Fixed Asset and Depreciation Refresher for Businesses
What should be capitalized? What should be expensed?
The basis of accounting for both tax and book purposes for depreciable fixed assets is cost and all normal expenditures of readying an asset for use. However, unnecessary expenditures that do not add to the utility of the assets are charged to expense. For example, an expense for repairing a piece of equipment that was damaged during shipment should be charged to expense (FASB Accounting Standards Codification 360-10 and IRS Publication 551).
The basis of property is usually the cost. The cost is the amount paid in cash, debt obligation, other property, or services. The cost also includes the amounts paid for the following:
- Sales tax
- Installation and testing
- Excise taxes
- Legal and accounting fees
- Revenue stamps
- Recording fees
- Real estate taxes (if assumed for the seller)
It may also be required to capitalize (add to basis) certain other costs related to buying or producing property, which includes the following:
- Settlement costs Asset basis includes the settlement fees and closing costs for buying property. However, fees and costs for getting a loan on property cannot be included in the basis. A fee for buying property is a cost that must be paid even if the property is bought for cash. The following items are some of the settlement fees or closing costs that can be included in the basis of the property:
- Abstract fees (abstract of title fees)
- Charge for installing utility services
- Legal fees (including title search and preparation of the sales contract and deed)
- Recording fees
- Transfer taxes
- Owners title insurance
- Any amounts the seller owes that the buyer agrees to pay, such as back taxes or interest
- Construction costs If a business builds property or has assets built for them, the expenses for this construction are part of the basis. Some of these expenses include the following costs:
- Labor and materials
- Architect’s fees
- Building permit charges
- Payments to contractors
- Payments for rental equipment
- Inspection fees
In addition, if a business uses its employees, material, and equipment to build an asset, the following expenses should not be deducted. They must be included in the assets basis.
- Employee wages paid for the construction work, reduced by any employment credits allowed
- Depreciation on equipment owned while it is used in the construction
- Operating and maintenance costs for equipment used in the construction
- The cost of business supplies and materials used in the construction
Do not add to the basis costs that can be deducted as current expenses. For example, amounts paid for incidental repairs or maintenance that are deductible as business expenses cannot be added to basis. Training costs are also expensed as incurred. However, a choice is available to either deduct or to capitalize certain other costs. These include the following:
- Carrying charges taxes and interest paid to carry or develop real property or to carry, transport, or install personal property. Certain carrying charges must be capitalized under the uniform capitalization rules. An election can be made to capitalize carrying charges not subject to the uniform capitalization rules, but only if they are otherwise deductible.
- Research and experimentation costs – these are costs that are incurred in a business for activities intended to provide information that would eliminate uncertainty about the development or improvement of a product. These costs are generally capital expenses. However, an election can be made to deduct these costs as a current business expense. The election to deduct these costs is binding for the year it is made and for all later years unless IRS approval is obtained to make a change.
When does depreciation begin?
Depreciation begins when the asset is placed in service. Property is placed in service when it is ready and available for a specific use, even if the property is not being used. Reference IRS Publication 946 page 7 for examples.
What methods & depreciation periods for book, tax, and AMT should be used?
Book: GAAP require that depreciation be determined in a manner that systematically and rationally allocates the cost of an asset over its estimated useful life. Straight-line, units-of-production, sum-of-the years-digits, and declining depreciation methods are considered acceptable, provided they are based on reasonable estimates of useful life and salvage value (FASB Accounting Standards Codification 360-10).
Tax: The Modified Accelerated Cost Recovery System (MACRS) must be used to depreciate most property placed in service after 1986. MACRS consists of two depreciation systems, the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). Generally, GDS must be used unless it is specifically required by law to use ADS or the taxpayer elects to use ADS. See IRS Publication 946 pages 31 -32 for a more thorough description of MACRS, GDS, and ADS.
