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1 Module 1 Instructor Guide Introduction This comprehensive small-business tax education program is designed for selfemployed small-business owners of all kinds. This audience includes a wide variety of business types, educational levels, and experience. For this reason, these materials have been organized for maximum flexibility and use in many settings and instructional situations. The Users Guide found at the beginning of the Instructor Resource File contains a description of the course design and each module. In addition, you will find teaching suggestions for the use of training aids, course materials, and course evaluations. Modules are available to cover the following small-business tax topics: Information for All Businesses 1. : Depreciation and Selling Depreciated Property 2. Business Use of the Home 3. Employment Taxes 4. Excise Taxes 5. Starting a Business/Recordkeeping 6. Schedule C and SE, and Form 1040-ES 7. Self-Employed Retirement Plans 8. The Small Business as a Partnership 9. Tip Reporting and Allocation Rules 10. S Corporation/Corporation For each program module, the program consists of materials for the instructor (an instructor guide and a set of transparency masters) and materials for the student (a study guide and a workbook). The student materials do not depend on an instructor's input and can be used for independent study. The instructor guide for each module contains an overview of the module; a plan for assessing the level of student knowledge before using the module; a list of teaching materials needed (including the provided transparency masters and other materials); background on the teaching topics; a pre/post-assessment quiz; and quiz answers. Students are given background information and explanations within their study guide and use the workbook for exercises and case studies (the solutions for which appear in the back of the student workbook). Instructor Guide 1

2 Additional IRS forms and publications may be helpful to you and your students but are not included with this program. Single copies of these forms and publications can be ordered by calling Overview This module covers depreciation of property. It also covers the disposal of property used in business. It is designed to help the typical small business taxpayer figure an annual deduction for the decrease in the value of his property. It will teach the businessperson how to determine gain or loss when property is disposed of and how to fill out Forms 4562 and 4797 and Schedule D. Recordkeeping is also covered. In this manual, you will find suggestions for presenting the material from the study guide as well as additional examples to help you illustrate difficult points. Pre-Assessment Follow the steps to help you assess what your students already know and what they want to learn from this class. Explain that this class will focus on depreciation, the reporting of gains and losses on business property, and how these affect taxes. Ask your students to name some types of depreciation. (Possible answers are straight-line, declining balance, section 179 deduction). Ask the class if they can define recapture of depreciation. Ask questions about your students' businesses. What kinds of personal property do they use? Do they have real property? Decide, based on what you have learned from the first three steps, the level of instruction that will benefit most of your students. Distribute the short quiz found at the end of the instructor guide. If you give this quiz before and after completion of this unit, you and your students can determine how much they have learned. Teaching Materials You will need the following transparencies when teaching this module: 1-1. Equipment Record 1-2. Form 4562, Depreciation and Amortization, page Form 4562, Depreciation and Amortization, page Schedule D, Capital Gains and Losses, page Form 4797, Sales of Business Property, page Form 4797, Sales of Business Property, page Property Eligible for Depreciation 1-8. Basis 1-9. Methods of Depreciation Instructor Guide 2

3 1-10. MACRS: Personal Property and Real Property Automobile Limitations Section 179 Deduction Gain or Loss Classifying Gains and Losses Computing Gains and Losses Holding Periods Depreciable Property Depreciation Recapture The text contains sufficient information so that participants do not need additional Internal Revenue Service publications and forms to complete the module successfully. You may find the materials listed below helpful when preparing to instruct this module. Call the IRS toll-free on to order. Publication 334, Tax Guide for Small Business Publication 535, Business Expenses Publication 537, Installment Sales Publication 544, Sales and Other Dispositions of Assets Publication 551, Basis of Assets Publication 917, Business Use of a Car Publication 946, How to Depreciate Property Form 4562, Depreciation and Amortization Form 4797, Sales of Business Property Form 6252, Installment Sale Income Schedule C, Profit or Loss From Business Schedule D, Capital Gains and Losses IRS instructions for the listed forms and schedules Teaching Topics Property Eligible for Depreciation Display the "Property Eligible for Depreciation" transparency while you discuss the following information. Generally, property used in business or held for the production of income with a useful life of more than one year can be depreciated. This means that a portion of its cost (basis) is deducted from business income each year until the cost is recovered. You can depreciate property only if you own it. For example, you cannot depreciate a car you lease. Depreciable property must meet certain requirements. It must: Instructor Guide 3

