Quickfinder. Depreciation Quickfinder Handbook (2012 Tax Year) Updates for the American Taxpayer Relief Act of 2012

Transcription

1 Quickfinder Depreciation Quickfinder Handbook (0 Tax Year) Updates for the American Taxpayer Relief Act of 0 Instructions: This packet contains marked up changes to the pages in the Depreciation Quickfinder Handbook that were affected by the American Taxpayer Relief Act of 0, which was enacted after the handbook was published. To update your handbook, you can make the same changes in your handbook or print the revised page and paste over the original page. Note: For many pages, the change is simply a matter of crossing out a paragraph and/ or inserting an amount or date.

2 TAX PREPARATION Depreciation Quickfinder Handbook Depreciation, Amortization, Sales and Exchanges 0 Tax Year 0 Vehicle Quick Facts Passenger Autos GVW (unloaded) up to 6,000 lbs. Depreciation limit Acquisition year (with bonus) $,60 Depreciation limit Acquisition year (without bonus) 3,60 Second-year limit 5,00 Third-year limit 3,050 All years thereafter,875 Trucks and Vans GVW (loaded) up to 6,000 lbs. Depreciation limit Acquisition year (with bonus) $,360 Depreciation limit Acquisition year (without bonus) 3,360 Second-year limit 5,300 Third-year limit 3,50 All years thereafter,875 Car, Truck or Van (Including SUVs and Minivans) GVW over 6,000 but not over 4,000 lbs. Depreciation limit N/A Maximum Section 79 deduction $ 5,000 Standard Mileage Rates Business 55.5 Depreciation component 3 Charitable 4 Medical and moving 3 Applies to the sum of MACRS depreciation, special (bonus) depreciation and Section 79 expense claimed. Some exceptions, including pickups with a bed at least six feet long. Overall limit on Section 79 expensing also applies. 0 Section 79 Limits Maximum deduction $ 500,000 Qualifying property threshold before phase-out,000,000 Additional deduction for federally declared disaster areas 00,000 Additional property limit for federally declared disaster areas 600,000 Additional deduction for empowerment zones 35,000 Additional property limit for empowerment zones -0-3 Maximum deduction for qualified real property 50,000 4 Maximum deduction (per vehicle) for car, truck or van (including SUVs and Minivans) with GVW over 6,000 but not over 4,000 lbs. 5,000 If less, the amount of qualifying Section 79 property placed in service in the specified location. See Increased Limits for Targeted Areas on Page Only 50% of the cost of qualified zone property is counted when determining whether the qualifying property threshold ($,000,000) has been exceeded. 4 See Qualified Real Property on Page 5-6. Recovery Periods for Common Assets Placed in Service in 0 Recovery Period (Years) MACRS/AMT ADS Assets Used in All Business Activities Office furniture and equipment 7 0 Computers and peripheral equipment 5 5 Typewriters, calculators, copiers 5 6 Airplanes (noncommercial) and helicopters 5 6 Automobiles 5 5 Light general purpose trucks (less than 3,000 lbs.) 5 5 Heavy general purpose trucks (3,000 lbs. or more) 5 6 Tractor units (for over-the-road use) 3 4 Trailers 5 6 Assets Used in Agricultural Activities Agricultural machinery and equipment 7 0 Breeding or dairy cattle 5 7 Breeding or work horses, years old or less 7 0 Farm buildings, other than single purpose 0 5 Single-purpose agricultural or horticultural structures 0 5 Assets Used in Oil and Gas Industry Assets used in drilling oil and gas wells 5 6 Assets used in exploring and producing oil and gas 7 4 Specialized Assets Assets unique to wholesale and retail trade, and personal and professional services 5 9 Section 45 assets used in marketing petroleum and petroleum products 5 9 High technology medical equipment 5 5 Real Property Qualified leasehold improvement property 5 39 Qualified restaurant property 5 39 Qualified retail improvement property 5 39 Land improvements (sidewalks, roads, drainage facilities, bridges, fences, landscaping, radio towers) 5 0 Retail motor fuel outlets 5 0 Billboards 5 0 Residential rental real property Nonresidential real property Other Assets used in construction activities by general building contractors, real estate subdividers and developers 5 6 Appliances, carpet and furniture used in a residential rental property 5 9 Replacement Page 0/03 Replacement Page 0/03 Copyright 0 Thomson Reuters. All Rights Reserved. 0 Tax Year Depreciation Quickfinder Handbook COV-

3 Depreciation Quickfinder Handbook Copyright 0 Thomson Reuters. All Rights Reserved. ISBN ISSN PO Box 966, Fort Worth TX Phone Fax Quickfinder.thomson.com The Depreciation Quickfinder Handbook is published by Thomson Reuters. Reproduction is prohibited without written permission of the publisher. Not assignable without consent. The Depreciation Quickfinder Handbook is to be used as a first-source, quick reference to basic tax principles applied to property used in a trade or business or for the production of income. Its focus is to present often-needed reference information in a concise, easy-to-use format. The summaries, highlights, tax tips and other information included herein are intended to be of concern for the average taxpayer only. Information included is general in nature and we acknowledge the existence of many exceptions. The information this publication contains has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. The publisher is not engaged in rendering legal, accounting or other advice and will not be held liable for any actions or suit based on this handbook. For further information that applies to a specific tax situation, see IRS publications, rulings, regulations, court cases and Code sections applicable to that situation. This handbook is not intended to be used as your only reference source. Exceptions to MACRS Declining Balance Method Straight-Line Method Required Asset Real estate commercial Real estate residential rental Listed property used 50% or less in trade or business Trees or vines bearing fruit or nuts Property used predominantly in farming if taxpayer elects out of uniform capitalization rules for plants with long preproductive life Qualified leasehold improvement property Qualified restaurant property Qualified retail improvement property Property used predominantly outside of the U.S. Property used in a tax-exempt activity or financed by tax-exempt bonds Property imported from a country subject to trade restrictions Water utility property Recovery Period 39 years 7.5 years ADS recovery period 0 years ADS recovery period 5 years 5 years 5 years ADS recovery period ADS recovery period ADS recovery period 5 years 3-Year, 5-Year, 7-Year, 0-Year and 5-Year MACRS Property Half-Year Convention Year Depreciation Rate for Recovery Period 3-year 5-year 7-year 0-year 5-year 33.33% 0.00% 4.9 % 0.00 % 5.00% Depreciation Recapture Rules Asset Description Section 45 Section 50 MACRS (post-986) Personal property [including 00% ordinary special (bonus) depreciation and Section 79 property] Real property held one year or less 00% ordinary Real property held more than one year Taxed at 5% maximum rate, to the extent of depreciation claimed ACRS (98 986) Personal property (including 00% ordinary Section 79 property) Nonresidential real property 00% ordinary held more than one year accelerated depreciation claimed Nonresidential real property held more than one year depreciation used Taxed at 5% maximum rate, to the extent of depreciation claimed Residential real property held more than one year Ordinary to extent of depreciation claimed over Pre-ACRS (pre-98) Personal property 00% ordinary Residential real property Ordinary to extent post-975 depreciation exceeds Nonresidential real property Ordinary to extent post-969 depreciation exceeds Low-income Housing Held less than one year 00% ordinary Held over one year Ordinary to the extent post-975 depreciation exceeds, reduced by % for each full month held over 00 Section 97 Intangibles Amortizable intangibles placed in service after 8/0/93 00% ordinary For noncorporate taxpayers, gain to the extent of depreciation claimed (other than recaptured Section 50 ordinary income) is unrecaptured Section 50 gain, taxed at 5% maximum rate. Section 80F Depreciation Limits Vehicles Placed in Service Before 0 Placed In Service Cars Trucks and Vans 0 First year (special depreciation)... $,060 $,60 First year (no special depreciation)... 3,060 3,60 Second year... 4,900 5,00 Third year...,950 3,50 Fourth year and thereafter...,775, First year (special depreciation)... $,060 $,60 First year (no special depreciation)... 3,060 3,60 Second year... 4,900 5,00 Third year...,950 3,050 Fourth year and thereafter...,775, First year (special depreciation)... $ 0,960 $,060 First year (no special depreciation)...,960 3,060 Second year... 4,800 4,900 Third year...,850,950 Fourth year and thereafter...,775, First year (special depreciation)... $ 0,960 $,60 First year (no special depreciation)...,960 3,60 Second year... 4,800 5,00 Third year...,850 3,050 Fourth year and thereafter...,775,875 Amounts must be pro-rated if less than 00% business use. COV- 0 Tax Copyright Year 0 Depreciation Thomson Quickfinder Reuters. All Handbook Rights Reserved. The Quickfinder logo and Quickfinder Handbooks are trademarks of Replacement Thomson Reuters. Page 0/03 Replacement Page 0/03