The following is a list of property classes that apply to GDS:
- 3 year property tractor units for over-the-road use; qualified rent-to-own property
- 5 year property automobiles, taxis, buses, and trucks; computers and peripheral equipment; office machinery (such as calculators and copiers); any property used in research and experimentation
- 7 year property office furniture and fixtures (such as desks, files, and safes); any property that does not have a class life and has not been designated by law as being in any other class
- 10 year property qualified small electric meter and qualified smart electric grid system; any single purpose agricultural or horticultural structure; vessels, barges, tugs, and similar water transportation equipment
- 15 year property certain improvements made directly to land or added to it (such as shrubbery, fences, roads, sidewalks, and bridges); any qualified leasehold improvement property; initial clearing and grading land improvements for gas utility property
- 20 year property farm buildings; initial clearing and grading land improvements for electric utility transmission and distribution plants
- 25 year property property that is an integral part of the gathering, treatment, or commercial distribution of water
- 27.5 year property residential real property
- 39 year property nonresidential real property
See IRS Publication 946 pages 32-35 for a more thorough description of which assets are included in which property class.
Under MACRS, there are three conventions in which to choose from. The convention used determines the number of months for which depreciation can be claimed in the year property is placed in service and in the year of the disposal of the property. The conventions are:
- Mid-month convention â€“ Used for nonresidential real property and residential rental property. Under this convention, all property placed in service or disposed of during a month is treated as placed in service or disposed of at the midpoint of the month.Â This means that a one-half month of depreciation is allowed for the month the property is placed in service and disposed of.
- Mid-quarter convention â€“ Use this convention if the mid-month convention does not apply and the total depreciable bases of MACRS property placed in service during the last 3 months of the tax year (excluding nonresidential real property, residential rental property, property placed in service and disposed of in the same year, and property that is being depreciated under a method other than MACRS) are more than 40% of the total depreciable bases of all MACRS property placed in service during the entire year. Under this convention, all property placed in service or disposed of during any quarter of the tax year is treated as placed in service or disposed of at the midpoint of that quarter. This means that 1.5 months of depreciation is allowed for the quarter the property is placed in service and disposed of.
- Half-year convention â€“ Use this convention if neither the mid-quarter convention nor the mid-month convention applies. Under this convention, all property is treated as placed in service or disposed of at the midpoint of the year. This means that a one-half year of depreciation is allowed for the year the property is placed in service and disposed of.
See IRS Publication 946 page 38 for more information on conventions.
MACRS provides three depreciation options under GDS. These include the following:
- 200% declining balance method this includes non-farm 3, 5, 7, and 10-year property. The benefits of this method are that the method provides a greater deduction during the earlier recovery years, and the method changes to the straight line method when it provides an equal or greater deduction.
- 150% declining balance method this includes all 15 and 20-year property (except qualified leasehold improvement property) and non-farm 3, 5, 7, and 10-year property. This method has the same benefits as the 200% declining balance method.
- Straight line method this includes nonresidential real property, qualified leasehold improvement property, water utility property, and all 3, 5, 7, 10, 15, and 20-year property. This method provides for equal year deductions (except for the first and last years).
See IRS Publication 946 pages 39-40 for a more thorough description.
AMT: Generally, depreciation must be refigured for AMT purposes. This includes the following:
- Property placed in service after 1998 depreciated for the regular tax using the 200% declining balance method (generally 3, 5, 7, or 10-year property under MACRS)
- Real property (land and buildings) placed in service after 1998 that is not depreciated for the regular tax using the straight line method
Do not refigure depreciation for the AMT for the following:
- Nonresidential real property with a class life of 27.5 years or more (generally, a building and its structural components) placed in service after 1998 that is depreciated for the regular tax using the straight line method
- Other real property placed in service after 1998 that is depreciated for the regular tax using the straight line method
- Property (other than real) placed in service after 1998 that is depreciated for the regular tax using the 150% declining balance method or the straight line method
If the property was placed in service after 1998, use the same convention and recovery period used for the regular tax. Use the straight line method for real property. For property other than real, use the 150% declining balance method, switching to the straight line method for the first tax year it gives a larger deduction.
See IRS Instructions for Form 4626 for a more thorough list of the depreciation that is / is not required to be refigured for the AMT and for details of how to depreciate assets placed in service before 1999.
How are expenses handled related to the relocation of existing equipment?
Generally, the cost of moving tangible personal property already placed in service from one facility to another similar facility is not required to be capitalized. Amounts paid to move and reinstall a unit of property that has already been placed in service generally are not amounts paid to acquire or produce a unit of property. Thus, these costs are not required to be capitalized under the rules of acquisition or production of property. But, if the costs of moving and reinstalling a unit of property directly benefit, or are incurred by reason of, an improvement to the unit of property that is moved and reinstalled, such costs are required to be capitalized. This is treated the same for both tax and book purposes. Reference Internal Revenue Bulletin 2012-14 Part 1 T.D. 9564 V. A. Examples can be found within the Federal Register Section 1.263(a)-3T(h)(4).
