Most businesses make a significant investment in property, plant, and equipment that is expected to provide benefits over a number of years. For both financial accounting and generally for tax accounting purposes, businesses must capitalize the cost of assets with a useful life of more than one year (on the balance sheet) rather than expense the cost im- mediately. Businesses are allowed to use various methods to allocate the cost of these assets over time because the assets are subject to wear, tear, and obsolescence.
The method of cost recovery depends on the nature of the underlying asset.
Depreciation is the method of deducting the cost of tangible personal and real prop- erty (other than land) over time. Amortization is the method of deducting the cost of intangible assets over time. Finally, depletion is the method of deducting the cost of natural resources over time. Exhibit 10-1 summarizes these concepts.
Generally, a significant portion of a firm’s assets consists of property, plant, equipment, intangibles, or even natural resources. In most cases, this holds true for small businesses like Teton and also for large publicly traded companies. For example, Exhibit 10-2 describes the assets held by Weyerhaeuser, a publicly traded timber company. As indicated in Exhibit 10-2, Weyerhaeuser has over $1.5 billion in property and equipment (net of depreciation) and
$14.3 billion in timber (net of depletion), together comprising roughly 80 percent of its assets.
Businesses must choose accounting methods for the assets acquired during the year. Attention to detail is important because the tax basis of an asset must be reduced by the cost recovery deductions allowed or allowable.2 This means that if a business fails to de- duct (by mistake or error) the allowable amount of depreciation for the year, the business still must reduce the asset’s tax basis by the depreciation the taxpayer could have deducted under the method the business is using to depreciate the asset. This means that the business will never receive a tax benefit for the amount of depreciation it failed to deduct.
LO 10-1
1Cost recovery is the common term used to describe the process by which businesses allocate the cost of their fixed assets over the time period in which the assets are used.
2If a business discovers that it failed to claim allowable depreciation in a previous year, it can deduct the depreciation it failed to claim in prior years in the current year by filing an automatic consent to a change in accounting method using Form 3115 (Rev. Procs. 2002-9, 2004-11, and 2015-14).
EXHIBIT 10-1 Assets and Cost Recovery
Asset Type Cost Recovery Method
Personal property comprises tangible assets such as automobiles, equipment, and machinery.
Depreciation Real property comprises buildings and land (although land is nondepreciable). Depreciation Intangible assets are nonphysical assets such as goodwill and patents. Amortization Natural resources are commodities that are considered valuable in their
natural form such as oil, coal, timber, and gold.
Depletion
EXHIBIT 10-2 Weyerhaeuser Assets
Assets (in millions) per 2016 10-K Statement 2016 2015
Total current assets $ 1,622 $ 3,639
Property and equipment, net (Note 7) 1,562 1,233
Construction in progress 213 144
Timber and timberlands at cost, less depletion charged to disposals 14,299 6,552
Minerals and mineral rights, less depletion 319 14
Investments in and advances to equity affiliates (Note 8) 56 —
Goodwill 40 40
Deferred tax assets (Note 19) 293 254
Restricted assets held by special purpose entities (Note 8) 615 615
Other 224 229
Total assets $19,243 $12,720
3Basis is defined under §1012. The mere purchase of an asset does not trigger cost recovery deductions. A business must begin using the asset for business purposes (place it in service) in order to depreciate the asset.
However, because businesses generally acquire and place assets in service at the same time, we refer to these terms interchangeably throughout the chapter.
4Throughout the chapter we use several different terms to refer to an asset’s tax basis. The differences in these terms are somewhat subtle but can often be important. For example, an asset’s initial basis refers to the tax basis of an asset at the time the taxpayer initially acquires the asset. If a taxpayer purchases the asset, the initial basis is the same as its cost. However, if a taxpayer acquires the asset through means other than purchase (e.g., gift, inheritance, nontaxable transaction, or conversion from personal use), the initial basis will typically differ from the asset’s cost. We discuss some of these differences in the Property Dispositions chapter. The broad term, tax basis, refers to an asset’s carrying value for tax purposes at a given point in time.
When an asset’s initial basis is recovered through depreciation, amortization, or depletion, the asset’s tax basis is often referred to as the adjusted tax basis or sometimes simply the adjusted basis. It is not common to use the term adjusted tax basis for assets that are not subject to cost recovery. For example, the tax basis for a common stock investment would typically be referred to simply as its tax basis rather than its adjusted tax basis. Finally, the depreciable basis of an asset refers to the amount of the initial basis that can be depreciated over time using the regular depreciation rules. In many cases, the depreciable basis and the initial basis are the same—for example in the case of real property (i.e., buildings). However, the depreciable basis may differ from the initial basis when taxpayers take advantage of special incentives such as §179 expensing or bonus depreciation that accelerate an asset’s cost recovery in the year it is placed in service.
5§1011.
6However, special basis rules apply when an asset is acquired through a nontaxable transaction. See discussion in the Property Dispositions chapter.
7Reg. §1.263(a)-1, -2, and -3.