4 Replacement Page 0/03 Leased Property For federal income tax, lease arrangements are treated as either rental arrangements or sales of the property. The person who has the incidents of ownership in the property is treated as its owner for tax purposes and can claim the depreciation deductions. In general, the person with incidents of ownership is the person who bears the economic risks and rewards related to the property. Incidents of ownership include: The legal title to the property. The legal obligation to pay for the property. The responsibility to pay maintenance and operating expenses. The duty to pay any taxes on the property. The risk of loss if the property is destroyed, condemned or diminished in value through obsolescence or exhaustion. The transaction s substance, not the terms used by the parties, is the controlling factor for determining who has retained the incidents of ownership. Also, a transaction s classification for accounting purposes does not control the tax classification. Capital (or financing) lease Economic owner Legal owner Lessee Lessor Operating lease Leasing Terminology A lease under which the lessee is the economic owner of the property. For tax, this transaction is treated as a sale of the property from the lessor to the lessee. The party who bears the economic risks and rewards related to the property. The party with legal title to the property. The person making payments to use the property. The person who legally owns the property and is receiving payments from the person using it. A lease under which the lessor is the economic owner. For tax, this is treated as a rental arrangement. Usually, no single factor will determine whether an arrangement is a capital or an operating lease. Instead, many factors are considered and the lease is classified depending on what the majority of the factors indicate. Description Lessee bears economic burdens of ownership. Lessee bears risk of loss if the property is destroyed or otherwise declines in value. The lessee acquires full or partial equity in the property through lease payments. The lessor has little or no investment risk in the leased property. Factors Indicating a Capital Lease Rev. Proc , but may be applied to tax years beginning after 0. Examples Lessee is responsible for paying taxes, maintenance and operating expenses. At the end of the lease, lessee must return the property (or equivalent value) in as good a condition or value as when leased. Lessee acquires title to the property after the required number of payments. Lessee can purchase the property at a nominal sum at the end of the lease. Total lease payments due in a relatively short period of time substantially cover the total cost of acquiring the asset. The property s useful life is not significantly longer than the lease term. Lease payments substantially exceed the property s fair market value. Lessee guarantees the lessor s loan to acquire the property. If the leased property is used for business or investment, payments under an operating lease generally are deducted as rent. If the property is subject to a capital lease, the asset must be capitalized and depreciated. Each lease payment is allocated between the capitalized property and interest expense (similar to allocating mortgage payments to principal and interest). Example: Dakota, Inc. enters into a lease agreement for a new copy machine. The lease calls for 36 monthly payments of $80 each. At the end of the lease term, Dakota can purchase the copier for $00. Dakota is responsible for all maintenance, taxes and insurance on the machine during the lease term. On the date the lease was signed, the copy machine could have been purchased for $5,000. Dakota has entered into a capital lease for tax because: it can acquire the copier at the end of the lease term for a nominal sum; its lease payments are made over a relatively short time period and substantially cover the total amount (including financing costs) that would have been required to buy the copier at the time of the lease; and the lessor has little or no risk of ownership since Dakota bears all the costs of maintaining the copier. Dakota capitalizes the copy machine at $5,000 at the time of the lease, by debiting Fixed Assets and crediting Obligation Under Capital Lease (or a similarly titled liability account). The $80 monthly lease payment is allocated between an imputed interest amount (currently deductible) and principal payment on the $5,000 lease obligation. Thus, over the term of the lease, Dakota will deduct $,480 ($6,480 total payments less $5,000) of interest expense. The $5,000 capitalized amount is deducted over the copier s MACRS recovery period as depreciation expense. Maintenance or Repairs vs. Capitalized Costs Background In general, no deduction is allowed for expenditures for () new buildings or permanent improvements or betterments made to increase the value of any property or estate or () restoring property or making good the exhaustion thereof for which an allowance has been made [IRC 63(a)]. There are exceptions to this general rule in Section 63 and elsewhere. A widely applicable exception has long provided that amounts paid or incurred for incidental repairs and maintenance of property are currently deductible, not capital expenditures. The Supreme Court has recognized the highly factual nature of determining if expenditures are for capital improvements or deductible repairs. Following its lead, other courts have articulated a number of ways to distinguish between deductible repairs and capitalizable improvements. Despite the court-developed guidance and IRS regulations and rulings on the capitalization versus deduction issue [see Tax Cases/IRS Rulings Capitalization Issues (for Tax Years Beginning Before 0) on Page -4], whether a cost is an ordinary repair or should be capitalized has continued to be a source of much controversy and uncertainty. Recognizing that the case law, regulations and rulings on Section 63(a) issues were difficult to understand and apply, the IRS issued proposed regulations in 006 and 008 to clarify the rules for when to deduct or capitalize amounts paid to acquire, produce or improve tangible property. They were withdrawn before ever becoming effective. In December 0, the IRS issued a third set of proposed regulations, along with a matching set of temporary regulations. The temporary regulations are effective for tax years beginning in Temporary Regulations Effective in 0 The temporary regulations attempt to clarify and significantly expand existing standards and provide new bright-line tests for applying them. Thus, they contain numerous examples illustrating a variety of situations. They also provide new rules on the disposition of depreciable property (see Taken Out of Service on Page -6) and amend the general asset account regulations (see General Asset Accounts on Page -). The entire text of the regulations can be found at (search for TD 9564 ). 0 Tax Year Depreciation Quickfinder Handbook -3

5 N Observation: The temporary regulations are scheduled to expire on December 3, 04. The IRS has received numerous comments that parts of them are too complex and unworkable. So, they may be changed when finalized. However, the temporary regulations are currently effective as is and are thus covered as the rules applicable to 0 in the remainder of this section and in Materials and Supplies beginning on Page -7. Capital Improvements vs. Deductible Repairs What must be capitalized? Expenditures that result in any of the following with respect to a unit of property must be capitalized: [Temp. Reg..63(a)-3T(d)] ) A Betterment defined on Page -6. ) A Restoration defined on Page -6. 3) An Adaptation to a New or Different Use defined on Page -7. If used for business or the production of income, these assets may be depreciated. What can be expensed currently? Taxpayers generally may deduct amounts paid for repairs and maintenance to tangible property if the amounts paid are not otherwise required to be capitalized under Section 63(a) or any other provision of the Code or regulations. [Temp. Reg..6-4T(a)] Repairs undertaken contemporaneously with improvements that do not directly benefit or are not incurred because of the improvement, do not have to be capitalized. [Temp. Reg..63(a)-3T(f)(3)] Exception: An individual may capitalize amounts paid for repairs made to his residence if made at the same time as remodeling improvements. This rule applies only to the part of the residence not used for business. Example: A company takes a truck out of service to overhaul its chassis. During the overhaul, the truck s broken taillights are replaced and tears in the driver s seat are mended. These expenses are deductible as repairs. The costs to move an existing unit of property to a new location and reinstall it there are not capitalized unless these costs directly benefit or are incurred because of an improvement to the property. Note: The cost to move or transport a new asset must be capitalized as part of the cost of acquisition. [Temp. Reg..63(a)-T(f)()] Example : A retail company purchases and installs new cash registers in its store. The costs to buy and install the cash registers (including any shipping) must be capitalized as acquisition costs. See Transaction Costs on Page -8. Variation: Two years later the company moves the store and its cash registers to a new location. The costs to move and reinstall the cash registers are expensed currently. Routine maintenance on property other than buildings. Costs of regularly scheduled, routine maintenance performed on () a unit of property (other than a building or its structural component) or () rotable and temporary spare parts can be deducted currently. Routine maintenance includes: [Temp. Reg..63(a)-3T(g)()] ) Inspection. ) Cleaning. Tax Cases/IRS Rulings Capitalization Issues (for Tax Years Beginning Before 0) Issue Decision Authority Aircraft engine maintenance Costs of heavy maintenance visit required by FAA currently deductible because none of the tests for Rev. Rul capitalization were met. Asbestos, removing and encapsulating Costs currently deductible. The asbestos had become potentially hazardous to workers due to deterioration. Purpose of the work was to allow taxpayer to continue to use the building. Cinergy Corp, 9 AFTR d (Ct. Fed CI. 003) Asbestos, removing and encapsulating Costs capitalized because the purpose was to make essentially useless property saleable and therefore converted the property into an entirely new use. Dominion Resources, 86 AFTR d (4th Cir. 000) Cleanup costs Costs to clean up land and treat groundwater that becomes contaminated as a result of the Rev. Rul manufacturer s operations are deductible. This applies only if the environmental remediation costs restore the contaminated property to its uncontaminated condition at the time it was acquired by the manufacturer. (TAM ) Caution: See Rev. Rul , noting that the costs would be capitalized into inventory under Section 63A uniform capitalization rules if the waste was generated while producing inventory. Mold removal Costs incurred to remove mold are currently deductible because the mold removal kept the building in an ordinarily efficient operating condition. The mold was not present when the taxpayer purchased the building, and the building could be used as a skilled nursing facility both before and after the mold removal. Ltr. Rul Overhauling towboat engines Costs currently deductible because none of the three tests for capitalization were met. Court not convinced a buyer would pay $00,000 more for an engine that had just been overhauled, even though that was the overhaul s cost. Also, engines were part of a towboat with a 40-year life, so overhauling engines every 3 4 years did not increase the boat s expected life, which was 40 years. IRS could not consider the engine s life alone. Ingram Industries, TC Memo Parking lot resurfacing Costs currently deductible because they restored parking lot to its original condition. Toledo Home Federal Sav. & Loan Ass n, 9 AFTR d 09 (DC OH 96); William K. Coors, 60 TC 368 (973) Roof repairs Roof repairs The IRS announced plans to publish final regulations on the capitalization rules in 03 that are expected to apply to tax years beginning after 03, but which may be applied to tax years beginning after 0 if the taxpayer so elects. Certain sections of the temporary regulations may be revised. Underground storage tanks (USTs) storing waste Removing and replacing all of the roof-covering material were deductible repairs because the purpose of the work was to prevent leaks and to keep the roof in good condition, not to prolong its life, increase its value or make it adaptable to another use. Replacing a roof is a capital expense. When the roofing material was removed down to the building s wooden structure, a new roof drain added and a new roof reapplied (with the replacement roof expected to last 0 years), the court found that the existing roof had been replaced, so costs were capitalized. The court also found that the existing roof could not be repaired because of a design flaw. Costs of removing, cleaning and disposing of old USTs containing waste by-products and acquiring, installing and filling new tanks do not create depreciable assets. Because the USTs are intended to be sealed indefinitely, they have no remaining useful life. Caution: See Rev. Rul , noting that the costs would be capitalized into inventory under Section 63A uniform capitalization rules if the waste was generated while producing inventory. Oberman Manufacturing Co., 47 TC 47 (967); Campbell, Nevia, TC Summ. Op Stark, Dennis, TC Memo 999- Rev. Rul See Maintenance or Repairs vs. Capitalized Costs beginning on Page -3 for explanation of the rules that apply to tax years beginning in 0 and later. if the taxpayer so elects -4 0 Tax Year Depreciation Quickfinder Handbook Replacement Page 0/03

6 MACRS Tab Topics MACRS General Rules... Page - Depreciation Methods... Page - Alternative Depreciation System (ADS)... Page - Assigning the Recovery Period... Page - Conventions... Page -5 Placed In and Taken Out of Service... Page -6 Alternative Minimum Tax (AMT) Depreciation... Page -6 Adjusted Current Earnings (ACE) C Corporations... Page -7 Farm Property... Page -7 Short Tax Years... Page -8 Special (Bonus) Depreciation Allowance... Page -0 Qualified Disaster Assistance Property... Page - General Asset Accounts... Page - Changes in an Asset s Use... Page -3 MACRS General Rules The Modified Accelerated Cost Recovery System (MACRS) is used to depreciate most business, rental and investment property placed in service after 986. Under MACRS, compute depreciation by: [IRC 68(a)] ) Applying an allowable depreciation method, ) Assigning the asset the proper recovery period and 3) Using the appropriate convention (assumption about when property is placed in and taken out of service). MACRS consists of two depreciation systems, the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). The GDS is the method used for regular tax, unless the ADS is used. The ADS can be elected for any asset. However, its use is mandatory in certain situations. See Alternative Depreciation System (ADS) on Page -. Note: For alternative minimum tax (AMT), depreciation is computed under different rules, often resulting in an adjustment to AMT income. See Alternative Minimum Tax (AMT) Depreciation on Page -6. Assets are classified under MACRS. The classification generally determines the depreciation method, convention and recovery period. See Property Classification on Page -3. Depreciation Methods Unless the alternative depreciation system (ADS) is required or elected, the general depreciation system (GDS) applies. General Depreciation System (GDS) Three depreciation methods are available under the general depreciation system. For most property, other than nonresidential real property and residential rental property, the default (no election made) is the 00% declining balance method over the GDS recovery period. Alternatively, taxpayers can elect either the: ) 50% declining balance method over the GDS recovery period or ) Straight-line method over the GDS recovery period. See MACRS Depreciation Methods Available for Regular Tax below for details on the methods for specific assets. Elective Depreciation Methods The election to use a depreciation method other than the default method is made the year the property is placed in service. Once an election is made to use a method for an item in a property class, the same method applies to all property in that class placed in service in the year of the election. Property Three-year, five-year, seven-year and 0-year property classes (except farm property). 3 Farm property (except real property). 3 5-year and 0-year property. Nonresidential real property. Residential rental property. Qualified leasehold improvement property. 4 Qualified restaurant property. 4 Qualified retail improvement property. 4 Trees or vines bearing fruit or nuts year (water utility) property. MACRS Depreciation Methods Available for Regular Tax No Election Made 00% declining balance over GDS recovery period. 50% declining balance over GDS recovery period. Straight-line over GDS recovery period. General Depreciation System (GDS) Elective 50% Declining Balance Method 50% declining balance over GDS recovery period. N/A Elective MACRS Straight-line over GDS recovery period. Straight-line over GDS recovery period. Alternative Depreciation System (ADS) Straight-line over ADS recovery period. Straight-line over ADS recovery period. N/A N/A Straight-line over ADS recovery period. For property placed in service before 999, elective 50% declining balance method used the ADS recovery periods. See ADS Recovery Periods on Page -. 3 New farm equipment placed in service in 009 was five-year property. Five-year treatment excluded grain bins, cotton ginning assets, fences or other land improvements [IRC 68(e)(3)]. New farm equipment placed in service in 0 is seven-year property. 4 Qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property have a 5-year recovery period if placed in service before 0. Expired Provision Alert: The 5-year recovery period for these property types expired for property placed in service after 0. It s possible Congress will extend it to 0, but had not done so at the time of this publication. See Expired Tax Provisions on Page 3- for more information. Replacement Page 0/03 0 Tax Year Depreciation Quickfinder Handbook -

