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Chapter 7 - Property Acquisitions and Cost Recovery

Deductions
Chapter7

QuestionsandProblemsforDiscussion

1. Thetaxlawpresumesthatnoexpenditureisdeductibleunlessaspecificstatutoryruleallows
thededuction.Furthermore,ifthetaxtreatmentofabusinessexpenditureisuncertain,the
expensemustbecapitalizedtoanassetaccountratherthandeductedinthecomputationof
taxableincome.

2. Ifadeductionforadvertisingexpensewasreplacedwith20yearamortization,theaftertaxcost
ofadvertising(inpresentvalueterms)wouldincreasesubstantially.Presumably,firmswould
purchaselessadvertisingoradvertisingcompanieswouldreducetheirprices(beforetaxcost)in
responsetosuchataxlawchange.

3. Costrecoverydeductionsarenotbasedoncurrentcashoutflows.Inotherwords,these
deductionsreducecapitalizedcostsratherthanthefirmscashaccount.However,thetax
savingsfromacostrecoverydeductionrepresentsapositivecashflow.

4. Costrecoverydeductionshavenorelationshiptoanydeclineinvalueofthepropertytowhich
thedeductionrelates.Taxpayersmayclaimcostrecoverydeductionsevenifthevalueofthe
propertyincreasesovertime.

5. Taxbasisrepresentstheunrecoveredinvestmentinabusinessasset.Iftheowneroftheasset
hasrecoveredherentireinvestmentintheformofcostrecoverydeductions,thebasisofthe
assetiszero.Anassetmaynothaveanegativetaxbasis.

6. Becauselandisanonwasting(nondepreciable)asset,capitalizedsoilandwaterconservation
expendituresarerecoveredintheyearthelandissold.

7. BecauseCorporationJsinsurancepremiumsrelatedtoassetsusedintheproductionof
inventory,theunicaprulesrequirethatthepremiumsbecapitalizedtoinventoryratherthan
deducted.CorporationKisaservicebusinesswithnoinventory.Therefore,itsinsurance
premiumsareperiodratherthanproductcostsandcanbededucted.

8. Inaperiodofinflationinwhichthemostrecentlypurchasedgoodsarethemostexpensive,the
LIFOcostingconventionmaximizescostofgoodssoldandminimizesthecapitalizedcostof
inventory.Consequently,theLIFOmethodminimizescurrentincome,whichisgoodfromatax
perspectivebutbadfromafinancialreportingperspective.FirmscannotuseLIFOfortaxand
anothermethodforfinancialreportingand,thus,musttakethegoodwiththebad.

9. Thecapitalizedcostofadepreciableassetcouldbedifferentfortaxpurposesthanforfinancial
statementpurposes.Thetimeperiodoverwhichthecostisrecoveredcouldbedifferent.The
methodforcomputingannualdepreciationcouldbedifferent.Finally,theconventionfor
determiningdepreciationintheyearofacquisitionordispositioncouldbedifferent.

10. Thepurposeoftheseconventionsistostandardizeandsimplifythedepreciationcalculationfor
ayearinwhichabusinessassetisacquiredordisposedof.Theactualdateinwhichtheassetis
placedinserviceortakenoutofserviceisirrelevantforcomputingMACRSdepreciation.

11. Thefirstyearintherecoveryperiod(theyearanassetisplacedinservice)isconstantacross
assetsbuttheyearofdispositionisdifferentforeveryasset.

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Chapter 7 - Property Acquisitions and Cost Recovery
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12. TheannualdollaramountthatcanbedeductedunderSection179isreduceddollarfordollarby
anyexcessofthetotalcostofdepreciablepersonaltyoverathresholdamount($450,000in
2007).Consequently,largefirmsthatroutinelypurchasemorethanthethresholdamountof
depreciablepersonaltyeachyearderiveareducedornobenefitfromthiselection.

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13. FirmOshouldelecttoexpenseaportionofthecostoftheseconditemwiththesevenyear
recoveryperiod.Thegreatertheaccelerationofcostrecoverydeductions,thegreaterthebenefit
oftheelection.

14. Thestrengthofthetaxruleprovidingfor15yearamortizationofanyassetmeetingthestatutory
definitionofpurchasedintangibleisitssimplicity.Firmsthatpayalumpsumpriceforabusiness
thatincludesnumerousintangibleassetsdonothavetodeterminethevalueorthe
ascertainablelifeofeachintangible.Instead,thesefirmssimplygroupallthepurchased
intangiblestogetherandamortizetheaggregatecostoverone(15year)amortizationperiod.
Theweaknessofthetaxruleisitsimprecisioninproperlymeasuringincome.Manypurchased
intangibleshaveascertainablelivesthatarefarlessorfargreaterthan15years.