Basis for Cost Recovery
Businesses may begin recouping the cost of purchased business assets once they begin using the asset in their business (place it in service).3 Once the business establishes its cost in an asset, the business recovers the cost of the asset through cost recovery deductions such as depreciation, amortization, or depletion. The amount of an asset’s cost that has yet to be recovered through cost recovery deductions is called the asset’s adjusted basis or tax ba- sis.4 An asset’s adjusted basis can be computed by subtracting the accumulated depreciation (or amortization or depletion) from the asset’s initial cost or historical basis.5
For most assets, the initial basis is the cost plus all the expenses to purchase, prepare for use, and begin using the asset. These expenses include sales tax, shipping costs, and installa- tion costs. The financial accounting and tax rules for computing an asset’s basis are very similar. Thus, a purchased asset’s initial basis is generally the same for both tax and book purposes.6 So how do taxpayers know whether they should immediately deduct the cost of an asset or capitalize and depreciate it? Taxpayers generally capitalize assets with useful lives over one year, but there are exceptions to this rule. The Treasury has issued regulations that are quite lengthy (over 200 pages) and complex to guide taxpayers in answering this question.7 The regulations provide a de minimis safe harbor that allows taxpayers to
THE KEY FACTS Cost Basis
• An asset’s cost basis in- cludes all costs needed to purchase the asset, pre- pare it for use, and begin using it.
• Cost basis is usually the same for book and tax purposes.
• Special basis rules apply when personal-use assets are converted to business use and when assets are acquired through nontax- able transactions, gifts, or inheritances.
immediately deduct low-cost personal property items used in their business. The definition of low-cost depends on whether the taxpayer has an applicable financial statement, which generally means a certified, audited financial statement. If taxpayers have an applicable fi- nancial statement, they may use the de minimis safe harbor to immediately deduct amounts paid for tangible property up to $5,000 per invoice or item.8 If taxpayers don’t have an ap- plicable financial statement, they may use the safe harbor to deduct amounts up to $2,500 per invoice or item. Taxpayers generally use the invoice amount to determine whether they meet the safe harbor; however, if the total invoice amount exceeds the $5,000/$2,500 threshold and the invoice provides detailed cost information about each item, taxpayers may immediately deduct individual items that are less than the threshold amount. Taxpayers must capitalize the cost of personal property that does not fall under the de minimis safe harbor provision.9
When a business acquires multiple assets for one purchase price, the tax laws require the business to determine a cost basis for each separate asset. For example, for Teton’s building purchase, Teton must treat the building and land as separate assets. In these types of acquisitions, businesses determine the cost basis of each asset by allocating a portion of the purchase price to each asset based on that asset’s value relative to the total value of all the assets the business acquired in the same purchase. The asset values are generally determined by an appraisal.10
8Taxpayers must have accounting procedures in place at the beginning of the year treating items costing less than a specified dollar figure as an expense for nontax purposes.
9Separate rules apply when taxpayers purchase materials and supplies to be used in their business (Reg. §1.162-3).
10Reg. §1.167(a)-5.
11 Later in this chapter, we discuss alternative ways to immediately deduct the cost of certain assets (§179 expensing and bonus depreciation). The first step however is to determine if it must be capitalized or immediately deducted under the Treasury regulations for §263.
Steve determined that he needed machinery and office furniture for a manufacturing facility and a design studio (located in Cody, Wyoming). During 2017, Steve purchased the following assets and in- curred the following costs to prepare the assets for business use. His cost basis in each asset is deter- mined as follows:
(1) (2) (1) + (2)
Date Purchase Business Preparation Cost
Asset Acquired Price Costs Basis
Office furniture 2/3/17 $ 20,000 $ 20,000
Warehouse 5/1/17 270,000* $ 5,000 (minor modifications) 275,000
Land (10 acres) 5/1/17 75,000* 75,000
Machinery 7/22/17 600,000 $ 10,000 (delivery and setup) 610,000
Delivery truck (used) 8/17/17 25,000 25,000
*Note that the warehouse and the land were purchased together for $345,000. Steve and the seller determined that the value (and cost) of the warehouse was $270,000 and the value (and cost) of the land was $75,000.
What if: Assume Steve acquired a printer for $800 on July 9. Would he immediately deduct the cost of the printer or capitalize it?
Answer: Assuming that Steve has a policy to expense items costing $2,500 or less for nontax purposes, he would be able to immediately deduct the cost of the printer under the de minimis safe harbor.11
Example 10-1
When a business incurs additional costs associated with an asset after the asset has been placed in service, are these costs immediately deducted or are they capitalized?
In general, the answer depends on whether the expenditure constitutes routine mainte- nance on the asset or whether it results in a “betterment, restoration, or new or different
use for the property.”12 Taxpayers can immediately deduct the costs if they meet the rou- tine maintenance safe harbor rules provided in the Treasury regulations.13 Routine main- tenance is defined as preventative or cyclical maintenance that is an essential part of the ongoing care and upkeep of a building or building system. Costs related to the replace- ment of damaged or worn parts with comparable and commercially available replacement parts arising from inspecting, cleaning, and testing of the property are immediately de- ductible if two conditions are met. First, the taxpayer must fully expect to perform the activity more than once during a 10-year period (for buildings and structures related to buildings), or more than once during the property’s class life (for property other than buildings). Second, the safe harbor cannot be used to deduct expenses incurred from ma- jor renovations, restorations, or improvements.