4 * be used in a trade or business or be held for the production of income * have a useful life that can be determined, and that life must be longer than one year * wear out, decay, get used up, or become obsolete Depreciable property may be: * tangible or intangible property * real (not land) or personal property * property used partially for business Examples of properties you cannot depreciate are land, goodwill, trademarks, inventory or stock in trade, and property that is rented instead of owned. However, beginning with certain intangibles you acquire after August 10, 1993, you must amortize their costs over 15 years. Some of these intangibles include: goodwill, trademarks, and patents. TRADE OR BUSINESS USE PROPERTY There is a wide variety of property used in a trade or business or held for the production of income. Ask students for examples, or mention some of the following examples: display cases, tools, dairy cows, lawn mowers, patents, office buildings, storage buildings, barns, garages, desks, machines, musical instruments, fishing boats, and telephones. TANGIBLE OR INTANGIBLE PROPERTY Tangible property can be seen or touched. Intangible property cannot be seen or touched. Although a stock certificate can be touched, the property is not the certificate itself, but what it represents and so stock is intangible. Other examples of intangible property are bonds, patents, copyrights, goodwill, and agreements not to compete. REAL OR PERSONAL PROPERTY Property can also be either real or personal property. Real property is land and everything attached to it, growing on it, or built on it. Some students confuse real property with tangible property in the sense that "real" things can be seen or touched. Remind the class to think of "real estate" when they consider real property. Personal property is property that is not real property. Personal property can be tangible or intangible. In this unit, personal property will usually refer to tangible Instructor Guide 4

5 property. Remind the class not to confuse "personal" property with "personal-use" property. Personal-use property is not used for business or for the production of income. It cannot be depreciated. PROPERTY USED PARTIALLY FOR BUSINESS Some property is part business and part personal-use property. An example of this is a car that is not used 100 percent for business. The business portion of the car can be depreciated; the personal-use portion (commuting and personal trips) cannot be depreciated. USEFUL LIFE The determinable life of a property is known as its useful life. If there is no determinable life, the asset cannot be depreciated. Most tangible property placed in service after 1980 has its cost recovered over a length of time known as the recovery period. Remind the class that they cannot "save up" depreciation and deduct it all in a year of high income. Depreciation must be taken each year of the recovery period for the property even if the other business expenses already reduced the income of the business. PROPERTY THAT WEARS OUT, DECAYS, GETS USED UP, OR BECOMES OBSOLETE A machine that makes widgets is worn out after making 750,000 widgets. Its useful life is 750,000 widgets, whether it takes one year or ten to make them. A certain radioactive isotope is used in a hospital for treating patients. After 12 years, it is no longer potent enough to be used. Property that does not wear out, decay, get used up, or become obsolete cannot be depreciated. Goodwill does not wear out; land does not decay or get used up; a Van Gogh painting does not become obsolete. Basis Show the class the "Basis" transparency. Basis is the businessperson's investment in property for tax purposes. The amount of depreciation allowed is determined by the basis of the property. In most cases, the basis is the amount paid to buy, deliver, and install the asset. Instructor Guide 5

6 Because land is never depreciated, its value must be subtracted from the basis of real property before depreciation is taken. Depending on the depreciation method used, you may have to subtract salvage value from the basis of property. Under those methods that require salvage value to be deducted, salvage value may be ignored if it is less than 10 percent of the basis. Over the years basis can be increased or decreased. Any depreciation that is allowed (even if the taxpayer did not take it) is a subtraction from basis. After the additions and subtractions, the basis is called the adjusted basis. The adjusted basis determines gain or loss when you sell or dispose of property. TRADE-INS When property is traded in, the basis of the newly acquired property depends on the basis of the trade-in property. The basis of the new property is the adjusted basis of the old property plus any additional amounts paid. The sticker or list price of the new property does not matter. EXAMPLE Judy uses a van exclusively for business. It cost $15,000 new. She has taken $9,450 in depreciation. In 1996, she traded it in on a new van. After negotiations, she and the dealer agree on a price of $17,000. The dealer gives her $5,000 on the trade-in and she signs a loan for $12,000. She gets a dealer's rebate of $500. Her basis in the new van is $17,050, calculated as follows: Adjusted basis of the old van $5,550 ($15,000-9,450 = $5,550) Amount due on loan 12,000 Dealer's rebate (500) Total (Basis in the new van) $17,050 PERSONAL-USE PROPERTY CONVERTED TO BUSINESS PROPERTY When personal-use property is converted to business property, the basis for depreciation is the lower of the adjusted basis or the fair market value (FMV) on the date of conversion. Instructor Guide 6