7 Exception: The election to use a different depreciation method is made on a property-by-property basis for nonresidential real and residential rental property. Method Electing a Depreciation Method How to Elect 50% method Enter 50 DB under column (f) in Part III of Form 456. Enter S/L under column (f) in Part III of Form 456. ADS Complete line 0 in Part III of Form 456. If the default method is selected, 00 DB is entered under column (f) in Part III of Form 456. Advantage of Straight-Line Depreciation MACRS straight-line depreciation is useful to taxpayers desiring smaller depreciation deductions than what regular MACRS provides. For example, taxpayers may elect straight-line if they desire to increase current income in order to use a net operating loss carryover or create passive income to offset passive losses. Alternative Depreciation System (ADS) Under the alternative depreciation system, assets are depreciated straight-line over their ADS recovery period. Applicable to property placed in service before 04. When ADS Is Required The ADS method can be elected for any asset, but is mandatory in the following situations: [IRC 68(b)(), 68(g)() and 80F(b)()] ) Listed property with 50% or less qualified business use. ) Tangible property used predominantly outside the United States during the year. 3) Tax-exempt use property. 4) Property financed by tax-exempt bonds. 5) Property used predominantly in a farming business if it is placed in service in a year an election not to apply the uniform capitalization rules to certain farming costs is in effect (see Farm Property on Page -7). 6) Property imported from a foreign country for which an Executive Order is in effect because the country maintains trade restrictions or engages in other discriminatory acts. ADS Recovery Periods The recovery periods for most property generally are longer under ADS than they are under GDS. ADS Recovery Periods Property Recovery Period Rent-to-own property 4 years Automobiles and light duty trucks 5 years Computers and peripheral equipment 5 years High technology telephone station equipment installed on customer premises 5 years High technology medical equipment 5 years New York Liberty Zone leasehold improvement property 9 years Personal property with no class life years Natural gas gathering lines 4 years Single purpose agricultural and horticultural structures 5 years Any tree or vine bearing fruit or nuts 0 years Electric transmission property used in the transmission at 69 or more kilovolts of electricity 30 years Natural gas distribution lines years Qualified leasehold improvement property, qualified restaurant property or qualified retail improvement property Nonresidential real property Residential rental property Section 45 real property not listed in Revenue Procedure Railroad grading and tunnel bore 40 years 3 40 years 40 years 40 years 50 years This list is not all-inclusive. The ADS recovery periods for property not listed above can be found in the tables in Revenue Procedure (reproduced at Tab ). Applicable to property placed in service after April, 005, the original use of which began after that date (but not applicable if under a binding contract or if construction began on a self-constructed asset before April, 005). 3 Expired Provision Alert: The 5-year GDS and 39-year ADS recovery periods for these property types expired for property placed in service after 0. It s possible Congress will extend them to 0, but had not done so at the time of this publication. See Expired Tax Provisions on Page 3- for more information. Tax-exempt use property subject to a lease. The ADS recovery period cannot be less than 5 percent of the lease term for any property leased under a leasing arrangement to a tax-exempt organization, governmental unit or foreign person or entity (other than a partnership). Assigning the Recovery Period The recovery period is the number of years over which an asset s basis is recovered under MACRS. Different recovery periods are often assigned under GDS and ADS. GDS Recovery Periods The GDS applies unless the taxpayer elects, or is required, to use the alternative depreciation system. Certain property is classified under Section 68. That classification determines the GDS recovery period. See Property Classification on Page -3. Revenue Procedure Recovery Periods Revenue Procedure (reproduced at Tab ) lists the recovery periods for assets not contained in Property Classification on Page -3. It also lists the recovery periods for assets used in specific activities. Revenue Procedure provides three lives for the assets listed: Class life. This is the class life that was applicable for the property as of January, 986, under former Section 67(m) and the Class Life Asset Depreciation Range (CLADR) System, which was used before 98. The class life is used to determine the recovery period for assets not specifically listed in Section 68 or in Revenue Procedure However, for the assets listed in the Revenue Procedure, the recovery periods are specified, so class life is not needed for determining the recovery period. GDS Recovery Period. ADS Recovery Period. - 0 Tax Year Depreciation Quickfinder Handbook Replacement Page 0/03

8 Classification 3-year property 5-year property Motorsports entertainment complex placed in service after October, 004 and before year property 0-year property 5-year property 0-year property 5-year property 9 Residential rental property Nonresidential real property 0 Property Classification Examples Tractor units for over-the-road use. Any race horse, regardless of age when placed in service. Any horse (other than a race horse) over years old when placed in service. Qualified rent-to-own property. 3 Automobiles, taxis, buses and trucks. Computers and peripheral equipment. Office machinery (such as typewriters, calculators and copiers). Property used in research and experimentation. Breeding cattle and dairy cattle. Appliances, carpets, furniture, etc., used in a residential rental real estate activity. Certain geothermal, solar and wind energy property. Office furniture and fixtures (such as desks, files and safes). Agricultural machinery and equipment. 5 Property that does not have a class life and has not been designated by law as being in any other class. Any natural gas gathering line placed in service after April, 005. Assets used to convert corn to ethanol. (IRS Notice ) Vessels, barges, tugs and similar water transportation equipment. Single purpose agricultural or horticultural structure (see Tab 7). Any tree or vine bearing fruits or nuts. 6 Qualified smart electric meters and qualified smart electric grid systems placed in service after October 3, Certain improvements made directly to land or added to it (such as shrubbery, fences, roads and bridges). Retail motor fuels outlet (see Tab 7), such as a convenience store. 04 Any municipal wastewater treatment plant. Qualified leasehold improvement property placed in service before 0 (see Tab 7). 6, 8 Qualified restaurant property placed in service before 0 (see Tab 7). 6, 8 Qualified retail improvement property placed in service before 0 (see Tab 7). 6, 8 Initial clearing and grading land improvements for gas utility property placed in service after October, 004. Electric transmission property (that is Section 45 property) used in the transmission at 69 or more kilovolts of electricity placed in service after April, 005. Any natural gas distribution line placed in service after April, 005. Farm buildings (other than single purpose agricultural or horticultural structures). Municipal sewers not classified as 5-year property. Initial clearing and grading land improvements for electric utility transmission and distribution plants placed in service after October, 004. Property that is an integral part of the gathering, treatment or commercial distribution of water, and that, without regard to this provision, would be 0-year property. Municipal sewers placed in service after June, 996, other than property placed in service under a binding contract in effect at all times since June 9, 996. Any building or structure, such as a rental home (including a mobile home), if 80% or more of its gross rental income for the tax year is from dwelling units (see Tab 7). Section 50 property, such as an office building, store or warehouse that is neither residential rental property nor property with a class life of less than 7.5 years (see Tab 7). Elective methods may be available. See MACRS Depreciation Methods Available for Regular Tax on Page -. GDS Depreciation Method 00% 4 Declining balance 00% 4 Declining balance 00% 4 Declining balance 00% 4 Declining balance 50% Declining balance 50% Declining balance GDS Recovery Period Convention 3 years Half-year or mid-quarter 5 years Half-year or mid-quarter 7 years Half-year or mid-quarter 0 years Half-year or mid-quarter 5 years Half-year or mid-quarter 0 years Half-year or mid-quarter Straight-line 5 years Half-year or mid-quarter Straight-line 7.5 years Mid-month Straight-line 39 years Mid-month Effective for race horses placed in service after December 3, 008 and before January, 04. Outside of that date range, only race horses more than two years old when placed in service are 3-year property. [IRC 68(e)(3)(A)] 3 Five years for qualified rent-to-own property placed in service before August 6, If used in farming, must use 50% instead of 00% declining balance. 5 New farm equipment placed in service in 009 was 5-year property. Five-year treatment excluded grain bins, cotton ginning assets, fences or other land improvements. [IRC 68(e)(3)(B)(vii)] 6 Must use straight-line method. [IRC 68(b)(3)(E) and (e)(3)(d)(ii)] 7 Must use 50% declining balance method. [IRC 68(b)()(C)] 8 Expired Provision Alert: The 5-year recovery period for these property types expired for property placed in service after 0. It s possible Congress will extend it to 0, but had not done so at the time of this publication. See Expired Tax Provisions on page 3- for more information. 9 0 years for property placed in service before June 3, 996, or under a binding contract in effect before June 0, years for property placed in service before May 3, 993. Replacement Page 0/03 0 Tax Year Depreciation Quickfinder Handbook -3