15. Startupcostsofanewbusiness(inexcessof$5,000)mustbecapitalizedandamortizedover
180months,whileexpansioncostsofanexistingbusinessaredeductible.

16. Mr.Bwillrecoverthecostoftheaccountsreceivableashecollectsthem;thecostofthe
inventoryascostofgoodssold;thecostoftheofficesuppliesasadeduction;thecostofthe
furnitureandfixturesthroughMACRSdepreciation;andtheleaseholdcostthroughamortization
overthe31monthleaseperiod.Thetotalcostoftheseassetsis$646,100.Mr.Bs$103,900
residualcost($750,000lumpsumprice$646,100)isallocabletothesellerscovenantnotto
compete,goodwill,andgoingconcernvalue.Mr.Bmayrecoverthecostofthesepurchased
intangiblesover15years,beginninginFebruary.

17. FirmWgenerateditsgoodwillandgoingconcernvaluethroughitsownbusinessoperations
and,therefore,hasnobasisinthesevaluableintangibleassets.FirmXmusthaveacquiredits
goodwillandgoingconcernvaluebypurchase,therebyestablishinganamortizablecostbasisin
theseintangibles.

18. Percentagedepletionisnotacostrecoverydeductiontotheextentitexceedsthecostbasisin
thedepletableproperty(i.e.,whenthebasisinthepropertyhasbeenreducedtozero).

ApplicationProblems

1. a. Becausethecostofthesurveymustbecapitalizedtothelandandisnotrecoverableuntil
thelandissold,itsaftertaxcostis$14,200.
b. Becausetheresearchandexperimentalexpenditureisdeductible,itsaftertaxcostis
$33,562($44,750[$44,75025%]).
c. Becausetheadvertisingcostisdeductible,itsaftertaxcostis$17,250($23,000[$23,000
25%]).
d. Becausethegradingcostmustbecapitalizedtothelandandisnotrecoverableuntilthe
landissold,itsaftertaxcostis$120,000.
e. Becausethegradingcostisdeductible(preferencedeductionforfarmers),itsaftertaxcost
is$90,000($120,000[$120,00025%]).

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2. a. $6,866costbasis($5,950purchaseprice+$416salestax+$500incidentalcost)
b. $169,600costbasis(FMVofstockexchangedforinventory)
c. $7,000costbasis(FMVofservicesexchangeformachinery)
d. $20,000costbasis

3. a. The$52,000excessoftaxableincomeoverbookincomeisanunfavorabledifference
resultinginan$18,200deferredtaxasset($52,00035%).

b. ThetemporarydifferencewillreverseintheyearthatZeZedisposesoftheland.

4. a. 2006 2007
Costofasset $(50,000)
Taxsavings:
Annualdepreciation35% 1,099 $2,520
Netcashflow $(48,901) $2,520

b. Initialcostbasis $50,000
Year1depreciation (3,140)
Adjustedbasisatendof2006 $46,860
Year2depreciation (7,200)
Adjustedbasisatendof2007 $39,660

5. a. 2006 2007
Costofasset $(50,000)
Debtproceeds 50,000
Interestexpense (3,800) $(3,800)
Taxsavings:
Interestdeduction35% 1,330 1,330
Annualdepreciation35% 1,099 2,520
Netcashflow $(1,371) $50

b. TheuseofleveragehasnoeffectonFirmAsadjustedbasisintheasset.

6. a. Theaftertaxcostoftheoverhaulis$36,300($55,000beforetaxcost[$55,000deduction
34%]).

b. Theaftertaxcostoftheoverhaulis$38,058.

Year0 Year1 Year2 Year3


Beforetaxcost $(55,000) 0 0 0
Taxsavingsof$13,750cost
recoverydeductionat34% 4,675 $4,675 $4,675 $4,675
Aftertaxcost $(50,325) $4,675 $4,675 $4,675
Discountfactor(7%) .935 .873 .816
Presentvalue $(50,325) $4,371 $4,081 $3,815

NPVofaftertaxcost $(38,058)

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7. CompanyXYZscostofgoodssoldforitsfirstyearofoperationsiscomputedasfollows.
Book Tax
Directmaterialcost $200,000 $200,000
Directlaborcost 130,000 130,000
Indirectcosts 85,000 116,000
Totalcostof1,000units $415,000 $446,000