7 EXAMPLE Les converts a garage on his property from personal use to business use. Originally, he built the garage for $1,000. A few years ago, he rewired the garage, insulated it, and put in a heater. These improvements cost $1,200. The adjusted basis of the garage is $2,200. Real estate has gone up in value in his area and the FMV on the date of conversion to business use is $2,500. The basis for depreciation that Les may use is the lower of the two figures, $2,200. INHERITED PROPERTY AND GIFTS The basis for depreciation of inherited property is usually the fair market value on the date of death or the alternate valuation date for federal estate tax purposes, if an estate tax return was filed and the estate elected to use the alternate valuation date. If property received as a gift is converted to business use, the basis depends on the donor's adjusted basis in the property, the FMV on the date of the gift, and the amount of gift tax paid. See Publication 551, Basis of Assets. RENTAL OR LEASED PROPERTY Property that is rented or leased cannot be depreciated because only the owner may depreciate property. Placed in Service Property is put into service on the date it is first ready for use. If it is put into service for personal use and later converted to business property, it is generally depreciated using the lesser of the fair market value or the adjusted basis on the date of change. See Publication 946, How to Depreciate Property, for details on conversion rules. Real property acquired before 1987 that is changed after 1986 to business or rental property is depreciated under the Modified Accelerated Cost Recovery System (MACRS). EXAMPLE Enrico converted a house into business property in He bought it in Although it was first put into service when Accelerated Cost Recovery System (ACRS) was in effect, MACRS must be used. Instructor Guide 7

8 Additions and Improvements Additions and improvements must be depreciated rather than expensed when they: * increase the useful life of the property * increase the value of the property * make the property more useful Such improvements and additions are depreciated as separate items. The costs are not added to the original property for depreciation purposes. When To Claim Depreciation You may depreciate property you own when it is used in a trade or business or for the production of income. Take the deduction for depreciation each year until you recover the basis of the property, dispose of the property, or convert it to personal-use property. If you dispose of your property before the end of its recovery period, under MACRS, you are allowed a depreciation deduction for the year. You cannot delay your depreciation deduction because the income from the business is low; it cannot be saved to be used when there is more income. When you sell property, gain or loss is figured using the adjusted basis of the property. Depreciation that is allowed or allowable is deducted from the basis in order to arrive at the adjusted basis. "Allowed or allowable" depreciation means depreciation that was taken or should have been taken. Depreciation Show the class the Methods of Depreciation transparency. There are basically three systems of depreciation, based on the year the property is placed in service. However, we will study only the Modified Accelerated Cost Recovery System (MACRS). If you dispose of your property before the end of its recovery period under MACRS, you are allowed a depreciation deduction for the year. You can elect to use the straight line method under MACRS instead of the regular MACRS method. The election is made for each class of property. If you decide to elect straight-line MACRS for one piece of 5-year property, you must use the same method on all 5-year property put into service in the same year. You may still use regular MACRS for any 3-year property put into service that year. You continue to Instructor Guide 8

9 use regular MACRS for 5-year property that you put into service in a previous year under the regular system. (Of course, this is true for the other classes of property as well.) MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) Display the MACRS transparency. Depreciate tangible personal and real property placed in service after December 31, 1986, under the Modified Accelerated Cost Recovery System (MACRS). MACRS provides two systems for depreciating property. The main system is referred to as the General Depreciation System (GDS) and applies to most property. The second system is referred to as the Alternative Depreciation System (ADS). Unless ADS is specifically required by law or you elect it, GDS is generally used to figure your depreciation. ADS is discussed in more detail later. See IRS Publication 946 for more information. Personal property placed in service before 1981, but first used for business after 1986, is depreciated using the straight-line or declining balance method based on salvage value and useful life. For personal property placed in service from 1981 to 1987, use ACRS. In both cases, use MACRS for property converted from personal to business use if MACRS results in a smaller deduction than the other methods. For real property acquired before 1987 and converted to business use after 1986, use MACRS. Automobiles for which the standard mileage rate is used for the first year of business use generally cannot be depreciated. However, if a change is made to the actual cost method in a later year before the car is considered fully depreciated, straight-line depreciation can be used. Personal Property: Classification Direct the class to the Table of Class Lives and Recovery Periods in their texts. Be sure the class realizes that the exhibit in the Study Guide is just the first page of the Table of Class Lives and Recovery Periods. The entire depreciation tables are in IRS Publication 946. Under GDS, property is divided into 8 main classes: 3-, 5-, 7-, 10-, 15-, and 20-year property, and residential rental and nonresidential real property. Three-year property includes property with a class life of 4 years or less. Five-year property includes property with a class life of more than 4 years but less than 10, and so forth. Instructor Guide 9