9 Indian Reservation Property The recovery periods for qualified property placed in service on an Indian reservation after 993 and before 0 are shorter than normal for some property classes. To be eligible for the shorter recovery periods, the property must be used predominantly in the active conduct of a trade or business or a rental real estate activity within an Indian reservation. [IRC 68(j)] Replacement Page 0/03 Recovery Periods for Qualified Indian Reservation Property Property Class Three-year property Five-year property Seven-year property 0-year property 5-year property 0-year property Nonresidential real property Recovery Period Two years Three years Four years Six years Nine years years years Expired Provision Alert: The shorter recovery periods for these property types expired for property placed in service after 0. It s possible Congress will extend them to 0, but had not done so at the time of this publication. See Expired Tax Provisions on Page 3- for more information. Conventions Half-Year Convention Under the half-year convention, all property placed in service or disposed of during a tax year is treated as placed in service or disposed of on the midpoint of that tax year [IRC 68(d)(4)]. Thus, half of a full year s depreciation is taken both in the year the property is placed in service and in the year of disposition. The half-year convention applies to all property except: ) Residential rental and nonresidential real property and ) Property subject to the mid-quarter convention (discussed below). 55,000 Mid-Quarter Convention If more than 40% of the basis of property is placed in service in the last three months of the year, the mid-quarter convention applies [IRC 68(d)(3)]. Then, all property placed in service or disposed of during any quarter of a tax year is treated as placed in service, or disposed of, at the midpoint of that quarter. Excluded items. To determine if the mid-quarter convention applies, the following items are not counted: 3,000 ) Property depreciated under a method other than MACRS, ) Residential rental property, 3) Nonresidential real property, 4) Property placed in service and disposed of in the same tax year and 5) Property expensed under Section ,000 55, ,000 Effect of mid-quarter convention. If the mid-quarter convention applies, property placed in service in the first half of the year receives more than a half-year s worth of depreciation in the year placed in service while property placed in service in the last half of the year receives less than a half-year s worth of depreciation (for example, property placed in service in the fourth quarter receives only.5% of a full year s worth of depreciation). Quarter Placed in Service Mid-Quarter Percentages % of Full Year Depreciation in Year Placed in Service % of Full Year Depreciation in Disposition Year First 87.5%.5% Second 6.5% 37.5% Third 37.5% 6.5% Fourth.5% 87.5% Note: The IRS has issued tables providing the MACRS depreciation percentages when the mid-quarter convention applies to an asset. See Tab 4. The mid-quarter convention is built into the tables for the placed in service year and every full year the asset is in service thereafter. But, in the year of disposition, the depreciation amount computed using the optional MACRS tables must be adjusted by multiplying the full year amount by the applicable percentage in the table above. See Convention in Year of Disposition below. Using the Section 79 deduction to avoid the mid-quarter convention. The Section 79 election can be used to avoid the mid-quarter convention by expensing property placed in service in the last quarter of the tax year. On the other hand, claiming a Section 79 deduction for assets placed in service during the first three quarters increases fourth-quarter additions relative to the total and may result in the application of the mid-quarter convention for any assets not expensed under Section 79. See the Section 79 Annual Limits table on Page 5-. Example: Norm is a calendar-year sole proprietor. He placed the following assets in service during 0: 477,000 78,000 Date Description Cost January... 78,000 Polishing machine... $ 30,000 December... Grinding machine ,000 6,000 Total... 4, ,000 $ 9,000 Norm claims a Section 79 deduction of $6,000 for the grinding machine and $77,000 for the polishing machine for a total of $39,000 in 0. 4,000 For the 40% test (to determine if the mid-quarter convention applies) Norm counts only the $53,000 ($30,000 $77,000 expensed under IRC 79) remaining basis in the polishing machine placed in service in January. The amounts expensed under Section 79 are not considered. Thus, the mid-quarter convention does not apply to Norm in 0 since 00% of the basis of property considered for the test was placed in service in the first quarter. The $53,000 remaining basis in the polishing machine is depreciated using the half-year convention. Variation: Now assume that Norm claims a $30,000 Section 79 deduction for the polishing machine and a $9,000 Section 79 expense for the grinding machine. For the 40% test, he has placed the $53,000 ($6,000 $9,000) remaining basis of the grinding machine in service in December. Since that is 00% of the basis counted for the 40% test, 00% of Norm s assets were placed in service in the last three months of the year and the mid-quarter convention applies to the grinding machine s remaining basis. 3,000 Convention in Year of Disposition 78,000 If property subject to the half-year convention is sold, the half-year convention also applies in the year of the sale. Thus, half a year s depreciation is claimed in the year of disposition. 55,000 If the mid-quarter convention applied to property in the year placed in service, the property is treated as disposed of at the midpoint of the quarter in which the disposition occurred. See Mid-Quarter Percentages above for the percentage of a full year s depreciation allowed in the year of disposition. Example: Barry purchased a truck for $7,500 in 009. The mid-quarter convention applied to all property placed in service that year. In April 0 (that is, during the second quarter), Barry sells the truck. Thus, for 0, Barry takes 37.5% (mid-quarter percentage for the second quarter) of the full 0 depreciation amount for the truck. 0 Tax Year Depreciation Quickfinder Handbook -5

10 Pass-Through Entities As a general rule, the 40% test is applied at the partnership or S corporation level and not at the individual owner level. However, if a pass-through entity is formed or used for the principal purpose of avoiding the mid-quarter convention or causing the mid-quarter convention to apply, anti-abuse rules apply. [Reg..68(d)-(b)(6)] Mid-Month Convention The mid-month convention applies to residential rental and nonresidential real property. Property placed in service or disposed of during any month is considered placed in service or disposed of on the midpoint of that month. So, for the month the asset is placed in service and disposed of, a half-month of depreciation is taken. Placed In and Taken Out of Service Date Placed In Service Depreciation begins when property is placed in service, which is when it is ready and available for use in a trade or business or forprofit activity, regardless of when the asset was purchased [Reg..67(a)-(e)]. An asset is not considered placed in service on the date of acquisition if it needs extensive repairs before use. However, even if property is not currently being used, it is considered placed in service when it is ready and available for its specific use. Example: Suzie purchased a printing press for her business in late October 0. The press was delivered in December 0, but was not installed or ready for operation until early January 03. The press is considered placed in service in 03. Variation: If the press was ready for use when it was delivered in late 0, it would have been considered placed in service in 0 even if Suzie did not start using the press until 03. Real property. Generally, a building is placed in service and thus depreciable when it is ready and available for use (for example, when the certificate of occupancy is issued). Building completed in sections. Depreciation may be claimed on each section as it is completed and placed in service. Commercial building with machinery and equipment. It does not matter that items of machinery and equipment are not yet in the building or placed in service, except when: The building itself is essentially an item of machinery or equipment or Use of the building is so closely related to use of the machinery or equipment that it could clearly be expected to be replaced or retired when the machinery or equipment it initially housed is replaced or retired. Then the readiness and availability of the machinery and equipment the building is intended to house must be considered in determining the readiness and availability of the building. Farm property. Property is placed in service when it is ready and available for a specific use in the farming activity. Fruit or nut trees and vines acquired during a two-year or greater preproductive period. These are considered placed in service when the trees and vines reach the income-producing state (bearing fruit, nuts or grapes in a sufficient quantity to commercially warrant harvesting). See Plants With a Preproductive Period of More Than Two Years on Page -8. Immature livestock acquired for draft, dairy or breeding purposes. Depreciation begins when the livestock reaches the age of maturity (can be worked, milked or bred). Taken Out of Service Non-MACRS assets. Depreciation ceases when an asset is retired from service [Reg..67(a)-0(b)]. Retirement from service includes abandonment, sale or other disposition. Temporary periods of idleness during the service life of an asset do not end the depreciation period. Depreciation continues until the asset is sold, disposed of or permanently retired. MACRS assets. Temporary Regulation Section.68(i)-8T covers dispositions of MACRS property in tax years beginning on or after January, 0. This regulation provides that a disposition occurs when ownership of the asset is transferred or when the asset is permanently withdrawn from use either in the taxpayer s trade or business or in the production of income. A disposition includes: [Temp. Reg..68(i)-8T(b)()] ) Sale or exchange. ) Retirement. 3) Physical abandonment or destruction of an asset. 4) Transfer of an asset to a supplies, scrap or similar account. 5) Retirements of structural components of buildings. Example: On July, 009, Dee purchased and placed in service a $0,000,000 office building (39-year recovery period). The building s structural components were not separately stated at the time of purchase. As of January, 0, the building s accumulated tax depreciation was $,6,000. On June 30, 0, Dee replaced one of the building s elevators. Using a reasonable and consistent method, Dee allocates $50,000 of the building s cost to the retired elevator. So, accumulated depreciation for the retired elevator as of December 3, 0, is $9,458 ($,6,000 $50,000 / $0,000,000). 0 depreciation (using the optional MACRS table for 39-year depreciation) is $,93 ($50, /). Dee s 0 loss for the retired elevator is determined as follows: Allocated cost... $ 50,000 Less: Depreciation for 0... $,93 04, but may be applied to tax years beginning after 0. Depreciation from ,458 <,38 > Recognized loss... $ 38,69 Note: The loss is subject to Section 3. See Disposing of Business Assets (Section 3 Transactions) on Page 8-. If an asset is physically abandoned, loss must be recognized equal to the adjusted depreciable basis of the asset at the time of the abandonment. However, if the abandoned asset is subject to nonrecourse debt, gain or loss is calculated as if the asset was sold. [Temp. Reg..68(i)-8T(d)()] If an asset is disposed of other than by sale, exchange, involuntary conversion, physical abandonment or conversion to personal use (for example, the asset is transferred to a supplies or scrap account), gain is not recognized. Loss is recognized equal to the excess of the asset s adjusted basis at the time of the disposition (considering the applicable convention) over the asset s FMV. [Temp. Reg..68(i)-8T(d)(3)] In and Out of Service in the Same Year No depreciation is allowed for property placed in service and disposed of during the same tax year. Special rules apply to property acquired in a like-kind exchange and property acquired as part of an involuntary conversion. See Tab 9. Alternative Minimum Tax (AMT) Depreciation For alternative minimum tax (AMT), taxpayers generally must compute depreciation at slower rates than for regular tax purposes. However, for property placed in service after 998, the same recovery period is used for AMT and regular tax [IRC 56(a)()]. (Before that date, a longer recovery period was also generally required for AMT.) -6 0 Tax Year Depreciation Quickfinder Handbook Replacement Page 0/03

11 Allocation method. Calculate depreciation for each later tax year by allocating to that year the depreciation attributable to the parts of the recovery years that fall within that year. For each recovery year included, multiply the depreciation attributable to that recovery year by a fraction. The fraction s numerator is the number of months (including parts of a month) that are included in both the tax year and the recovery year. The denominator is. The allowable depreciation for the tax year is the sum of the depreciation figured for each recovery year. Example #: Mary Jones forms a proprietorship that has a short tax year beginning March 5 and ending December 3. She is treated as having a 0-month tax year and, under the half-year convention, calculates a $67 ($,000 40% 5 ) depreciation allowance for year on a $,000 asset with a five-year life. If Mary uses the simplified method for computing depreciation in the following years, her depreciation in years and 3 will be as follows: Year Depreciation Allowance... ($,000 $67) 40% = $ ($,000 $67 $333) 40% = $00 Example #: Assume the same facts as in Example #, except that the allocation method is used to compute the depreciation in years after the short year. For the second year, a two-part calculation is required. Seven months of depreciation is calculated using the method applicable to the first short-year calculation, and five months of depreciation is computed using the adjusted basis of $600 ($,000 original cost less $400 depreciation allowance claimed in the first months). The following table shows the calculations for the first three years under this method. Year Depreciation Allowance... [40% $,000 (5 )] = $67... [40% $,000 (7 )] + [40% $600 (5 )] = $ [40% $600 (7 )] + [40% $360 (5 )] = $00 Straight-Line Method To avoid complex calculations in figuring depreciation for years after a short tax year, the taxpayer may elect to depreciate all assets placed in service during the short year under the method. Under, depreciation after the short tax year is determined by dividing the number one by the years remaining in the recovery period at the beginning of a year, then multiplying the result by the unrecovered adjusted basis. When figuring the number of years remaining, consider the convention used in the year property is placed in service. If the number of years remaining is less than one, the depreciation rate for that tax year is.0 (00%). Special (Bonus) Depreciation Allowance Expired Provision Alert: For assets acquired and placed in service between September 9, 00 December 3, 0, the special depreciation allowance was 00% (rather than 50%). It s possible that Congress will extend the 00% rate to 0, but had not done so at the time of this publication. See Expired Tax Provisions on Page 3-. A special (bonus) depreciation allowance can be claimed in the year qualified property is placed in service, even if it is a short year. Short year depreciation computations are then applied to the remaining adjusted basis. To be eligible for the special (bonus) depreciation allowance in 0, an asset must pass four tests: [IRC 68(k)()(A)] ) It must be qualified property. See Qualified Property in the next column. ) It must be new (see Original Use on Page -). 3) It must be acquired by purchase (a) after 007 with no written binding contract to acquire in effect at any time before 008 or (b) pursuant to a written binding contract entered into during For self-constructed property this test is met if the taxpayer begins manufacturing, constructing or producing the property during ) It must be placed in service before 03. Exception: See Long Production Period Property and Aircraft on Page - for the extended placed in service date for certain assets. The special depreciation allowance for 0 generally equals 50% of the property s basis. [IRC 68(k)()(A)] Special Depreciation Percentages Date Qualifying Property Placed in Service Special Depreciation Allowance Percentage Before 008 0% //08 9/8/0 50% 9/9/0 /3/, % 0 50% After % 0% Must be acquired and placed in service during this period to qualify for 00% special depreciation. For this test, property is acquired when the taxpayer pays or incurs the cost of the property. (Rev. Proc. 0-6) Certain long production period property and aircraft qualify for 00% special depreciation allowance if placed in service 9/9/0 /3/. 3 Certain long production period property and aircraft qualify for 50% special depreciation allowance if placed in service in 03. Computing the Deduction Determine the special (bonus) depreciation allowance without any pro-ration based on when the property was placed in service. Property placed in service on the last day of the tax year is eligible for the full special (bonus) depreciation amount. The special (bonus) depreciation allowance is an additional deduction computed after any Section 79 deduction (if applicable) and before regular MACRS depreciation is calculated. Qualified Property To qualify for the special (bonus) depreciation allowance, an asset must be one of the following: [IRC 68(k)()] ) MACRS asset with a recovery period of 0 years or less, ) Depreciable computer software other than software amortizable under Section 97 (for example, off-the-shelf software), 3) Water utility property defined in Section 68(e)(5) or 4) Qualified leasehold improvement property (see Qualified leasehold improvement property below). Qualified property does not include: ) Property placed in service and disposed of in the same tax year. ) Property converted from business use to personal use in the same tax year it is acquired. [Reg..68(k)-(f)(6)] 3) Property that must be depreciated using the Alternative Depreciation System (ADS). This includes listed property used 50% or less for business. 4) Property for which taxpayer elected not to claim any special depreciation allowance. Qualified leasehold improvement property. A leasehold improvement qualifies for special depreciation if it meets four tests: [IRC 68(k)(3)] ) The improvement is to an interior portion of a building. ) The building is nonresidential real property. 3) The improvement was made pursuant to a lease by the lessee, sub-lessee or the lessor (landlord) to property to be occupied exclusively by the lessee or sub-lessee. 4) The improvement is placed in service more than three years after the date the building was first placed in service Tax Year Depreciation Quickfinder Handbook Replacement Page 0/03