Costofendinginventory(260units) (107,900) (115,960)


Costofgoodssold(740units) $307,100 $330,040

8. a. CompanyXYZscostofgoodssoldforitssecondyearofoperationsundertheFIFOcosting
conventioniscomputedasfollows.
Book Tax
Costofbeginninginventory(260units) $107,900 $115,960
Costof2,000units
Directmaterialcost $410,000 $410,000
Directlaborcost 275,000 275,000
Indirectcosts 139,000 193,000
Totalcost* 824,000 878,000
Costof2,260unitsavailableforsale $931,900 $993,960
*$412perunitforbooks;$439perunitfortax

Costofendinginventory(300units) (123,600) (131,700)


Costofgoodssold(1,960units) $808,300 $862,260

Costofgoodssoldequalsthecostofthe260unitsinbeginninginventoryplusthecostof
1,700unitsmanufacturedduringtheyear.

b. CompanyXYZscostofgoodssoldforitssecondyearofoperationsundertheLIFOcosting
conventioniscomputedasfollows.
Book Tax
Costofbeginninginventory(260units) $107,900 $115,960
Costof2,000units
Directmaterialcost $410,000 $410,000
Directlaborcost 275,000 275,000
Indirectcosts 139,000 193,000
Totalcost 824,000 878,000
Costof2,260unitsavailableforsale $931,900 $993,960
*$412perunitforbooks;$439perunitfortax

Costofendinginventory(300units) (124,380) (133,520)


Costofgoodssold(1,960units) $807,520 $860,440

Costofgoodssoldequalsthecostof1,960unitsmanufacturedduringtheyear.

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9. a. Alandirrigationsystemis15yearrecoveryproperty.FirstyearMACRSis$3,125($62,500
5%).
b. Duplicatingequipmentis5yearrecoveryproperty.FirstyearMACRSis$12,500($62,500
20%).
c. Anoceangoingbargeis10yearrecoveryproperty.FirstyearMACRSis$6,250($62,500
10%).
d. Smallmanufacturingtoolsare3yearrecoveryproperty.FirstyearMACRSis$20,831
($62,50033.33%).

10. a. HereltsMACRSdepreciationfor2007is$54,816($383,60014.29%).ItsMACRS
depreciationfor2008is$93,944($383,60024.49%).
b. $383,600$54,816$93,944=$234,840adjustedbasisonDecember31,2008.
c. HereltsMACRSdepreciationfortheyearofdispositionisbasedonthehalfyear
convention.Thus,2009depreciationis$33,546(50%[$383,60017.49%]).

11. a. Inthiscase,KnuteusesthehalfyearconventiontocomputeMACRSdepreciation.Based
ontherecoverypercentagesinTable72,theannualdeductionsare:
Year1 33.33%$650,000 $216,645
Year2 44.45%$650,000 288,925
Year3 14.81%$650,000 96,265
Year4 7.41%$650,000 48,165

b. Becausemorethan40percent(infact,100percent)ofKnutestangiblepersonaltywas
placedinserviceduringthefourthquarter,itmustuseamidquarterconventiontocompute
MACRSdepreciation.BasedonthelasttableinAppendix7A,annualdeductionsfor
propertyplacedinserviceinthefourthquarterare:
Year1 8.33%$650,000 $54,145
Year2 61.11%$650,000 397,215
Year3 20.37%$650,000 132,405
Year4 10.19%$650,000 66,235

12. a. Inthiscase,ErwinusesthehalfyearconventiontocomputeMACRSdepreciation.First
yeardepreciationforthefiveyearrecoverypropertyis$62,560(20.00%$312,800),and
firstyeardepreciationforthesevenyearrecoverypropertyis$82,025(14.29%$574,000).
b. BecauseErwinplaced65percent($574,000$886,800)ofitstangiblepersonaltyinservice
duringthefourthquarter,itmustuseamidquarterconventiontocomputeMACRS
depreciation.BasedonthefirsttableinAppendix7A,firstyeardepreciationforthefiveyear
recoverypropertyplacedinserviceinthefirstquarteris$109,480(35.00%$312,800).
BasedonthelasttableinAppendix7A,firstyeardepreciationforthesevenyearrecovery
propertyplacedinserviceinthefourthquarteris$20,492(3.57%$574,000).

