of other capital equipment that is included in other classes of economic activity, that is, computers used primarily for process or production control, switching, channeling, and automating distributive trades and services such as point of sale (POS) computer systems. Also, does not include equipment of a kind used primarily for amusement or entertainment of the user.	6	5	5
00.13	Data Handling Equipment; except Computers: Includes only typewriters, calculators, adding and accounting machines, copiers, and duplicating equipment.	6	5	6
00.21	Airplanes (airframes and engines), except those used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines)	6	5	6
00.22	Automobiles, Taxis	3	5	5
00.23	Buses	9	5	9
00.241	Light General Purpose Trucks: Includes trucks for use over the road (actual weight less than 13,000 pounds)	4	5	5
00.242	Heavy General Purpose Trucks: Includes heavy general purpose trucks, concrete ready mix-trucks, and ore trucks, for use over the road (actual unloaded weight 13,000 pounds or more)	6	5	6
00.25	Railroad Cars and Locomotives, except those owned by railroad transportation companies	15	7	15
00.26	Tractor Units for Use Over-the-Road	4	3	4
00.27	Trailers and Trailer-Mounted Containers	6	5	6
00.28	Vessels, Barges, Tugs, and Similar Water Transportation Equipment, except those used in marine construction	18	10	18
00.3	Land Improvements: Includes improvements directly to or added to land, whether such improvements are section 1245 property or section 1250 property, provided such improvements are depreciable. Examples of such assets might include sidewalks, roads, canals, waterways, drainage facilities, sewers (not including municipal sewers in class 51), wharves and docks, bridges, fences, landscaping shrubbery, or radio and television transmitting towers. Does not include land improvements that are explicitly included in any other class, and buildings and structural components as defined in section 1.48-1(e) of the regulations. Excludes public utility initial clearing and grading land improvements as specified in Rev. Rul. 72-403, 1972-2 C.B. 102.	20	15	20
00.4	Industrial Steam and Electric Generation and/or Distribution Systems: Includes assets, whether such assets are section 1245 property or 1250 property, providing such assets are depreciable, used in the production and/or distribution of electricity with rated total capacity in excess of 500 Kilowatts and/or assets used in the production and/or distribution of steam with rated total capacity in excess of 12,500 pounds per hour for use by the taxpayer in its industrial manufacturing process or plant activity and not ordinarily available for sale to others. Does not include buildings and structural components as defined in section 1.48-1(e) of the regulations. Assets used to generate and/or distribute electricity or steam of the type described above, but of lesser rated capacity, are not included, but are included in the appropriate manufacturing equipment classes elsewhere specified. Also includes electric generating and steam distribution assets, which may utilize steam produced by a waste reduction and resource recovery plant, used by the taxpayer in its industrial manufacturing process or plant activity. Steam and chemical recovery boiler systems used for the recovery and regeneration of chemicals used in manufacturing, with rated capacity in excess of that described above, with specifically related distribution and return systems are not included but are included in appropriate manufacturing equipment classes elsewhere specified. An example of an excluded steam and chemical recovery boiler system is that used in the pulp and paper manufacturing equipment classes elsewhere specified. An example of an excluded steam and chemical recovery boiler system is that used in the pulp and paper manufacturing industry.	22	15	22

Immediate Expensing (7 of 10)

Immediate Expensing

For personalty placed in service during the year, there are two elective methods that further accelerate cost recovery. These are §179 expensing and bonus depreciation, both of which allow for the immediate expensing of some or all of the basis of an asset. Of course, there are limits to both, so you can’t get too much of a good thing. Click below to learn more and see examples.

§179 Expensing

§179 expensing helps small businesses acquire new or used personalty to be used in the business. The maximum amount that can be deducted each year using §179 has varied over the years. The annual limit is currently set at $1,160,000 for 2023 and will be inflation adjusted in the future. The TCJA expanded the Section 179 depreciation incentive to enable taxpayers to immediately expense up to $1 Million of tangible personal property placed in service in 2018. However, the limit is subject to a phase-out over $2,890,000 for 2023.

Example of §179 Expensing

For example, if a business places $1.5 million of personalty in service during 2023, their §179 limit for that year is $1,160,000 plus the depreciation expense on the remaining $340,000 of assets.

§179 expensing is an annual election, so the business can choose whether to use it and on which assets to use it. They can spread it out over several assets or use it all on one asset.

Another Example of §179 Expensing

For example, a business places $1 million of personalty in service during the year, consisting of 10 machines costing $100,000 each. Assuming adequate taxable income, the business can choose to use the $500,000 to immediately expense five machines and depreciate the remaining five machines over their normal lives. Or the business could choose to use $50,000 of §179 expensing on each machine and depreciate the remaining $50,000 basis of each machine over their normal lives. Or they could choose to skip §179 expensing that year.

Bonus Depreciation

The Economic Stimulus Act used bonus depreciation to help stimulate the economy following the 2008 recession. Congress recently extended bonus depreciation through 2019. Like §179 expensing, it is an annual election, but it is not subject to the income limitation or the phase-out over $2 million. The TCJA also extended Bonus Depreciation in 2019. Bonus depreciation under the new tax law allows qualified property to be expensed at 100% through 2022 then scales back the expense in future years through 2026. For 2023, bonus depreciation is limited to 80% on qualified property. Taxpayers may elect out of the additional first-year depreciation.