12 The following improvements are not qualified leasehold improvement property: ) The enlargement of the building, ) An elevator or escalator, 3) Any structural component benefiting a common area and 4) The internal structural framework of the building. U Caution: Leases between related parties do not qualify. Related parties include an individual and his or her spouse, children, grandchildren, parents, grandparents and siblings. They also include an individual and certain entities (for example, corporations) if the individual owns (directly or indirectly) 80% or more of the entity s value. N Observation: According to Revenue Procedure 0-6, qualified restaurant property and qualified retail improvement property (neither of which is eligible for bonus depreciation on its own) that also fall within the definition of qualified leasehold improvement property are eligible for bonus depreciation. Original Use To qualify for the special (bonus) depreciation allowance, the asset must generally be new, rather than pre-owned (that is, original use must commence with the taxpayer) [IRC 68(k)(); Reg..68(k)-(b)(3)]. However: New property acquired after December 3, 007 for personal use and subsequently converted to business use meets the original use requirement. Capital expenditures to recondition or rebuild acquired or owned property satisfy the original use requirement. Assets that are reconditioned or rebuilt before the taxpayer buys them generally don t meet the original use test, but property containing used parts is not treated as reconditioned or rebuilt if the cost of the used parts is 0% or less of the property s total cost. Assets placed in service after December 3, 007 by a person and then sold to the taxpayer for leaseback to that person within three months after being placed in service will be treated as a new asset placed in service by the taxpayer on a date not earlier than the date it is used first by the lessee under the leaseback arrangement. Example: During 0, Bobcat Company buys a used machine for $0,000 and spends $5,000 to recondition it. The $0,000 purchase price is ineligible for the special (bonus) depreciation allowance. The $5,000 additional cost to recondition the machine is eligible for the special (bonus) depreciation allowance, assuming all other requirements are also met. Long Production Period Property and Aircraft The special (bonus) depreciation allowance is available for long production period property and noncommercial aircraft placed in service before 04. Long production period property. The property must be () certain transportation property or () certain self-produced MACRS property with a recovery period of 0 years or longer or MACRS property with a recovery period of 0 years or longer that is acquired for resale. The asset must have an estimated production period of more than one year and a cost of more than $ million. [IRC 68(k)()(B)] Noncommercial aircraft. The aircraft must () be originally used by the taxpayer, () not be transportation property other than for agricultural or firefighting purposes, (3) at the time of contract for purchase, have a nonrefundable deposit of 0% of the cost (or $00,000, if less) and (4) have an estimated production period exceeding four months and cost more than $00,000. [IRC 68(k)()(C)] Replacement Page 0/03 04 Assets placed in service in 0. Generally, assets acquired and placed in service from September 9, 00 December 3, 0 qualified for a 00% special depreciation allowance. However, long production period property and noncommercial aircraft can be placed in service in 0 and still qualify for the 00% allowance. The adjusted basis attributable to manufacture, construction or production before 03 qualifies for the 00% allowance. [IRC 68(k)(5); Rev. Proc. 0-6, Sec. 3.03()] qualifies Long-production period property and noncommercial aircraft that otherwise qualify for special depreciation and that are placed in service in 03 qualify for 50% special depreciation to the extent of adjusted basis attributable to manufacture, construction or production before 03. [IRC 68(k)()(B)(ii)] is 04 Electing Out of the Special (Bonus) Depreciation Allowance A taxpayer can elect not to claim special depreciation for any class of property for any tax year [IRC 68(k)()(D); Reg..68(k)-(e)]. The election to not claim special depreciation must be made for all additions within an entire class placed in service for the tax year. The election out of special depreciation is made by attaching a statement similar to that below to the tax return for the year it is to be effective. Generally, it must be made by the due date, including extensions, of the tax return for the tax year in which the qualified property is placed in service. Election Out of Special Depreciation Taxpayer elects under Internal Revenue Code Section 68(k)()(D)(iii) to not claim the additional first-year bonus depreciation deduction (the special depreciation allowance) for the following classes of property placed in service during the tax year ended [year-end]: [list property classes for which election is made]. Foregoing Special (Bonus) Depreciation Allowance to Claim Additional Credits Corporations may forego the special (bonus) depreciation allowance and instead elect to claim additional research or minimum tax credits. [IRC 68(k)(4)] A corporation making the election foregoes the special (bonus) depreciation deductions and instead increases the limit on the use of research credits or minimum tax credits. The increases in the allowable credits are treated as refundable. The depreciation for qualified property is calculated for both regular tax and AMT purposes using the straight-line method in place of the method that would (Round Two) or 0 (Round 05 Three) otherwise be used., and This provision applies to years ending, and property placed in service, after March 3, 008 and before 00 (0 for certain long-lived assets). The election to forego the special depreciation allowance and instead increase the limit on certain credits is also available for assets placed in service in 0 and 0 (0 03 for long-production-period property and certain aircraft) [IRC 68(k) (4)(D)]. The election can be made for Round Two property, which is property eligible for the special depreciation allowance solely because it meets the requirements under the extension of the special depreciation allowance deduction for certain property placed in service after 00. However, corporations that have already made this election for an earlier year can elect to not apply the election to Round Two property. Also, for Round Two property, the limit on unused research credits cannot be increased by making this election. See Revenue Procedures , and for guidance on making the election. or Round or Round Three Three 0 Tax Year Depreciation Quickfinder Handbook -

13 January 3, 03 and second generation biofuel plant property placed in service after January, 03 and before January, 04 Qualified Recycling and Cellulosic Biofuel Plant Property, A 50% special (bonus) depreciation allowance applies to certain reuse and recycling property placed in service after August 3, 008 [IRC 68(m)] and cellulosic biofuel plant property placed in service after October 3, 008 and before 03. [IRC 68(l)] Note: These provisions are separate from the special (bonus) depreciation allowance under Section 68(k). Property qualifying under Section 68(k) is not eligible for the special depreciation allowed under Sections 68(l) and 68(m). Qualified reuse and recycling property is any machinery and equipment (including software to operate the equipment but not buildings or real estate) which is used exclusively to collect, distribute or recycle qualified reuse and recyclable materials such as: Scrap plastic, glass, textiles, rubber or packaging. Recovered fiber. Scrap ferrous and nonferrous metals or electronic scrap (such as cathode ray tubes, flat panel screens, similar video display devices and central processing units). Qualified cellulosic biofuel plant property is property used to make cellulosic biofuel (any liquid fuel), including ethanol from cellulose, in the manner prescribed in Section 68(l). Qualified Disaster Assistance Property An additional 50% special (bonus) depreciation allowance is available for qualified disaster assistance property placed in service after 007 in federally declared disaster areas for disasters declared after 007 and occurring before 00. [IRC 68(n)] Qualified disaster assistance property is property used in an active trade or business that is: ) MACRS property with a recovery period of 0 years or less, ) Computer software, 3) Water utility property, 4) Qualified leasehold improvement property, 5) Nonresidential real property or 6) Residential rental property. Qualified disaster assistance property must also meet the following requirements: ) Substantially all of the property s use must be in a federally declared disaster area. ) The property must replace or rehabilitate property that was damaged or destroyed. 3) Its first use in the disaster area must begin with the taxpayer. 4) It must be acquired by the taxpayer by purchase on or after the disaster date, but only if no written binding contract for the acquisition was in effect before that date. 5) It must be placed in service by the taxpayer on or before the last day of the third calendar year following the disaster date (fourth calendar year in the case of nonresidential real property and residential rental property). General Asset Accounts A taxpayer can elect to group depreciable assets into one or more general asset accounts (GAAs) if the assets have the following attributes in common. [IRC 68(i)(4); Temp. Reg..68(i)-T(c)()] Depreciation method, Recovery period, Convention (for example, half-year convention) and Tax year in which they were placed in service. Second generation biofuel is any liquid fuel derived by or from qualified feed stocks. [IRC 40(b)(6)(E)] The following rules also apply for establishing a GAA: Property subject to the mid-quarter convention can only be grouped into a GAA with property placed in service in the same quarter. Property subject to the mid-month convention can only be grouped into a GAA with property placed in service in the same month. Passenger automobiles subject to the limits on passenger automobile depreciation must be grouped into a separate GAA. Property not eligible for the special (bonus) depreciation allowance or property for which the taxpayer elected out of the special (bonus) depreciation allowance must be grouped into a separate GAA. Property eligible for the special (bonus) depreciation allowance may only be grouped into a GAA with property where the same percentage applies. Listed property other than passenger autos must be grouped into a separate GAA. Calculating Depreciation for a GAA Each GAA is treated as a single asset and depreciated using the applicable depreciation method, recovery period and convention for the assets in the GAA. For each GAA, the depreciation allowance must be maintained in a separate depreciation reserve account. Example: Make & Sell, a calendar-year corporation, set up a GAA for 0 machines. The machines cost a total of $00,000 and were placed in service in June 0. One of the machines cost $8,000 and the rest cost a total of $8,000. This GAA is depreciated under the 00% declining balance method with a five-year recovery period and a half-year convention. Make & Sell did not claim the Section 79 deduction or special (bonus) depreciation on the machines. The depreciation allowance for 0 is $0,000 [($00,000 40%) ]. As of January, 03, the accumulated depreciation on the GAA is $0,000. Passenger automobiles. If a GAA consists of automobiles subject to limits on the annual depreciation amount (see Tab 6), depreciation for the GAA is computed by multiplying the amount determined using these limits by the number of automobiles originally included in the account, reduced by the total number of automobiles removed from the GAA. Special (bonus) depreciation. An asset in a general asset account is eligible for special (bonus) depreciation if all the assets in that general asset account are eligible. The special (bonus) depreciation for the general asset account for the placed-in-service year is determined by multiplying the unadjusted depreciable basis of the general asset account by the additional first year depreciation deduction percentage applicable to the assets in the account (such as 50% or 00%). The remaining adjusted depreciable basis of the general asset account is then depreciated using the applicable depreciation method, recovery period and convention for the assets in the account. [Temp. Reg..68(i)-T(d)()] Dispositions from a GAA The disposition of any asset from a GAA is treated as if the asset has an adjusted basis of zero for purposes of reporting gain or loss [Temp. Reg..68-T(e)]. Thus, all sale proceeds are treated as income. Note: A disposition of an asset inside a GAA includes a sale, exchange, retirement, physical abandonment, destruction of an asset or a transfer to a supplies, scrap or similar account. It also includes the retirement of a structural component of a building. [Temp. Reg..68(i)-T(e)()] The income is ordinary income from depreciation recapture until the total ordinary income recognized on all sales from that GAA - 0 Tax Year Depreciation Quickfinder Handbook Replacement Page 0/03