10 The Table of Class Lives and Recovery Periods lists the class lives for many assets along with the recovery period to be used for both GDS and ADS. Most personal property will fall under the 5- and 7-year property classes. Property that is not described in any asset class in this table will be assigned to the 7-year property class for GDS and will have a 12-year recovery period under ADS. * The 5-year category includes automobiles (placed there by law even though their class life is 3 years), trailers, both light and heavy trucks, computers, and office machinery. * The 7-year classification includes office furniture and fixtures, assets used in the manufacture of musical instruments, and property not assigned to another class. Personal Property: Basis To determine the depreciable basis for MACRS personal property: * Reduce basis by any section 179 deduction taken. * Use only the business percentage of the basis if the property is used partly for personal use. * Do not reduce basis by salvage value or depreciation previously taken. Personal Property: Computing Depreciation Using MACRS Under MACRS, GDS is accelerated depreciation. Property in the 3-, 5-, 7-, and 10- year classes is depreciated using the 200% or double declining balance method with a switch to straight-line method in the year it provides a larger deduction. For property in the 15- and 20-year class, the 150% declining balance method is used, also with a switch to the straight-line method. Point out to the students that the percentage tables in Publication 946 automatically switch to the straight-line method. For those students who may want to figure MACRS depreciation without using the percentage tables, refer them to Publication 946. Unless a special rule requiring use of the mid-quarter convention applies, generally the half-year convention is used. The conventions are discussed in more detail later. Instructor Guide 10

11 TABLE 1-1 MACRS Personal Property Half-year Convention Property Recovery Class Year 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year % 20% 14.29% 10% 5% 3.75% Refer your students to Table 1-1, MACRS Personal Property. The basis of the property is multiplied by the applicable percentage for the proper year and property class. For 5- and 7-year property, the first year's percentages are 20% and 14.29%, respectively. Instructor Guide 11

12 EXAMPLE Yuan Li Chi uses his car 95 percent for business. He bought and placed it in service in January 1996 for $12,000. The business portion of the basis is $11,400 ($12,000 x.95). Automobiles are in the 5-year category. Mr. Yuan does not elect to take the section 179 deduction. The 1996 depreciation is figured by multiplying $11,400 by 20%, which results in $2,280. Instructor Guide 12

13

14 Personal Property: MACRS in Year of Disposal In the year of disposal, take depreciation on MACRS property under the half-year convention unless the mid-quarter convention applies. Figure depreciation for the full year and divide by two to arrive at the deduction amount. (If you bought a piece of property at the beginning of the year and sold later in the year, no depreciation may be taken.) Personal Property: Mid-Quarter Convention Use the mid-quarter convention when the total depreciable basis of your MACRS property placed in service during the last three months of that year are more than 40% of the total depreciable basis of all MACRS property (other than residential rental and nonresidential real property) placed in service during the entire year. Do not include property placed in service and disposed of in the same tax year or residential rental or nonresidential real property. You cannot use the GDS percentages. Have your students look at Table 1-2, MACRS Personal Property, Mid-Quarter Convention Applies, in the study guide. Students can become confused about figuring the depreciation under this convention. Stress that the percentage of the property put into service in the last quarter must be calculated in order to determine if the mid-quarter convention applies. Then, if it does, each piece of property is depreciated according to the quarter it was placed in service. EXAMPLE Louis puts $9,200 worth of personal property into service in 1996 as follows: a $3,000 machine in January, a $2,000 computer in June, $500 worth of shelves in July, and two more machines, one for $2,000 in October and one for $1,700 in November. The $3,700 cost of assets put into service in the last quarter is divided by the total amount of assets (other than residential rental and nonresidential real property) put into service during the entire year: $3,700/$9,200 = 40.2%. Since the property put into service in the last quarter is more than 40% of all the personal property put into service in that tax year, he is subject to the mid-quarter convention. Instructor Guide 14

15 All the property is 7-year property, except the computer. The $3,000 machine was bought in January so the depreciation is $3,000 times the 7-year percentage for the first quarter (25%)$750. The computer is 5-year property so the second quarter percentage for 5-year property is used: $2,000 x 0.25 = $500. The shelves require the percentage for 7-year property in the third quarter: $500 x = $ The two machines bought in the last quarter are depreciated using 3.57% ($2,000 x.0357 = $71.40 and $1,700 x.0357 = $60.69). In 1997, Louis will use the 7-year first quarter percentage for recovery year 2 (21.43%) for the $3,000 machine, the 5-year second quarter percentage for year 2 (30%) for the computer, and so on. Personal Property: Mid-Quarter Convention in the Year of Disposal Depreciation in the year of disposal must be prorated for the time it is in service. First, figure the depreciation for the year using the correct quarter's percentage. Multiply that depreciation by the disposal percentage. The percentage allowed depends on the quarter when the asset is sold. Quarter Quarter Quarter Quarter Disposal in Disposal Percentage 12.5% 37.5% 62.5% 87.5% EXAMPLE If Louis sells his computer in September 1997, the depreciation for the full year is $2,000 x 0.3=$600. September is in the third quarter so the $600 is multiplied by for a 1996 deduction of $375. Instructor Guide 15