Example of Bonus Depreciation

So, in the first year of its useful life, personalty with basis of $1 million and useful life of 5 years could have cost recovery of $1,000,000 (bonus depreciation) in year 1.

Listed Property

The IRC requires that certain types of business assets, primarily automobiles and computer equipment, be listed on the second page of Form 4562. Because these assets often have both business and personal uses, the IRS requires detailed recordkeeping of business usage. If the business use is more than 50%, the business can use regular depreciation methods on the asset. If the business use is 50% or less, the business must use straight-line depreciation for the asset.

In addition to being listed property, automobiles weighing less than 6,000 pounds are subject to limits on the amount of annual depreciation that can be taken. This is to discourage the use of luxury autos in a business. They are still eligible for §179 and bonus depreciation elections, but there are additional limits imposed. The limits for 2023 on depreciation of an automobile are $12,200 in the first year, $19,500 in the second year, $11,700 in the third year, and $6,950 in succeeding years.

Amortization (8 of 10)

Amortization

Amortization is the cost recovery method used for intangible assets, such as trademarks or patents. The one rule to keep in mind is that amortization always uses the straight-line method. For tax purposes, there are four general types of intangible assets subject to amortization: §197 purchased intangibles, start-up expenditures and organizational costs, research and experimentation costs, and patents and copyrights (also see IRS examples of intangible assets). Click on each button below to learn more about intangible assets subject to amortization.

§197 Purchased Intangibles

When a business purchases an intangible asset from an outside source, the cost of the intangible asset is amortized over 180 months, no matter the expected life of the asset. In this case, the full-month convention is used, meaning the purchasing business can deduct a full month’s amortization for the month of acquisition and for all subsequent months. So, even if the intangible is purchased on the 25th day of April, the business will take a full month’s amortization for the month of April.

Start-up Expenditures and Organizational Costs

Start-up expenditures are incurred when starting a business. This includes the costs to create a business or to investigate the creation of a business, such as analysis of potential markets or products, advertisements, or travel, as long as the costs are incurred before the business begins operations. Organizational costs consist of the expenditures incurred to form and organize a business as a corporation or partnership. These expenditures may include legal fees, filing fees, etc. A business can immediately expense up to $5,000 of organizational costs and up to $5,000 of start-up expenditures. These amounts are subject to a dollar-for-dollar phase-out when each of the expenses exceeds $50,000, meaning the immediate expensing disappears when the expenses are $55,000 or greater. Any start-up expenditures or organizational costs that are not immediately expensed are to be amortized over 180 months.

Research and Experimentation Costs

A business incurs research and experimentation costs when it invests in activities expected to create new, innovative products, or to improve its current products or processes. This will include the costs of research laboratories, including salaries and materials. The business can elect to either amortize the costs over at least 60 months, beginning in the month it begins to get economic benefit, or to deduct them in the year incurred, or to write them off using the straight-line method over 10 years beginning in the year the expense was incurred. Starting in 2022, the Tax Cuts and Jobs Act (TCJA) will require companies to amortize their R&D costs over five years, instead of deducting them immediately each year.

Patents and Copyrights

The method used to amortize patents and copyrights depends on whether the business purchased the intangible asset or created it itself. Patents and copyrights that have been purchased are amortized over 15 years. Those that the firm created cannot be amortized.

Depletion (9 of 10)

Depletion

The harvester picking up logs in a forest. — Abadonian / iStock / Thinkstock

Depletion is the method used to recover the costs of natural resources, such as forests, mining, or oil and gas. Either of two methods are permitted for calculating depletion, cost depletion or percentage depletion. The business gets to make the choice each year, and can change from year to year.

Cost depletion requires an annual estimate of the resource remaining. The basis of the resource is then allocated based on the number of units sold during the year. The calculation consists of taking the basis of the resource and subtracting the residual value of the land or other assets after extraction is completed. This number is then divided by the estimated number of resources remaining to be extracted. This yields the basis per unit. The basis per unit is multiplied by the number of units sold during the year to get the cost depletion deduction.

Example of Depletion

For example, assume a forest that cost $10 million to acquire has an expected residual value after harvesting of $1 million. Further, the forest is believed to have 2 million board-feet of lumber remaining. The basis per unit = $10 million − $1 million = $9 million. Dividing that number by the 2 million board-feet of lumber remaining gives a basis per unit of $4.50 per board-foot. If 100,000 board-feet were sold this year, the cost depletion would be $4.50 × 100,000 = $450,000.

Percentage depletion is determined by a statutory percentage of gross income from the property. The statutory percentage varies by the type of resource. Examples of the statutory percentages can be found under Mines and Geothermal Deposits. This shows that gold and silver mined in the United States have a percentage depletion of 15%, meaning 15% of the gross income from the mine that generated the gold or silver would be the amount of percentage depletion.

Summary (10 of 10)

Summary

This lesson has reviewed the determination of types of assets eligible for cost recovery and the determination of an asset’s basis. You also reviewed the methods of recovering the costs of the different types of assets.

ACCTG410:

Lesson 2: Life Cycle of Business Property #1