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13. a. Bookdepreciationiscalculatedasfollows.
Costofequipment $800,000
Residualvalue (50,000)
Depreciablebasis $750,000120months=$6,250monthlydepreciation
Tenmonths$6,250=$62,500bookdepreciation

b. Initialbasisofequipment $800,000
Year1recoverypercentagefor7yearMACRS .1429
MACRSdepreciation $114,320

c. Book Tax
Costofequipment $800,000 $800,000
Accumulateddepreciation (62,500) (114,320)
Adjustedbasisatbeginningofnextyear $737,500 $685,680

14 a. Thecommercial(nonresidential)realtyis39yearrecoveryproperty,andRylandmustuse
amidmonthconventionfortheyeartherealtyisplacedinservice.BasedonTable74,the
percentageforpropertyplacedinserviceinthefifthmonthis1.605%,soRylandsfirstyear
MACRSdepreciationis$28,890(1.605%$1,800,000costbasisofthebuilding).
b. Thepercentageforpropertyplacedinserviceintheninthmonthis.749%,soRylandsfirst
yearMACRSdepreciationis$13,482(.749%$1,800,000costbasisofthebuilding).
c. Residentialrealtyis27.5yearrecoveryproperty.BasedonTable73,thepercentagefor
propertyplacedinserviceinthefifthmonthis2.273%,soRylandsfirstyearMACRS
depreciationis$40,914(2.273%$1,800,000costbasisofthebuilding).

15. Themanufacturingplantis39yearrecoveryproperty,andAPmustuseamidmonthconvention
fortheyeartheplantisplacedinservice.BasedonTable74,MACRSdepreciationiscomputed
asfollows.
Year1 2.033%$9,465,000(9.5months) $192,423
Year2 2.564%$9,465,000 242,683
Year3 2.564%$9,465,000 242,683

16. a. ThecostbasisofeachMiniCooperis$14,300,andfirstyearMACRSis$2,860(20%
$14,300).MACRSdepreciationislessthanthefirstyearlimiteddepreciationforpassenger
automobiles($2,960in2006).Consequently,Nelsonsdepreciationdeductionis$22,880
($2,8608automobiles).
b. ThecostbasisofeachBuickLucerneis$27,000,andfirstyearMACRSis$5,400(20%
$27,000).MACRSdepreciationismorethanthefirstyearlimiteddepreciationfor
passengerautomobiles($2,960in2006).Consequently,Nelsonsdepreciationdeductionis
$23,680($2,9608automobiles).

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17. a. Totalcostofdepreciablepersonalty $164,000


Section179election/2007dollaramount (112,000)
TaxbasisrecoverablethroughMACRS $52,000
Year1percentagefor7yearMACRS .1429
Year1regularMACRSdepreciation $7,431
Totaldeduction($112,000+$7,431) $119,431

b. Totalcostofdepreciablepersonalty $490,000
Section179election:
Totalcost $490,000
Threshold (450,000)
Excesscost $40,000
2007dollaramount($112,000$40,000) (72,000)
TaxbasisrecoverablethroughMACRS $418,000
Year1percentagefor7yearMACRS .1429
Year1regularMACRSdepreciation $59,732
Totaldeduction($72,000+$59,732) $131,732

c. Totalcostofdepreciablepersonalty $675,000
Year1percentagefor7yearMACRSproperty .1429
Totaldeduction $96,458

18. a. FirmLcandeduct$71,300(nolimitondeduction).

b. FirmLcandeductonly$49,200(deductionlimitedtotaxableincome).The$22,100
nondeductibleexpenseiscarriedoverinto2008.

c. FirmLcannotdeductanyoftheSection179expensebecauseithasnotaxableincome.
Theentire$71,300nondeductibleexpenseiscarriedoverinto2008.

19. a. CompanyWsdeductionis$87,900($63,600+$24,300carryforwardof2006expense).

b. CompanyWsdeductionis$112,000,whichisthelimiteddollaramountfor2007.The
deductionconsistsof$99,000expensefor2007+$13,000carryforwardof2006expense.
Thus,thecompanyhasa$11,300carryforwardof2006expenseinto2008.

20. a. In2006,LonisSection179deductionislimitedto$94,100,soitstaxableincomeiszero
($94,100taxableincomebeforethededuction$94,100deduction).Lonis$13,900
nondeductibleexpenseiscarriedforward.
b. In2007,LonisSection179deductionis$77,600($63,700+$13,900carryforward),andits
taxableincomeis$150,400($228,000taxableincomebeforethededuction$77,600
deduction).