16 TABLE 1-2 GDS Personal Property Mid-Quarter Convention Applies 3-, 5-, 7-, and 10-Year Property Recovery Year Quarter Placed in Service Year Property: % 41.67% 25% 8.33% Year Property: 1 35% 25% 15% 5% Year Property: 1 25% 17.85% 10.71% 3.57% Year Property: % 12.5% 7.5% 2.5% Instructor Guide 16

17 Personal Property: MACRS Straight-Line and 150% Declining Balance Elections Under GDS, the straight-line or 150% DB over an ADS recovery period may be chosen instead of using the 200% or 150% over GDS recovery periods. The half-year and mid-quarter conventions apply. The election of either method is made on a classby-class basis. Once a method is assigned to a particular item, the same method is used throughout the life of that item. EXAMPLE Marsha buys office furniture in Office furniture is 7-year property. If she elects to depreciate any of it under the straight-line method, she must depreciate all 7-year property put into service in 1996 under the straight-line method. Next year she may choose to depreciate new 7-year property under GDS using the 200% or the 150% DB method, but will continue to depreciate her office furniture under the straight-line method. Real Property: Residential and Nonresidential You may want to display the MACRS transparency again. Real property under MACRS is depreciated with a mid-month convention. Remind the class that land value must be subtracted from the basis of real property. Residential rental property is given a recovery period of 27.5 years and nonresidential real property a recovery period of 31.5 years if placed in service before May 13, 1993, 39 years if placed in service after May 12, Ask your class to turn to Table 1-3, MACRS Nonresidential Real Property, in the study guide. The mid-month convention allows a half-month's depreciation for the month of acquisition and the month of disposal. The mid-month convention for the year and quarter of acquisition is built into the table. If a warehouse is bought in July, the column for the 7th month is used each year until the cost is recovered. If the property is disposed of early, the full year's depreciation must be adjusted for the mid-month convention. In the mid-month convention (see IRS Publication 946), a half month's depreciation is allowed for the month of sale. Instructor Guide 17

18 EXAMPLE Jose is a calendar year taxpayer. His warehouse was bought in July The basis of the warehouse excluding land is $45,000. In 1995, the depreciation is $45,000 times for a total of $ In 1996, the depreciation will be $1, ($45,000 x ). If he sells at anytime during May 1996, he will be allowed a half month's depreciation for May. The depreciation for the year will then be $1, times 4.5 months divided by 12 months. ($1, x 4.5/12 = $535.78) Instructor Guide 18

19 TABLE 1-3 Nonresidential Real Property Mid-Month Convention Straight Line Years Month Property Placed in Service Year Instructor Guide 19

20 Table 1-3a Nonresidential Real Property Mid-Month Convention Straight Line-39 Years For Property Placed in Service after May 12, 1993 Month Property Placed in Service Year % 2.247% 2.033% 1.819% 1.605% 1.391% 1.177% 0.963% 0.749% % 0.107% ALTERNATIVE DEPRECIATION SYSTEM (ADS) The Alternative Depreciation System (ADS) uses the straight-line method. It uses a half-year or mid-quarter convention for personal property and a mid-month convention for residential rental and nonresidential real property. You make a class-by-class election to use ADS for personal property. When using the ADS system, depreciate personal property under the straight-line and 150% declining balance (DB) methods. The election to use ADS for real property is made on a property-by-property basis. ADS is required for property used outside the United States. ADS is also used for real property when computing the Alternative Minimum Tax. (Special tables for 150% declining balance depreciation of personal property are provided in IRS Publication 946.) Recovery Periods Have your students look at the Table of Class Lives and Recovery Periods in their texts. Point out that some of the recovery periods for ADS are longer than those under GDS. Automobiles and computers are 5-year property under both systems, but the recovery period for office furniture is extended from 7 years under GDS to 10 years under ADS and the recovery period for office machines is extended from 5 years under GDS to 6 under ADS. If property has not been assigned a recovery period in the table, then a recovery period of 12 years is used. Real property, both nonresidential and residential rental, has a recovery period of 40 years under ADS. Instructor Guide 20

21 Personal Property: Computing Depreciation Using ADS The tables for ADS are (for the most part) the same as the tables for straight-line under GDS, except that the recovery periods on the tables provided by the IRS range from 2.5 to 50 years. Depreciation is calculated just as it is for straight-line under GDS. Real Property: Computing Depreciation Using ADS IRS has a 40-year table for calculating depreciation on real property under ADS. The calculations are made in the usual manner, and the mid-month convention is used for the year of acquisition and the year of disposal. SECTION 179 DEDUCTION Display the Section 179 transparency. The businessperson may elect to deduct up to $17,500 ($10,000 before 1993) of the cost of certain business property rather than depreciating the entire basis. Qualifying property is Section 1245 property and primarily tangible personal property. Nonqualifying property includes buildings and structural components, property acquired from a decedent, and property acquired in certain related party transactions. See Publication 946. Guidelines The property must qualify for expensing the first year it is put into service, and the election must be made on the original tax return for the year. The election cannot be made on an amended return after the due date. Property converted from personal to business use does not qualify for the Section 179 deduction. The amount deducted is limited to the amount paid for the property. The amount of basis carried over from a trade-in cannot be deducted under section 179. The amount of the Section 179 deduction is subtracted from the basis of the property before depreciation is figured. Only the business percentage of property used for both personal and business use may be expensed, and then only if the business percentage is greater than 50%. If at any time during the recovery period (for property placed in service after 1986) the business percentage drops to 50% or less, some of the Section 179 deduction will have to be recaptured (included in income). Instructor Guide 21