12Reg. §1.263(a)-3.
13The routine maintenance safe harbor is discussed in Reg. §1.263(a)-3(i). In addition to the routine mainte- nance safe harbor, the regulations provide an additional safe harbor for small taxpayers. This safe harbor allows taxpayers with average annual gross receipts over the last three years of $10 million or less to immedi- ately deduct amounts paid for maintenance and improvement on buildings with an unadjusted basis of $1 mil- lion or less if the amounts expended are less than the lesser of 2 percent of the building’s unadjusted basis or
$10,000 [Reg. §1.263(a)-3(h)].
14Reg. §1.263(a)-3.
15The regulations provide detailed guidelines for taxpayers to use to establish when they have expenditures related to these three distinct concepts. Coverage of these concepts is beyond the scope of this chapter. See Reg. §1.263(a)-3 for details.
16After 2017, Steve may have an opportunity to expense the cost of the roof under §179 (discussed later in the chapter) as the TCJA modified the definition of real property for purposes of the expensing provision.
17Reg. §§1.167(g)-1 and 1.168(i)-4(b). However, this rule creates an interesting situation when selling converted assets. The taxpayer uses the lower of the adjusted basis or the fair market value at the time of the conversion for computing loss but uses the adjusted basis to compute a gain when selling converted assets.
Example 10-2
What if: Suppose that Steve’s business requires an annual safety certification on all its equipment and machinery. As a result of a required inspection of the machinery, Steve finds a defect in the engine of one of his machines and must replace the engine at a cost of $3,000. Can Steve immediately de- duct the cost of the new engine?
Answer: Steve’s business requires an annual safety certification inspection; thus Steve meets the re- quirement of reasonably expecting to perform the activity more than once during the machinery’s class life. Assuming that Steve replaces the engine with a comparable, commercially available engine, he may immediately deduct the $3,000 cost of the new engine.
If the routine maintenance safe harbor rules do not apply, then taxpayers must deter- mine whether the costs result in a betterment, restoration, or adaptation for a new or dif- ferent use for the property.14 If so, they must capitalize the costs; if not, they may immediately deduct the costs.15 For example, if the roof of Teton’s warehouse was com- pletely replaced because it was leaking, Steve would be required to capitalize the costs to replace the roof as a restoration because a significant portion (100 percent) of a major component was replaced. If Teton needed to replace only 10 percent of the roof, Steve would most likely be able to immediately deduct the costs.16
Special rules apply when determining the tax basis of assets converted from personal to business use or assets acquired through a nontaxable exchange, gift, or inheritance. If an asset is used for personal purposes and is later converted to business (or rental) use, the basis for cost recovery purposes is the lesser of (1) the cost basis of the asset or (2) the fair market value of the asset on the date of conversion to business use.17 This rule prevents taxpayers from converting a nondeductible personal loss into a deductible business loss. For example, if Steve had purchased a truck for $20,000 several years ago for personal use but decided to use it as a delivery truck when its value had declined to $15,000, his basis in the
truck for cost recovery purposes would be $15,000. The $5,000 decline in the truck’s value from $20,000 to $15,000 would be a nondeductible personal loss to Steve, and the reduction in basis ensures that he will not be allowed to deduct the loss as a business loss.
Assets acquired through a nontaxable exchange, such as a like-kind exchange (like-kind exchanges are discussed later in the Property Dispositions chapter), generally take the same basis the taxpayer had in the property that the taxpayer transferred in the transaction. Assets acquired by gift have a carryover basis. This means that the taxpayer’s basis in property re- ceived through a gift is generally the same basis the transferor had in the property.18 For example, if Steve’s parents gave him equipment worth $45,000 to help him start his busi- ness and his parents had purchased the equipment 10 years earlier for $25,000, Steve’s basis in the equipment would be $25,000 (the same basis his parents had in the equipment). As- sets acquired through inheritance generally receive a basis equal to the fair market value on the transferor’s date of death.19 For example, if Steve inherited a building worth $90,000 from his grandfather who originally paid $35,000 for it, Steve’s basis would be $90,000 (its fair market value at date of death) because Steve acquired it through an inheritance.
ETHICS
Catherine Travis is starting a new business. She has several assets that she wants to use in her business that she has been using personally.
Since she plans to convert several assets from personal to business use, she will need to find out how much each asset is worth so she can de-
termine her basis for depreciating the assets.
Catherine has decided that getting an appraisal would be too costly so she simply uses her cost basis for the assets. What do you think of Cathe- rine’s strategy for determining her business asset bases?
18§1015. The basis may be increased if the transferor is required to pay gift tax on the transfer [see §1015(d)].
In addition, special dual basis rules apply if the basis in the gifted property at the gift date is greater than its fair market value.
19§1014. In certain circumstances, the estate can elect an alternative valuation date six months after death.
20IRS Publication 946 provides a useful summary of MACRS depreciation.