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21. Hiramcanexpenseanddeduct$112,000ofthecostofthetoolspurchasedin2007.
Consequently,theinitialcostbasisrecoverablethroughregularMACRSdepreciationis$11,000.
InitialCost Recovery Recovery 2007
Basis PeriodYear Percentage Depreciation
Furniture $30,750 Year3 17.49 $5,378
Equipment 70,000 Year4 11.52(onehalf) 4,032
Machinery 58,000 Year4 11.52 6,682
Tools 11,000 Year1 33.33 3,666
$19,758
Costrecoverydeduction($112,000+$19,758) $131,758

22. AjaxInc.candeduct$5,000ofits$16,300organizationalcostsandmustcapitalizethe$11,300
remainder.Itcanelecttoamortizethecapitalizedcostover180monthsattherateof$62.78per
month.Ifitmakesthiselection,Ajaxcanalsodeduct$377amortization(6months$62.78).
Withtheelection,Ajaxcandeduct$5,377organizationalcostonitsfirsttaxreturn.

23. Mr.andMrs.FBhave$15,490startupexpenditures.
RentforApril:
Commercialrealestate $2,100
Equipment 990
Advertisingduringpreoperatingphase 900
Staffhiringandtrainingduringpreoperatingphase 11,500
$15,490
Theycandeduct$5,000oftheseexpendituresandmustcapitalizethe$10,490remainder.They
canelecttoamortizethecapitalizedcostover180monthsattherateof$58.28permonth.If
theymaketheelection,theycandeduct$466amortization(8months$58.28)ontheircurrent
yeartaxreturn.
Mr.andMrs.FBcandeductthe$24,720rentonthecommercialrealestateandrestaurant
equipmentforMaythroughDecember.

24. a. Mr.Zcandeducttheentire$4,750startupexpenditures.
b. Mr.Zcandeduct$5,000oftheexpendituresandmustcapitalizethe$22,320remainder.He
canelecttoamortizethecapitalizedcostover180monthsattherateof$124permonth.
Firstyearamortizationwouldbe$372(3months$124),andMr.Zsfirstyeardeduction
wouldbe$5,372.
c. Mr.Zcandeduct$1,880oftheexpenditures($5,000$3,120excessexpendituresover
$50,000)andmustcapitalizethe$51,240remainder.Hecanelecttoamortizethe
capitalizedcostover180monthsattherateof$284.67permonth.Firstyearamortization
wouldbe$854(3months$284.67),andMr.Zsfirstyeardeductionwouldbe$2,734
($1,880+$854).
d. Mr.Zmustcapitalizethe$88,380expenditure.Hecanelecttoamortizethecapitalizedcost
over180monthsattherateof$491permonth.Mr.Zsfirstyeardeductionwouldequalthe
$1,473firstyearamortization(3months$491).

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25. MNOsfirstyearcostrecoverydeductioniscomputedasfollows.
Amortizationofleaseholdcostover36monthlease
(10months$90permonth) $900
FirstyearMACRSonleaseholdimprovements
($8,800.1429) 1,258
$2,158

26. a. Mrs.Ymustallocate$19,000ofherpurchasepricetothetaxicabandthe$41,000
remainingpricetopurchasedintangibles.Shecanamortizethecostoftheintangiblesover
180monthsyears,beginningwiththemonth(April)thatshebeganbusiness.Her
amortizationdeductionis$2,050,computedasfollows.
($41,000costbasisofintangibles180months)9months=$2,050
Mrs.Ystaxableincomeincludingtheamortizationdeductionbutbeforeconsiderationofthe
costrecoverydeductionforthetaxicabis$34,840($36,890$2,050).Therefore,shecan
makeaSection179electiontoexpensethe$19,000costofthetaxi,deducttheentire
expense,andreducehertaxableincometo$15,840($34,840$19,000).
b. Mrs.Ystaxableincomeincludingtheamortizationdeductionbutbeforeconsiderationofthe
costrecoverydeductionforthetaxicabis$15,050($17,100$2,050).Therefore,shecan
deductonly$15,050ofher$19,000Section179expenseandreducehertaxableincometo
zero.Shecarriesforwardher$3,950nondeductibleexpenseintothefollowingyearwhenit
willbedeductiblesubjecttotheSection179limiteddollaramountforthatyear.

27. a. Thegoodwillscostbasisis$135,000($750,000purchaseprice$615,000FMVofrecorded
assets).
b. $135,000180months=$750permonthamortization.Underhillsfirstyeardeductionis
$1,500(2months$750).
c. Underhillsbookamortizationforpurchasedgoodwilliszero.Consequently,the$1,500tax
deductionisafavorabledifferencebetweenbookandtaxableincome.Ata35%taxrate,the
differenceresultsina$525deferredtaxliability.