22 There are some limitations on the amount that may be deducted: * The maximum deduction each year is $17,500. Spouses filing separately are treated as one taxpayer for the $17,500 maximum. * The $17,500 maximum is reduced dollar for dollar for each dollar of Section 179 property put into service over $200,000 each year. * The Section 179 deduction cannot be used to create a loss or increase a loss. In other words, the Section 179 deduction can be taken only up to the amount of taxable income from an active trade or business figured without the deduction. Any cost of Section 179 property not taken because of this limitation can be carried over to the next year. See Publication 946 for a worksheet that can be used to figure the deduction. Special Rules for Listed Property Listed property is defined in Section 280F of the Internal Revenue Code and includes automobiles and other property generally used for transportation; property used for entertainment, recreation, or amusement; computers and peripheral equipment; and cellular telephones that are not used exclusively in a place of business and owned by the owner of that business. Listed property has special limitations on the amount of depreciation and section 179 deduction that may be deducted. There are also special recordkeeping rules for listed property. You may only claim GDS and section 179 deductions on listed property if the property is used more than 50 percent for business. If the property is used 50 percent or less for business, straight-line under ADS must be used to figure depreciation, and no section 179 deduction is allowed. Point out to the class that only business use percentage is considered for this text, not the investment use. If the test is met[fcmd]then depreciation is figured for both the business and investment use. AUTOMOBILES Display the Automobile Limitations transparency. If a businessperson uses an automobile for business and uses the standard mileage-rate method of claiming expenses, no section 179 or MACRS deductions are allowed. The standard mileage rate includes an amount for depreciation. If the person elects to use the standard mileage rate, it must be used the first year the automobile is placed in service. The rate is 31 cents a mile for Instructor Guide 22

23 If the actual method of claiming automobile expenses is used, section 179 deduction and depreciation may be taken on the business portion. There are dollar limits on them, however. The total limits on section 179 deduction and depreciation for automobiles placed in service in 1996 are: * 1st year: $3,060 * 2nd year: $4,900 * 3rd year: $2,950 * Each succeeding year: $1,775 The half-year and mid-quarter conventions apply, but they do not reduce those maximum amounts. If the automobile is not used exclusively for business, each year's limit is reduced. The limit is the amount allowed for the year multiplied by the business percentage of use. Sixty percent business use would allow a first year limit of $1,836 ($3,060 x 0.60). Of course, no section 179 or depreciation deductions can be taken on a leased car. RECORDKEEPING FOR LISTED PROPERTY In order to take deductions for listed property, complete and accurate records of expenses and of business and nonbusiness use must be kept. In the case of automobiles, this includes total mileage for the year, and the date and purpose of each business trip along with the mileage. Automobile logs for keeping the necessary records are available in office supply stores or the businessperson can develop one. Depreciation Records Show the Equipment Record transparency to the class. The transparency illustrates the type of record that should be kept on depreciable property. Any format is acceptable, but the record should contain the following information: * description of the property along with any serial or ID number * cost or other basis and date placed in service * depreciation method and recovery period * yearly and total depreciation * adjusted basis Depreciation records should be kept even after the property has been fully depreciated. The information will be needed when the property is disposed of. Instructor Guide 23

24 Completing Form 4562, Depreciation and Amortization Claim the section 179 deduction and depreciation for the year on Form The case study in the Student Guide illustrates how the form is filled out, and the order in which it is done. Part V is filled out first. Display the transparency of Form 4562, page 2. Since Su Lee Wong is the owner of the car and is using the actual expense method for the car, she fills out all applicable columns in Section A. Point out the two questions in Section A and remind the class about the special recordkeeping requirements for listed property. No deduction is allowed unless these requirements are met. If Su Lee were using the standard mileage rate for the car or deducting lease payments, she would fill out columns (a) through (d) only. She would also fill out Section B and, if applicable, Section C. The "200 DB" in column (g) in Section A refers to the regular MACRS percentage which is based on the double declining balance method. If she were using straight-line MACRS, she would enter "S/L." The "HY" is for the -year convention. The business use percentage in column (c) comes from the figures in Section B. The figures in Section B come from the car log. Total business miles driven (8,000) are divided by the total miles driven during the year (10,000) to arrive at the business percentage. The depreciation deduction is carried to line 20 on page 1. Show the transparency of Form 4562, page 1. Part I is where the section 179 deduction is placed. Su Lee is expensing 100% of the cost of the office furniture. The office furniture cost $13,500 so that leaves $4,000 of the $17,500 maximum amount allowed. (Her taxable income is at least $17,500 so she gets the full allowance.) She takes a section 179 deduction of $4,000 on the computer and printer she bought, leaving $1,500 to be depreciated over 5 years. If she had taken any 179 deduction on the automobile, the amount would have been carried to this section. Ask the class why the computer and printer are not included as listed property on page 2. (Both were used 100% in a business and located in the business establishment.) This is an exception provided by law. Instructor Guide 24