14 Property Class 3-year, 5-year, 7-year and 0- year (Nonfarm) 3-year, 5-year, 7-year and 0- year (Farm Property) 3, 4 5-year 5 0-year Residential Rental Real Property Nonresidential Real Property 5 3-year, 5-year, 7-year and 0- year (Nonfarm) 3-year, 5-year, 7-year and 0- year (Farm Property placed in service after 988) 3,4 5-year 0-year Residential Rental Real Property Nonresidential Real Property (placed in service after 986 and before May 3, 993) Nonresidential Real Property (placed in service after May, 993 and before 999) No election made 00% DB GDS recovery period Tables 4 50% DB GDS recovery period Tables 4 50% DB 5 years Table 5 50% DB 0 years Table years Table 7 39 years Table 9 00% DB GDS recovery period Tables 4 50% DB GDS recovery period Tables 4 50% DB 5 years Table 5 50% DB 0 years Table years Table years Table 8 39 years Table 9 Quick Guide to MACRS Depreciation Tables General Depreciation System Regular Tax Election (if elected, also use for AMT) Alternative Depreciation System (if elected or required, also use for AMT) Property Placed in Service after 998 GDS recovery period ADS recovery period Tables 5 9 Tables 5 9 GDS recovery period Tables years Table 5 0 years Table 6 N/A N/A Property Placed in Service GDS recovery period 6 Tables 5 9 GDS recovery period 6 Tables years 6 Table 5 0 years 6 Table 6 N/A N/A N/A ADS recovery period Tables 5 9 ADS recovery period Tables 5 9 ADS recovery period Tables years Table 0 40 years Table 0 ADS recovery period Tables 5 9 ADS recovery period Tables 5 9 ADS recovery period Tables 5 9 ADS recovery period Tables years Table 0 40 years Table 0 40 years Table 0 Alternative Minimum Tax 50% DB GDS recovery period Tables 4 50% DB GDS recovery period Tables 4 If Section 50 property, 5 years If Section 45 property, 50% DB 5 years Table 5 If Section 50 property, 0 years If Section 45 property, 50% DB 0 years Table years Table 7 39 years Table 9 50% DB ADS recovery period Tables % DB ADS recovery period Tables 0 4 ADS recovery period Tables 5 9 ADS recovery period Tables years Table 0 40 years Table 0 40 years Table 0 Can be elected for any asset, if not already required. [IRC 68(b)()(D) and (g)()(e)] Additional special (bonus) depreciation is available for [IRC 68(k)]. See Tables ADS method is required for farm assets when an election to not apply the uniform capitalization rules is in effect. [IRC 63A(e)()] 4 Trees and vines bearing fruit or nuts and placed in service after 988 are depreciated over 0 years for regular tax and AMT. [IRC 68(b)(3)(E) and (e)(3)(d)(ii)] 5 Qualified leasehold improvement property and qualified restaurant property placed in service after 0//04 and before 0, and qualified retail improvement property placed in service during 009 0, are depreciated using over 5 years for regular tax and AMT. [IRC 68(b)(3) and (e)(3)(e)] Expired Provision Alert: The 5-year recovery period for these types of property expired for property placed in service after 0. It s possible Congress will extend it to 0, but had not done so at the time of this publication. See Expired Tax Provisions on Page 3- for more information. 6 Use the ADS recovery period for AMT [IRC 56(a)()]. See Tables Tax Year Depreciation Quickfinder Handbook Replacement Page 0/03

15 Table 4 0-Year MACRS For property placed in service after % Declining Balance 50% Declining Balance Regular tax depreciation for personal property with 0-year recovery period Regular tax depreciation for 0-year assets used in a farming business (including (includes boats not used for transportation and assets used in certain activities). single-purpose farm structures). AMT depreciation for personal property with 0-year recovery period placed in service after 998. Can be elected for regular tax. Year Half-Year Mid-Quarter Convention Half-Year Mid-Quarter Convention Year Convention Quarter in Which Acquired Convention Quarter in Which Acquired % 7.50%.50% 7.50%.50% % 3.3% 9.38% 5.63%.88% These percentages incorporate the switch from declining-balance (DB) to straight-line () method when yields a larger deduction. Note: For early disposition, multiply the depreciation obtained from these tables by ½ if half-year convention applied. For a disposition of property under the mid-quarter convention, see Convention in Year of Disposition on Page -5. Table 5 5-Year MACRS For property placed in service after % Declining Balance Straight-Line Regular tax depreciation for property with a 5-year recovery period, including Regular tax depreciation for qualified leasehold improvement property and land improvements (both Section 45 and 50 property) and assets used in qualified restaurant property placed in service after 0//04 and before 0, and certain activities. qualified retail improvement property placed in service during Expired Provision Alert: The 5-year recovery period for these types of property expired for property placed in service after 0. It s possible Congress will extend it to 0, but had not done so at the time of this publication. See Expired Tax Provisions on Page 3- for more information. AMT depreciation for 5-year property placed in service after 998 that is Section 50 property. ADS depreciation for assets with 5-year ADS life. Can be elected for regular tax and AMT. Year Half-Year Mid-Quarter Convention Half-Year Mid-Quarter Convention Year Convention Quarter in Which Acquired Convention Quarter in Which Acquired % 8.75% 6.5% 3.75%.5% % 5.83% 4.7%.50% 0.83% These percentages incorporate the switch from declining-balance (DB) to straightline () method when yields a larger deduction. Note: For early disposition, multiply the depreciation obtained from these tables by ½ if half-year convention applied. For a disposition of property under the mid-quarter convention, see Convention in Year of Disposition on Page Tax Year Depreciation Quickfinder Handbook Replacement Page 0/03

16 Section 79 Expensing Tab 5 Topics Expensing Assets Under Section Page 5- Annual Deduction Limit... Page 5- Increased Limits for Targeted Areas... Page 5- Business Taxable Income Limit... Page 5- Pass-Through Entities... Page 5-3 Recapture... Page 5-4 Qualifying Property... Page 5-5 Comparing Special Depreciation and Section 79 Expensing... Page 5-7 Making the Section 79 Election... Page 5-7 State Conformity to Federal Special (Bonus) Depreciation and Section 79 Expensing Rules... Page 5-8 Expensing Assets Under Section ,000 Taxpayers can elect to currently deduct some or all of the cost of certain qualifying property that would otherwise be subject to depreciation. (See Qualifying Property on Page 5-5.) This Section 79 deduction is limited, however, to a maximum annual amount, which is scaled back when the taxpayer places more than a certain amount of Section 79 property in service during the tax year. The deduction is also limited by taxable income. Note: The Section 79 limits are for tax years beginning in a specified year [IRC 79(b)()]. Thus, for fiscal year taxpayers, the annual deduction limit and qualifying property phase-out threshold apply to assets placed in service during the fiscal year. This is different than the rules for special (bonus) depreciation, which applies to assets acquired and placed in service during the calendar year regardless of the taxpayer s fiscal year. See Tab for a discussion of special (bonus) depreciation. 500, ,000 Example: Lasso, Inc. started business on December, 0, and has a December 3 year-end. On December 0, 0, Lasso placed in service a machine acquired that day for $39,000. No other depreciable assets were placed in service during that year. If Lasso so desires, the entire $39,000 may be expensed under Section 79, subject to the business taxable income limit (see Business Taxable Income Limit on Page 5-), even though Lasso s initial tax year consisted of only one month. Section 79 Annual Limits,000,000 Year Maximum Qualifying Property Beginning In Deduction Threshold 500, or $50, $800, or 0... $500, $,000,000 or $39,000...$560, or later... $5,000...$00,000 Expired Provision Alert: For 0, the maximum deduction and qualifying property threshold were $500,000 and $,000,000, respectively. It s possible that Congress will extend those increased amounts to 0, but it had not done so at the time of this publication. See Expired Tax Provisions on Page 3- for more information. These limits have been scheduled to fall several times in the past and Congress has raised them. Be alert for developments.,0,000,000,000 Example: In 0, Chris placed in service machinery costing $66,000. This cost is $0,000 more than $560,000, so he must reduce his Section 79 annual deduction limit to $37,000 ($39,000 $0,000). A husband and wife, whether filing joint or separate returns, are treated as one taxpayer for the annual deduction limit and qualifying property threshold. If separate returns are filed, the annual deduction limit (after any reduction for qualifying property additions over the threshold) is split in half unless both spouses elect a different allocation by multiplying the total limitations by the percentage elected. The sum of the percentages the taxpayer and spouse elect must equal 00%. [Reg..79-(b)] 500,000 When a corporation is a member of a controlled group (greater than 50% ownership), the annual dollar and qualifying property limitations are apportioned among the members of the group. Also, the controlled group is treated as one taxpayer for the business taxable income limitation. In addition, property purchased from another group member does not qualify as Section 79 property. Annual Deduction Limit The total cost of property that can be expensed any year is limited to a maximum deduction amount. In addition, for each dollar of Section 79 property placed in service during the year over the qualifying property threshold, the maximum deduction is reduced (but not below zero) by one dollar. See the Section 79 Annual Limits table in the next column. Exception: The annual deduction limit and qualifying property threshold are higher for property placed in service in certain locations. See Increased Limits for Targeted Areas in the next column. If Section 79 property is placed in service during a short tax year or part way through a tax year, the annual deduction limit is not pro-rated. The limit applies no matter when during the tax year the property is placed in service. U Caution: The maximum Section 79 expense for certain heavy vehicles (including SUVs) is limited to $5,000 per vehicle [IRC 79(b)(6)]. See Section 79 Limit for Heavy Vehicles on Page 6-6. Increased Limits for Targeted Areas Disaster Assistance Property An increased Section 79 deduction is available for qualified Section 79 disaster assistance property placed in service in a federally declared disaster area if the disaster occurred before 00. A list of the federally declared disaster areas is available at Qualified Section 79 disaster assistance property is property that qualifies for Section 79 expensing (see Qualifying Property on Page 5-5), is placed in service after 007 and is qualified disaster assistance property. Generally, qualified disaster assistance prop Replacement Page 0/03 0 Tax Year Depreciation Quickfinder Handbook 5-