28. SEPsnetbookincomebeforetax $918,000


Bookdepreciationexpense $98,222
MACRSdepreciation (120,000)
(21,778)
Amortizationofstartupcosts
([$27,480 180months]12months) (1,832)
SEPstaxableincome $894,390
SEPcandeductthe$75,000researchcosts,soithasnobook/taxdifference.

29. TGWsnetbookincomebeforetax $3,908,000


Bookdepreciationexpense $448,000
MACRSdepreciation (377,900)
70,100
Bookindirectinventorycosts $(678,000)
Taxindirectinventorycosts 802,000
124,000
Bookcostofgoodssold $2,557,000
Taxcostofgoodssold (2,638,000)
(81,000)

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Bookgoodwillimpairmentexpense 750,000
Taxamortizationofgoodwill
([$2,250,000 180months]12months) (150,000)
TGWstaxableincome $4,621,100

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30. A&ZInc.scostdepletionis$107,500.
215,000tonssold$450,000depletablebasis=$107,500
900,000tonsestimated

A&Zspercentagedepletionis$151,580.
Grossincomefromuraniummine $689,000
Statutorydepletionpercentage* .22
$151,580
*Percentagedepletionislessthan50percentofthe$489,000taxableincomefromthemine.

A&Zcandeduct$151,580(greaterofthetwodepletioncalculations).

IssueRecognitionProblems

1. CanCorporationJdeductthe$20,000demolitioncost,ormustitcapitalizethe$20,000aspart
ofthecostoftheland?

2. Isthedepreciablebasisoftherentpropertythe$180,000originalcostorthe$120,000market
valueonthedateMr.Rconvertedhisresidencefromanonbusinesstoabusinessasset?

3. ForpurposesoftheSection179expensingelection,isthetaxablebusinessincomelimitation
computedonlywithreferencetoMr.KsbusinessorwithreferencetoMr.andMrs.Ks
combinedbusinessactivitiesreportedontheirjointreturn?

4. Howshouldthelumpsumpurchasepricebeallocatedamongthebuildings,thelandonwhich
thebuildingsandparkinglotsareconstructed,andthe12acresofundevelopedrealestate?

5. CanFirmPYdeductthe$12,800transportationexpenseand$1,700insurancepremium,or
mustthesecostsbecapitalizedtothebasisoftheindustrialequipment?

6. IsWRTInc.merelyexpandinganexistingbusinessorstartinganewbusinessbyopeningcoffee
barsinitsbookstores?Arethe$30,000upfrontexpendituresdeductibleoperatingexpensesof
anexistingbusinessorstartupexpenditures(subjecttocapitalization)ofanewbusiness?

7. CanFirmZfileanamended2005returnonwhichitelectstoexpensethe$10,000costthatthe
IRSrequiredittocapitalizetoanassetaccount?

8. DidCompanyJJplacetheairplaneinserviceinDecemberofthecurrentyearorFebruaryofthe
followingyear?InwhichyearcanCompanyJJbeginrecoveringthecostoftheairplanethrough
MACRSdepreciation?

9. CanTCJdeductthe$4,300expenditureasamaintenancecost,orshouldtheexpenditurebe
capitalizedtothebasisoftheland?

10. WilltheNPVofthefuturetaxsavingsattributabletotheclassificationofthecomponentsas5
yearor7yearrecoverypropertyexceedtheaftertaxcostofthe$15,000fee?Isthefeeitself
deductibleormustthefeebecapitalizedaspartofthecostofthecomponents?

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ResearchProblems

1. ThekeyissueinthisresearchproblemistheextenttowhichElsworthys$115,000costofeach
greencanbecapitalizedtoadepreciableassetaccount.InRev.Rul.200160,20012CB587,
theIRSruledthatthegreenitselfisasophisticatedimprovementtothelandthatwill
deteriorateovertimeandthathasadeterminableusefullife.Thegreensaresimilarto
sidewalks,roads,canals,sewers,fences,andbridges,andareclassifiedas15yearrecovery
propertyforSection168purposes.Therefore,Elsworthycancapitalizethe$85,000construction
costofeachgreentoanassetaccountandrecoverthecostthroughMACRSdepreciation.
However,therevenuerulingalsostatesthattheearthmoving,grading,andinitialshapingofthe
areaunderneaththemoderngreenareinextricablyassociatedwiththelandTherefore,
Elsworthymustcapitalize$30,000ofthecostofeachgreentotheunderlyingland.