25 In Part II, use line 15 (a) through 15 (h) for property put into service in 1996 and depreciated under GDS. Line 16 is used for depreciation using ADS. The total deduction for property put into service before 1996 and depreciated using MACRS is put on line 17 in Part III. The depreciation for the automobile is entered on line 20 of Part IV. Some things to note about Part II: * The figures for all property of a given class are totaled. * The basis for depreciation in column (c) is the basis less section 179 deduction or land value. * The instructions for Form 4562 state that the entries in columns (e) and (f) must be specific. HY and 200 DB are used for 3-, 5-, 7-, and 10-year property using regular MACRS with a half-year convention. MQ and 200 DB are used for the same classes using regular MACRS with a mid-quarter convention. HY and 150 DB or MQ and 150 DB are used for 15- and 20- year property and any property for which the 150% DB is elected. HY and S/L or MQ and S/L are used for personal property that uses straight-line MACRS. Part III is for ACRS and other depreciation. It is used for MACRS (GDS) and ADS deduction for property placed in service before Instructor Guide 25

26

27

28 Part IV totals the depreciation and Section 179 deduction for the year. See IRS Publication 551, Basis of Assets, for a discussion of this subject. Part VI is for amortization of certain expenses such as business start-up expenditures or organizational expenses for a corporation or partnership. Disposing of Business Property COMPUTING GAIN AND LOSS You may wish to display the gain or loss transparency as you make these points. The sale of business property results in a gain or loss. Sales price minus the adjusted basis equals gain or loss. The selling price includes money, fair market value of property and services received, and the face value of any mortgages or liabilities assumed by the buyer. The adjusted basis is the original basis (usually cost plus sales tax, freight, and installation costs) plus or minus certain items or: * Some additions to basis are improvements, local assessments, closing costs, and sale expenses. * Some subtractions to basis are the depreciation taken (or allowable, even if it was not deducted), depletion, Section 179 deduction, and rebates. Other adjustments to basis are listed in IRS Publication 551, Basis of Assets. Your students may have trouble understanding why depreciation and section 179 deduction are subtracted from basis. This is especially so when this subtraction turns a "loss" into a taxable gain. EXAMPLE Krista's 7-year-old truck is fully depreciated. She paid $4,000 for it in In 1996, she sells it for $900 after placing an ad in the newspaper for $5. Since she sells the truck for much less than she paid for it, she may think she has a loss. In reality, she has a gain of $895. The gain is figured as follows: Instructor Guide 28

29 Original basis $4,000 Sales price $900 Depreciation allowed -4,000 Adjusted basis -5 Expense of sale +5 Gain $895 Adjusted basis $5 Explain that Krista recovered the money she paid for the truck through depreciation. In other words, she already deducted the cost of the truck through depreciation. If depreciation is not subtracted from the basis, Krista would be expensing the cost of the truck twice--once by depreciation and once through the loss on the sale. CLASSIFYING GAINS AND LOSSES You may wish to display the Classifying Gains and Losses transparency while you are discussing this section. Gains and losses can be classified as capital or ordinary long-term or short-term losses. Note: Capital gains are taxed like ordinary income. However, for taxpayers who are individuals, the maximum rate at which net capital gains can be taxed is 28%. Capital Assets Capital assets are all assets except: * property held mainly for sale to customers (inventory, stock in trade) * accounts and notes receivable * depreciable property, whether or not it is fully depreciated * real property used in a trade or business * some copyrights, literary, musical, or artistic works, and private letters * some government publications Capital Gains and Losses Capital losses are allowed in full against capital gains plus up to $3,000 of ordinary income. Section 1231 property is business-use property held for more than one year whose net long-term gain is treated as a capital gain and whose net losses are treated as ordinary losses; i.e., not subject to the $3,000 limitation. Capital gains and losses are reported on Schedule D. Instructor Guide 29