17 erty is property acquired by purchase on or after the applicable disaster date that rehabilitates or replaces property damaged, destroyed or condemned as a result of the federally declared disaster. The property must be placed in service by the last day of the third calendar year following the applicable disaster date. See IRS Pub. 946 for more information. Example: A disaster occurred in a federally declared disaster area on January, 009. John Smith placed property in service on December 30, 0. This property meets the requirements to be considered qualified Section 79 disaster assistance property for 0 as it was placed in service on or before December 3, 0 (the end of the third calendar year following the applicable disaster date). Annual deduction limit. The annual Section 79 deduction limit is increased by the smaller of: $00,000 or the cost of qualified Section 79 disaster assistance property placed in service during the year. [IRC 79(e)()] Qualifying property threshold. The qualifying property threshold is increased by the smaller of: $600,000 or the cost of qualified Section 79 disaster assistance property placed in service during the tax year. Enterprise Zone Businesses Expired Provision Alert: The Section 79 deduction limit was subject to special rules for certain property placed in service in an empowerment zone before 0. It s possible that Congress will extend these rules to 0, but it had not done so at the time of this publication. See Expired Tax Provisions on Page 3- for more information. An enterprise zone business that places qualified zone property in service in an empowerment zone before 0 can increase its Section 79 deduction and qualifying property limits. For definitions of enterprise zone business and qualifying zone property see Code Sections 397A, 397C and 397D. See the Tab 3 glossary for the definition of empowerment zone. Annual deduction limit. The annual Section 79 deduction limit is increased by the smaller of: $35,000 or the cost of Section 79 property that is also qualified zone property placed in service during the year. [IRC 397A(a)] Qualifying property threshold. Only 50% of the cost of qualified zone property placed in service is counted when determining whether the qualifying property threshold has been exceeded. U Caution: Qualified Section 79 disaster assistance property (see Disaster Assistance Property on Page 5-) is not treated as qualified zone property unless the taxpayer elects not to treat the property as qualified Section 79 disaster assistance property. Business Taxable Income Limit The Section 79 deduction is limited to the taxpayer s aggregate taxable income derived from the active conduct of all trades or businesses, including:,000,000 Wages, salaries, tips and other compensation. A partner or S corporation shareholder s pass-through share of entity taxable income or loss from the active conduct of any of the entity s trades or businesses, provided that he is engaged in the active conduct (that is, he meaningfully participates in management or operations) of at least one of the entity s trades or businesses. Section 3 gains (or losses) from a trade or business. 04 Interest earned from working capital related to a trade or business. Income or loss from Schedule C and Schedule F. Business taxable income is not reduced by: Any NOL carryover or carryback to the tax year. The deduction for self-employment taxes. Unreimbursed employee business expenses. The Section 79 deduction. Special deductions, such as the dividend received deduction (for corporations other than S corporations). Taxable income or losses from investments or hobbies do not count as income from an active trade or business. The active conduct of a trade or business for the Section 79 taxable income limit is not the same as material participation under the Section 469 passive activity rules. Income is derived from an active trade or business for the Section 79 test if the taxpayer meaningfully participates in the business s management or operations [Reg..79-(c)(6)(ii)]. This includes making high-level management decisions, even if the everyday operational decisions are left to an agent or employee. Example: Adam owns a salon as a sole proprietorship and employs Brenda to operate it. Adam manages the salon by performing tasks such as reviewing developments relating to the business and approving the annual budget, while Brenda performs the day-to-day operating functions, including hiring employees, purchasing supplies and writing checks for bills and salaries. In 0, Brenda purchased, for use in the salon and with its funds, qualified Section 79 equipment for $9,500. Adam s net income from the salon, before the Section 79 deduction, was $8,000. Adam also is a partner in PRS, a partnership that owns a grocery store. Adam does not participate in the management or operations of the grocery store, and PRS did not purchase any Section 79 property during 0. Adam s allocable share of partnership net income was $6,000. Based on the facts and circumstances, Adam meaningfully participates in the management of the salon but not the grocery store. Therefore, Adam s aggregate taxable income derived from the active conduct of any trade or business is $8,000, the net income from the Strategy: Business taxable income does not have to be generated by the business in which the Section 79 property is used to count toward the business taxable income limit. In fact, the trade or business in which the Section 79 property is used can generate a loss, as long as the taxpayer s net business taxable income from all sources is positive. Example: Jon actively conducts the business of his sole proprietorship, which has a $45,000 loss for 0 before considering any Section 79 deduction. He also reports $00,000 of wages and $3,000 of Section 45 depreciation recapture from a partnership interest. He is active in the partnership s business. Jon s aggregate business taxable income for the Section 79 taxable income limit is $58,000 ($00,000 plus $3,000 from the partnership minus $45,000 loss from the proprietorship). Jon can claim the full $39,000 Section 79 deduction in 0 (assuming total qualifying property does not exceed $560,000) for Section 79 property placed in service for his Schedule C activity. a $58,000 Joint return. If a joint return is filed, the taxable incomes (or losses) of both spouses are aggregated, even though the Section 79 deduction may be related to the activities of only one spouse. Example: Sue and Bo file a joint return. Sue has Form W- income of $6,000 in 0. Her husband, Bo, reports a $3,000 business loss from his proprietorship; their aggregate business taxable income for claiming a Section 79 deduction for Bo s proprietorship is $3,000 ($6,000 $3,000). Bo can claim up to $3,000 (smaller of $3,000 or $39,000 limit) of Section 79 expense in 0 assuming total qualifying property additions do not exceed Section 45 and 50 depreciation recapture from a trade or business. $560, , Tax Year Depreciation Quickfinder Handbook,000,000 Replacement Page 0/03

18 Planning for the Business Income Limit Use one of the methods shown below when the Section 79 deduction is reduced by the business taxable income limit. Either method will result in net income of zero for the current year, but will provide different rates of cost recovery in future years. Projections are necessary to determine the best method to use. Method #: Determine the amount of Section 79 expense that will result in a taxable income of zero when combined with depreciation. Remaining basis is recovered via depreciation over future years. This will avoid the possibility that Section 79 carryovers are locked up by the taxable business income limit in future years. Use the Formula for optimal Section 79 deduction (Method #) below. Note: This formula only works if the regular MACRS method is used, if the mid-quarter convention does not apply and if special (bonus) depreciation is not taken on the asset. Formula for optimal Section 79 deduction (Method #) [ (M N) A ] [ M ] = D M = MACRS Recovery Period N = Business Taxable Income Before Depreciation and Section 79 Deduction Replacement Page 0/03 A = Asset Cost D = Section 79 Deduction Example: Martha purchased a previously used five-year MACRS asset on March, 0, for $05,000. Her business taxable income was $3,700 before the Section 79 deduction and depreciation. Using Method #, the optimal Section 79 deduction is: (5 $3,700) $05,000 = $3,500 = < $3,375> 5 <4> Business taxable income before depreciation and Section 79 expense... $ 3,700 Section 79 deduction... < 3,375 > MACRS depreciation ($05,000 $3,375) 0.00%... < 0,35 > Net taxable income... $ 0 500,000 Method #: Elect the maximum Section 79 expense available for the tax year. The amount disallowed because of the business taxable income limit is carried forward as a Section 79 expense in the following year. This method is beneficial if income increases enough in the next year to absorb most or all of the carried forward Section 79 expense. Example: Using Method # for the above example, Section 79 election is made for the entire $05,000 basis of the asset placed in service. Only $3,700 is deductible in 0. The remaining $8,300 ($05,000 $3,700) carries over and may be deductible as a Section 79 expense in 03, subject to the business taxable income limit and the annual deduction limit. 03 æ Practice Tip: If the annual deduction limit falls to $5,000 for years beginning after 0 as scheduled, generating a large Section 79 carryforward before then may not be desirable. The amount that can be used in years beginning after 0 will be $5,000 at the most (less if qualifying property over the threshold, scheduled to fall to $00,000, is placed in service or if business taxable income is less than the adjusted deduction limit). Carryovers Any Section 79 deduction that cannot be deducted because of the taxable income limit is carried over to the following year [Reg..79-3(a)]. This disallowed deduction amount is shown on line 3 of Form 456. It should be entered on the following year s Form 456. There is no limit on the number of years a Section 79 deduction can be carried forward. Exception: Special rules apply to carryforwards attributable to qualified real property. See Qualified Real Property on Page 5-6. The carryover is used on a first-in, first-out basis. If costs from more than one year are carried forward to a year where they cannot all be utilized, the earliest year carryovers are used first. If the property is disposed of (including a transfer at death) before the related carryover is utilized, a Section 79 deduction is not allowed for the remaining carryover amount. Instead, the carryover is added to the property s basis. If more than one property is placed in service in a year, the taxpayer can select the properties for which all or a part of the costs will be carried forward. This selection must be shown in the taxpayer s books and records. Section 79 costs allocated from a partnership or an S corporation are treated as one item of Section 79 property. If no selection is made, the carryover is allocated equally among the properties expensed for the year. Pass-Through Entities Partnerships and S corporations must apply the annual deduction limit, qualifying property limit and business taxable income limit before passing through any Section 79 expense. The limits then apply again to each individual partner or shareholder. [Reg..79-(b) and (c)] U Caution: Estates and trusts cannot make Section 79 elections. Therefore, the fiduciary must capitalize and depreciate all tangible personal property placed in service by the entity. However, estates and trusts can claim the Special (Bonus) Depreciation Allowance (Page -0). Annual Deduction and Qualifying Property Limits The annual deduction limit applies at both the pass-through entity level and the owner level. In other words, for 0, a passthrough entity cannot allocate a Section 79 deduction exceeding $39,000, and an owner cannot deduct a Section 79 expense (including the amount passed through by the entity) exceeding $39,000. However, an owner does not include his allocable share of the pass-through entity s cost of qualifying property in determining whether his qualifying property additions exceed the threshold. [Reg..79-(b)(3) and (4)] U Caution: A taxpayer who owns interests in two or more pass-through entities could be allocated Section 79 deductions that total more than the taxpayer s annual deduction limit. If this occurs, the amount in excess of that amount is not allowed as a carryforward. The excess deduction is permanently lost unless the pass-through entities revoke an appropriate amount of their Section 79 election. In addition, taxpayers must reduce their basis in the pass-through entities as if the full Section 79 deductions had been allowed. (Rev. Rul. 89-7) See Revoking the Election on Page 5-7 for information regarding revoking a Section 79 election. Business Taxable Income Limit The amount of Section 79 expense that can be allocated by a pass-through entity to its owners cannot exceed the entity s aggregate business taxable income for that year. If aggregate business taxable income is less than the deduction limit, a pass-through entity may still elect expensing up to the deduction limit, but it cannot pass through the amount that would reduce its taxable income below zero. That amount is carried forward at the entity level. 0 Tax Year Depreciation Quickfinder Handbook 5-3