2. ThisresearchproblemisbasedonthefactsinDanaCorp.v.UnitedStates,38Fed.Cl.356
(1997),revd,174F.3d1344(CAFed.Cir.1999).Thetrialcourtheldthatacorporationcould
deducttheannualretainerpaidtoalegalfirmeveninayearinwhichthefirmprovidedservices
inconnectionwiththecorporationsacquisitionofanothercompany.Accordingtothecourt,the
corporationshistoryofpayingtheretainerregardlessoftheamountornatureoflegalservices
receivedduringtheyearestablishedtheannualpaymentasanordinaryandnecessarybusiness
expenseundertheoriginofclaimdoctrine.Theappellatecourtdisagreedwiththis
interpretationandheldthatthecorporationsspecificuseofthefeeinaparticularyear
determinedtheoriginofclaim.Inayearinwhichtheretainerwasapartialpaymentforlegal
servicesincurredinconnectionwithacapitalacquisition,theretainerhadtobecapitalizedas
partofthecostofacquisition.

3. ThisresearchproblemisbasedonthefactsinU.S.Bancorpv.Commissioner,111TC231
(1998).Inthiscase,theTaxCourtheldthatafeeincurredontheterminationofanexistinglease
andpayableoverthetermofasimultaneouslyinitiatednewleasemustbecapitalizedand
amortizedoverthetermofthenewlease.Thecourtobservedthattheterminationoftheexisting
leasecouldnotbeisolatedfromthenegotiationsforthenewlease.Becausethetwoevents
wereintegrated,theterminationfeeprovidedafuturebenefittothelesseeandmustbe
capitalizedratherthanexpensed.AccordingtotheTaxCourtslogic,Manabeeshouldtreatthe
$200,000leasecancellationfeeasaleaseholdcost.

4. AccordingtoSection280F(b)and(d)(1),iftheannualbusinessusepercentageoflisted
propertydoesnotexceed50percent,thepropertydoesnotqualifyfortheSection179expense
electionandcanbedepreciatedonlyundertheSection168(g)alternatedepreciationsystem
(ADS).AccordingtoSection280F(d)(4)(A)(iii)andReg.Sec.1.280F6(b)(3)(i),videorecording
equipmentmeetsthedefinitionoflistedproperty.During2007,Peterusedhisequipment59
percentofthetimeforpersonalreasonsandonly41percentofthetimeforbusinessreasons.
Therefore,hecannotelecttoexpensethe$22,600cost.

713
Chapter 7 - Property Acquisitions and Cost Recovery
Deductions

TaxPlanningCases

1. a. MRTcanusethehalfyearconventiontocomputeitsMACRSdepreciationdeduction
becauselessthan40percentofthetotalcostofdepreciablepersonaltywasplacedin
serviceduringthelastquarteroftheyear.MRTstotalMACRSdeductionis$89,730.
Costof5yearrecoveryproperty $195,000
Year1recoverypercentage .20
$39,000
Totalcostof7yearrecoveryproperty $355,000
Year1recoverypercentage .1429
50,730
$89,730

b. IfMRTplacesanother$200,000ofpersonaltyintoserviceinthefourthquarter,itmustuse
themidquarterconventionforcomputingMACRSforallpropertyplacedinserviceduringthe
year.Inthiscase,thedepreciationdeductionwithrespecttothepropertiesalreadyacquired
woulddecreaseto$75,482.
5yearpropertyplacedinservicein3rdquarter $195,000
Year1recoverypercentage .15
$29,250
7yearpropertyplacedinservicein2 quarter
nd
$235,000
Year1recoverypercentage .1785
41,948
7yearpropertyplacedinservicein4thquarter $120,000
Year1recoverypercentage .0357
4,284
$75,482

714
Chapter 7 - Property Acquisitions and Cost Recovery
Deductions
2. IfCompanyCleasestheequipment,theaftertaxcostiscomputedasfollows.
Annualleasepayment $(21,000)
Taxsavingsofdeductionat34% 7,140
Aftertaxpayment $(13,860)

NPVofyear0payment $(13,860)
NPVofyears17payments:
($13,8605.206discountfactor) (72,155)
Aftertaxcostofrentoption $86,015

IfCompanyCbuystheequipment,theaftertaxcostiscomputedasfollows.
Interest/ MACRSand TaxSavings NetCash Present
Year Principal InterestDeduction at34% Flow Valueat8%
0 0 $14,290 $4,857 $4,857 $4,857
1 $(11,500) 35,990 12,237 737 682
2 (11,500) 28,990 9,857 (1,643) (1,408)
3 (11,500) 23,990 8,157 (3,343) (2,654)
4 (111,500) 20,430 6,946 (104,554) (76,847)
5 0 8,920 3,033 3,033 2,065
6 0 8,930 3,036 3,036 1,913
7 0 4,460 1,516 1,516 884
NPVofaftertaxcostofpurchaseoption $(70,508)

Therefore,CompanyCshouldpurchasetheequipmenttominimizeaftertaxcost.

