Friday, November 11, 2011

Capitalization and Depreciation

Capitalization and Depreciation- Matching Expenses with the Income that those expenses help produce

§168 of the Internal Revenue Code provides various cost recovery schedules. Under the accelerated cost recovery system ACRS, the cost recovery of an asset depends on three things:
  1. The total amount of cost to be recovered
  2. The number of years over which the cost is to be recovered
  3. The rate at which the cost is to be recovered over those year.
In theory, the total amount of cost to be recovered is the total expected decline in value while the asset is used in the taxpayer’s business, as measured by the different between the original cost and the salvage value.

For simplicity, § 168(b)(4) provides that the salvage value is always zero. Each asset class has a different life as defined by the code. Although § 168 requires straight-line depreciation for buildings and a few other types of assets, most assets are eligible for an accelerated schedule under which larger deductions are allowed in earlier years. Use the Revenue Procedure that tells you how to do it.

Double Decline Balance Method - Under the 200 percent (or double declining balance method), the first step is to calculate the percentage of cost the taxpayer could recover each year under the straight-line method. The next step is to determine the rate, which is double (200 percent of) the straight line method. That percentage is then applied each year to the unrecovered basis of the asset, to produce the ACRS deduction for the year. REDUCE BASIS

“Half-year convention” – If an asset is not placed in service at beginning of Year 1, the deduction for that year should be based on less than an entire years use of the asset. § 168(d)(1) treats assets as being placed in service in the middle of the year, with the result that only a half year’s worth of depreciation is allowed in the first year.

To accelerate a deduction is to defer income, and taxpayers ordinarily benefit from deferral. Congress intentionally permits cost recovery allowances that will usually be significantly faster than the actual declines in value of business assets.

 § 168  and tax deferral encourage investment in physical plant and equipment.2ACRS may compensate for depreciation deductions are not adjusted for inflation. ACRS is a compromise between income tax and proponents of a consumption tax. Any depreciation system that allows deductions slower that immediate expensing, but faster than actual declines in value, can be understood as a compromise between proponents of an income tax and proponents of a consumption tax. As long as a taxpayer holds a § 168 asset, the IRS assumes the asset declines in value in accordance with the applicable ACRS schedule. When asset is sold, IRS can measure the extent to which that assumption was mistaken, and require an appropriate correction.

No tax benefit rule to fix OVERSHOOTING because of §§ 1016 and 1001.  Since ACRS is a method of recovering a taxpayer’s cost, § 1016(a)(2) provides that the taxpayer’s adjusted basis in an ACRS asset must be reduced by the amount of the deduction allowed under § 168

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