30 Holding Period Display the Holding Periods transparency to the class. For all practical purposes, only two dates need be remembered. Property acquired after June 22, 1984, and before January 1, 1988, must be held for over six months (at least six months and a day) in order for it to be long-term property. Property acquired after December 31, 1987, must be held for over a year (at least a year and a day) to be considered longterm property. Section 1245 Property Display the depreciable property transparency while discussing sections 1245 and 1250 property. Remember that section 1231 property is property used in a trade or business and held long-term. If section 1231 property is sold at a gain, the depreciation may be recaptured as ordinary income under code sections 1245 and (If business property is held short-term, all gain is ordinary income. If there is a loss on business property, the loss is an ordinary loss whether it is held long- or short-term.) Section 1245 property includes depreciable tangible personal property. Show your students the transparency on depreciation recapture. Under the rules for section 1245 recapture, any gain is treated as ordinary income up to the amount of depreciation or section 179 deduction taken. Gain in excess of this is capital gain. EXAMPLE Recall the $895 profit Krista made on the sale of her truck. Since she has taken $4,000 in depreciation over the years, any gain up to that amount is ordinary income. The $895 is thus all ordinary income to her. Section 1250 Property Section 1250 property is real property held long-term that is not, nor ever has been, section 1245 property. In other words, it is residential real property depreciated under any method. The recapture rules under section 1250 come into effect only if accelerated depreciation was used. There is no recapture if straight-line depreciation was used. Instructor Guide 30

31 The seller must recapture the excess of the accelerated depreciation over straight-line depreciation as ordinary income. Calculate the straight-line depreciation and subtract it from the accelerated depreciation. This gives the recapture amount. Gain up to the recapture amount is ordinary income and any gain in excess of it is capital gain. SPECIAL SITUATIONS Like-Kind Exchanges Like-kind exchanges are exchanges of qualified business property for similar property. The property must be business or investment property other than inventory and used for the production of income. The property must be tangible and be exchanged for the same kind of property. The property being exchanged must be identified within 45 days of the transfer of your property and it must be received by you within 180 days. If there is a loss on the exchange (for example, you traded land with a basis of $10,000 for land worth $9,000), the loss is not deductible. If there is a gain, tax is deferred until the property received is sold. However, if you receive money or other property in addition to the exchanged property, gain is taxed immediately up to the amount of the cash or other property. The most common form of like-kind exchange is a trade-in. When an old car is traded in for a new one, it is a like-kind exchange. Any gain or loss not recognized on an exchange between related parties may be recognized if either party disposes of the property within 2 years of the exchange. The exchange of foreign real property for U.S. real property is not regarded as a like-kind exchange. Depreciable tangible personal property may be either "like-kind" or"like-class" to qualify for nonrecognition treatment. Like-class properties are depreciable tangible personal properties within the same General Asset Class or Product Class. General Asset Classes describe the types of property frequently used in many businesses. For students wishing more information, refer them to Publication 544. If you have a like-kind exchange, you must file Form 8824, Like-Kind Exchanges in addition to Schedule D (Form 1040) or Form Involuntary Conversions An involuntary conversion occurs when your property is damaged, destroyed, condemned, or disposed of under the threat of condemnation and you receive other property or money in payment (i.e., insurance or a condemnation award). An insurance company may reimburse you for a casualty or a theft. A city may award you a settlement if it takes your property to widen a road. Instructor Guide 31

32 Losses are reported in the year they occur. Gains are deferred if the cost of repairing or replacing the property equals or exceeds any proceeds from the converted property. Installment Sales An installment sale occurs when property is sold in one year and one or more payments are received in another year. The payments may extend over many years. Some students may be familiar with installment sales under other names: land contracts or seller-financed mortgages. Generally, gains from installment sales are reported only as you receive the payments, i.e., the installment method. Payments on installment sales usually consist of principal and interest. If your sale results in a loss, you may not report it under the installment method. If the loss is on an installment sale of business assets, you can deduct the loss only in the year of the sale. Thereafter, only the interest portion of any payments need be reported. If there is a gain, any section 1245 or section 1250 recapture of depreciation must be reported in the year of sale even if no payments are received. The businessperson may elect to recognize the entire gain in the year of sale. If he or she does not make that choice, part of the principal payments received each year will be taxable along with the interest payments. The taxable portion is determined by the gross profit percentage. Once determined, the percentage stays the same each year. TAX DUE Gains and losses from the disposal of an individual's business property are reported on Form Some of these amounts are then reported on Schedule D (Form 1040). The figures from these forms go directly onto Form They are not reported on the Schedule C, Profit or Loss From Business (Form 1040). As a result, gains do not increase the amount of self-employment tax due nor do losses lower it. They do, however, raise or lower the amount of income tax due on Form Gains should be considered when determining estimated tax payments. Instructor Guide 32

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