715
Chapter 7 - Property Acquisitions and Cost Recovery
Deductions

3. a. IfMGkeepstheoldequipment,itsaftertaxcostiscomputedasfollows.
DeductibleRepair TaxSavings NetCash Present
Year andMaintenance at34% Flow Valueat10%
0 $(1,400) $476 $(924) $(924)
1 (1,400) 476 (924) (840)
2 (1,500) 510 (990) (818)
3 (1,600) 544 (1,056) (793)
NPVofaftertaxcost $(3,375)

IfMGbuysnewequipment,itsaftertaxcostiscomputedasfollows.
CashPaid Recovery TaxSavings NetCash Present
Year onPurchase Deduction at34% Flow Valueat10%
0 $(5,000) $1,667 $567 $(3,333) $(4,433)
1 2,222 755 755 686
2 741 252 252 208
3 370 126 126 95
NPVofaftertaxcost $(3,444)
Therefore,MGshouldkeeptheoldequipmenttominimizeaftertaxcost.

b. IfMGcanexpensetheentirecostofthenewequipment,itsaftertaxcostiscomputedas
follows.
CashPaid Recovery TaxSavings NetCash Present
Year onPurchase Deduction at34% Flow Valueat10%
0 $(5,000) $5,000 $1,700 $(3,300) $(3,300)
Therefore,MGshouldbuythenewequipmenttominimizeaftertaxcost.

716
Chapter 7 - Property Acquisitions and Cost Recovery
Deductions

4. TheNPVofthecostofthefirstalternativeiscomputedasfollows.
Annualrent $(79,000)
Taxsavingsofrentdeductionat35% 27,650
Aftertaxcostofannualrent $(51,350)

Aftertaxcostofyear0rent $(51,350)
NPVofaftertaxcostofrentforyears19
($51,3505.995discountfactor) (307,843
)
NPVofannualrentcost $(359,193
)

TheNPVofthesecondalternativeiscomputedasfollows.
Annualrent $(72,000)
Taxsavingsofrentdeductionat35% 25,200
Aftertaxcostofannualrent $(46,800)

Aftertaxcostofyear0rent $(46,800)
NPVofaftertaxcostofrentforyears19
($46,8005.995discountfactor) (280,566
)
NPVofannualrentcost $(327,366)
NPVofcostofleaseholdimprovement(seetable) (35,824)
TotalNPV $(363,190)

Costof Recovery TaxSavings NetCash Present


Year Improvements Deduction at35% Flow Valueat9%
0 $(50,000) $7,145 $2,501 $(47,499) $(47,499)
1 12,245 4,286 4,286 3,930
2 8,745 3,061 3,061 2,577
3 6,245 2,186 2,186 1,688
4 4,465 1,563 1,563 1,107
5 4,460 1,561 1,561 1,015
6 4,465 1,563 1,563 932
7 2,230 779 779 426
NPVofleaseholdimprovement $(35,824)

Tominimizethecostoftheleaseinpresentvalueterms,KPshouldpaythehigherrentand
havethebuildingsownerpayforthe$50,000leaseholdimprovement.

717
Chapter 7 - Property Acquisitions and Cost Recovery
Deductions
5. IfMr.Scapitalizesthecostoftheasset,theaftertaxcostis$43,317
Costinyear0 ($56,600)
TaxsavingsofMACRSdepreciation:
Year0($56,600.333325%) 4,716
Year1($56,600.444525%).935discountfactor 5,881
Year2($56,600.148125%).873discountfactor 1,830
Year3($56,600.074125%).816discountfactor 856
$(43,317)

IfMr.Sexpensesthecostoftheasset,theaftertaxcostis$44,247.
Costinyear0 ($56,600)
Taxsavingsofdeductioninyear2:
($56,60025%).873discountfactor 12,353
($44,247)
Therefore,Mr.Sshouldcapitalizethecostinsteadofelectingtoexpenseittominimizetheafter
taxcostoftheasset.

718