19 Example: Winston Co. (a calendar-year partnership) owns and operates a restaurant. During 0, Winston places in service a cash register costing $5,000 and office furniture costing $6,000. Both qualify as Section 79 property. Winston elects under Section 79 to expense $,000. For 0, Winston s taxable income (before any Section 79 deduction) derived from the active conduct of its restaurant business is $6,000. Therefore, Winston can pass through only $6,000 ($,000 $5,000) of Section 79 expense to its partners in 0. The remaining $5,000 is carried forward at the partnership level. Winston reduces the Section 79 property s adjusted basis by $,000, the full amount elected to be expensed. Assume that in 03, Winston makes no fixed asset purchases and generates $0,000 of business taxable income. It will pass through the $5,000 Section 79 expense carried forward from 0 to its partners in 03. Pass-through entity's taxable income. Business taxable income for pass-through entities is computed the same way as for all taxpayers (see Business Taxable Income Limit on Page 5-) except S corporation deductions for compensation paid to shareholder/employees and partnership deductions for guaranteed payments are added back to income. Example: Kayco, Inc., an S corporation, generated a $65,000 loss from trade or business activities and $8,000 of income from investment activities in 0. Kayco paid its sole shareholder, Kay, $80,000 in salary during 0. All of this salary was deducted from the trade or business income. Kayco also purchased one asset during the year, a $400,000 piece of equipment that is Section 79 property. Kayco s business taxable income limit is as follows: Loss from trade or business ,000 $ <65,000> Employee/shareholder wages... 80,000 Business taxable income limit ,000 $ 5,000 Kayco can elect expensing up to $39,000 for 0, but can only pass through $5,000 to Kay. The remaining $4,000 ($39,000 $5,000) is carried forward at the corporate level. 485,000 Owner s share of pass-through entity s taxable income. For the business taxable income limit, partners and S corporation shareholders who are engaged in the active conduct of one or more of a pass-through entity s trades or businesses include their allocable share of taxable income derived from the entity s active conduct of any trade or business. 475,000,05, ,000 Example: In 0, Asta Partnership placed in service Section 79 property costing $585,000. Asta must reduce its annual deduction limit by $5,000 ($585,000 $560,000), so its maximum Section 79 deduction is $4,000 ($39,000 $5,000). Asta elects to expense $4,000. Asta s business taxable income for the year was $600,000, so it can pass through the full $4,000 to its partners. Asta passes through $9,500 of its Section 79 deduction and $50,000 of its taxable income to Dean, a partner. Dean is also a partner in Jethro Partnership, which allocated him a $30,000 Section 79 deduction and $5,000 of taxable income from the active conduct of its business. He also operates a sole proprietorship that placed in service qualifying Section 79 property costing $55,000 and generated a net loss of $5,000 (before considering any Section 79 expense). 500,000 Dean does not have to include Section 79 partnership asset additions to figure the reduction in his annual deduction limit. His qualifying property additions for the year are $55,000, so his annual deduction limit is $39,000. He elects to expense the $39,500 ($9,500 from Asta plus $30,000 from Jethro) of Section 79 costs passed through from the partnerships plus $55,000 of his sole proprietorship s Section 79 costs, for a total of $94,500. But, his deduction is limited to his business taxable income of $60,000 ($50,000 from Asta Partnership, plus $5,000 from Jethro Partnership minus $5,000 loss from his sole proprietorship). He carries over $34,500 ($94,500 $60,000) of the elected Section 79 costs to 03. Basis Adjustments The entity reduces its basis in assets for the full amount of Section 79 expense elected, even if some of the expense cannot be passed through to the owners due to the business taxable income limit [Reg..79-(f)]. The owners, however, reduce their basis in the partnership or S corporation only by the amount of Section 79 expense passed through. The owner s basis in his partnership interest or S corporation stock is reduced even if he gets no current deduction due to the taxable income limit at the owner level. However, any Section 79 carryovers remaining when the pass-through entity is disposed of increase the owner s basis in the entity and, thus, reduce the gain (or increase the loss) realized upon the disposition. Example: Gordon is a general partner in GeeDee and is active in the partnership s business. During 0, GeeDee allocates $5,000 of Section 79 expense and $5,000 of taxable income (all of which is from the active conduct of a trade or business) to Gordon. Gordon also conducts a business as a sole proprietor. For 0, the business incurs an $,000 taxable loss, so his taxable income limit for Section 79 expensing is $4,000 ($5,000 $,000). Therefore, Gordon can deduct only $4,000 of passed through Section 79 expense and carries over the remaining $,000. However, he reduces his basis in GeeDee by $5,000. On January, 03, Gordon sells his partnership interest. Immediately before the sale, Gordon increases the adjusted basis of his partnership interest by $,000, the Section 79 carryover remaining. U Caution: Only the Section 79 expense that was unused due to the owner s business taxable income limit increases his basis when the interest in the entity is disposed of. In contrast, a basis reduction for passed-through Section 79 expense that was unused because it exceeded the owner s annual deduction limit is permanent. Carryover from C corporation to S corporation years. A C corporation may have a Section 79 carryover at the time it makes an election to be an S corporation. A Section 79 carryover cannot be carried from a C corporation year to an S corporation year. [IRC 37(b)] æ Practice Tip: A C corporation that finds itself in this situation may want to revoke its Section 79 election rather than losing the carryover. See Revoking the Election on Page 5-7 for further discussion. Trusts and Estates as Partners or Shareholders While the Section 79 election is made at the pass-through entity level, the tax benefits are reaped at the owner level. Partners or shareholders that are trusts or estates are ineligible for the Section 79 expensing privilege. Still, the pass-through entity should consider the election when other partners or shareholders will benefit. Depreciable personal property additions allocable to trust and estate owners that otherwise would be immediately deducted under Section 79 must be capitalized and depreciated using any allowable depreciation method. [Reg..79-(f)(3)] Recapture The Section 79 deduction is recaptured as ordinary income if, in any year during the property s recovery period (see Assigning the Recovery Period on Page -), the percentage of business use drops to 50% or less [Reg..79-(e)()]. The basis of the underlying property is increased by the recaptured amount. The amount recaptured equals: The 79 deduction claimed minus The depreciation that would have been allowable on the Section 79 deduction beginning with the year placed in service and including the year of recapture Tax Year Depreciation Quickfinder Handbook Replacement Page 0/03

20 Common situations where the recapture rule applies include when an asset is converted from use in a trade or business to: Personal use or Use for the production of income (for example, investment use). Recapture also applies when business use falls to 50% or less. However, it does not apply to an auto or other listed property because listed property is subject to recapture rules under Section 80F. (See Recapturing Excess Depreciation on Page 6-3.) Nor does it apply when the property is sold, but the 79 deduction is treated as depreciation when calculating ordinary income recapture. See Section 45 Depreciation Recapture on Page 8-3. Example: On January, 0, Sal purchased $0,000 of used video equipment for exclusive use in his advertising business. He expensed the $0,000 under Section 79. On June 5, 0, Sal purchased new video equipment for use in his business and converted the equipment purchased in 0 to personal use property. The recapture is calculated as follows: Section 79 deduction claimed (0)... $0,000 Minus: Allowable depreciation (instead of Section 79 expensing) 0 ($0,000 00% business use 0%)... $,000 0 [$0,000 00% business use 3% 50% (half-year convention)]...,600 < 3,600> 0 Recapture amount... $ 6,400 Note: Basis in the 0 equipment is increased by the $6,400 of recapture income. Where to Report When the qualified business use of an asset decreases to 50% or less, the recapture amount is first entered on Form 4797, Part IV. This amount is then reported as income on the form where the deductions were originally claimed. If the Section 79 deduction was originally claimed on Schedule C or F, the recaptured amount is subject to SE tax. Qualifying Property To qualify for the Section 79 deduction, property (new or used) must be all of the following: Eligible property (see Eligible Property in the next column). Used more than 50% in an active trade or business in the year placed in service. Acquired by purchase from an unrelated party. Related persons. For this test, related persons include: ) An individual and his family members (including only a spouse, ancestors and lineal descendants). ) A corporation and an individual who owns (directly or indirectly) more than 50% of the value of the corporation s stock. 3) Two corporations that are members of the same controlled group. 4) The grantor and fiduciary, and the fiduciary and beneficiary, of any trust. 5) The executor and beneficiary of any estate. 6) A partnership and a person who directly or indirectly owns more than 50% of the partnership interest. See IRS Pub. 946 for additional related parties. N Observation: Property acquired in a like-kind exchange qualifies for Section 79 expensing only to the extent of any excess basis (generally, boot given in the trade). See Depreciating Property After a Like-Kind Exchange on Page 9-5. Example: Ken Larch is a tailor. He bought two industrial sewing machines from his father. He placed both machines in service in the same year he bought them. They do not qualify as Section 79 property because Ken and his father are related persons. Partial business use. When property is used for both business and nonbusiness purposes, the Section 79 deduction can be elected only if the property is used more than 50% for business in the year it is placed in service. Even then, only the business-use portion of the property qualifies for the Section 79 election. Property converted from personal use. An asset must meet all the requirements for expensing in the year it is placed in service. Property originally acquired for personal use (or 50% or less business use) and later converted to more than 50% business use does not qualify. Example: Courtney purchased a computer for $,000 in 0. During that year, she uses it 80% for her business and 0% for personal purposes. Only $,600 ($,000 80%) of the computer s cost qualifies for the Section 79 election. Variation: Assume that Courtney uses the computer 40% for business in 0 and 80% for business in 03. She cannot take a Section 79 deduction on this property in any year because it did not meet the requirements for expensing (that is, wasn t used more than 50% for business) in the year it was placed in service. Listed property purchased by an employee. No Section 79 expense is allowed for listed property (for example, cars, computers or cameras) purchased by an employee for use in his employer s business unless the use of the asset is: [IRC 80F(d)(3)(A)] ) Required as a condition of employment and ) For the employer s convenience. See Tab 6 for more on listed property. Eligible Property To be eligible for the Section 79 deduction, property must be one of the following types of depreciable property: ) Tangible personal property. ) Other tangible property (except buildings and their structural components) used as: An integral part of manufacturing, production or extraction or of furnishing transportation, communications, electricity, gas, water or sewage disposal services or A research or bulk storage facility used in connection with such activities. 3) Single purpose agricultural (livestock) or horticultural structures. 4) Storage facilities (except buildings and their structural components) used in connection with distributing petroleum or any primary product of petroleum. 04 5) Off-the-shelf computer software (if placed in service in a tax year beginning before 03). 03 6) Qualified real property placed in service in a tax year beginning in 00 or 0. See Qualified Real Property on Page Strategy: Real property (other than a building or structural component) used as an integral part of manufacturing, production or extraction (including farming) can qualify for Section 79 expensing [IRC 79(d)()(B) and 45(a)(3)(B)]. Used as an integral part means that the asset is used directly in the activity and is essential to its completeness. Examples include storage facilities, fencing used in a farming activity and water wells that provide water for an activity. Tax professionals should not overlook this category of Section 79-eligible assets. Replacement Page 0/03 0 Tax Year Depreciation Quickfinder Handbook 5-5