How are expenses handled related to buildings?
Improvements should be applied separately to the primary components of the building (the building structure) and to the specifically defined building systems. Thus, a cost is treated as a capital expenditure if it results in an improvement to the building structure or to any of the specifically defined building systems. Regulations define the building structure as the building and its structural components other than the components specifically enumerated as building systems. Building systems are defined to include (1) the heating, ventilation, and air conditioning systems (HVAC); (2) the plumbing systems; (3) the electrical systems; (4) all escalators; (5) all elevators; (6) the fire protection and alarm systems; (7) the security systems; (8) the gas distribution systems; and (9) any other systems identified in published guidance.
Accordingly, if an amount paid results in a restoration of a building structure, such as the replacement of an entire roof, then the expenditure constitutes an improvement to the building unit of property. Similarly, if an amount paid results in a betterment to a building system, such as an improvement to the HVAC system, then the expenditure also constitutes an improvement to the building unit of property.
See Internal Revenue Bulletin 2012-14 Part 1 T.D. 9564 VI. B. 2.
How should disposals be treated?
Disposal other than by sale: Assets to be disposed of other than by sale shall continue to be classified as held and used until disposition. An asset to be abandoned is considered disposed of when it ceases to be used. If an entity commits to a plan to abandon a fixed asset before the end of its estimated useful life, depreciation estimates shall be revised in accordance with FASB Accounting Standards Codification 250 to reflect the use of the asset over a shorter useful life than originally expected. A temporarily idle asset is not considered abandoned. An asset to be exchanged for a similar productive asset is considered disposed of when it is exchanged.
Disposal by sale: A fixed asset to be sold is classified as held for sale in the period in which all of the following criteria are met:
- Management commits to a plan to sell the asset
- The asset is available for immediate sale in its present condition
- An active program to locate a buyer has been initiated
- The sale of the asset is probable, and transfer of the asset is expected to qualify for recognition as a completed sale within one year
- The asset is being actively marketed for sale at a price that is reasonable in relation to its fair value
- Actions required to complete the plan indicate that it is unlikely that significant changes in the plan will be made or that the plan will be withdrawn
A fixed asset classified as held for sale shall be measured at the lower of its carrying amount or fair value less cost to sell. Also, it should not be depreciated once it is classified as held for sale.
Costs to sell are the direct costs to transact a sale. These are the costs that result directly from and are essential to a sale transaction and that would not have been incurred if the decision to sell had not been made. These include broker commissions, legal and title transfer fees, and closing costs that must be incurred before legal title can be transferred.
A loss shall be recognized for any initial or subsequent write-down to fair value less cost to sell. A gain shall be recognized for any subsequent increase in fair value less cost to sell, but not in excess of the cumulative loss previously recognized. The loss or gain shall adjust only the carrying amount of a fixed asset.
For a better understanding of impairments, reference FASB Accounting Standards Codification 360-10. Disposals are treated the same for both tax and book purposes.
How should partial disposals be treated?
In September 2014, the Internal Revenue Service published final regulations relating to the disposal of tangible fixed assets (IRS Bulletin 2014-36 T.D. 9689). This Bulletin contains a great deal of information relating to partial disposals. Businesses and taxpayers are now allowed to claim a loss upon disposal of a structural component (or a portion thereof) of a building or upon disposal of a component (or a portion thereof) of any other asset without identifying the component as an asset before the disposal event. The partial disposition rule is available for any type of MACRS property. A partial disposition election must be made on the federal tax return for each year this election is taken.
When a fixed asset is partially disposed, sometimes it is difficult to determine the partial asset’s depreciable basis. The IRS expects that reasonable methods are available that use information readily available or known to the taxpayer and do not necessitate undertaking an expensive study to allocate the basis of the disposed portion of the asset. Reference IRS Bulletin 2014-36 T.D. 9689 for more information.
The following example shows the treatment of a partial disposal. Reference FASB Accounting Standards Codification 360-10 and IRS Bulletin 2014-36 T.D. 9689
Cost of equipment $500,000 $500,000
Accumulated depreciation 200,000 250,000
Net value $300,000 $250,000
Allocable portion being disposed $ 60,000 20% $ 50,000
Allocable portion not being disposed 240,000 80% 200,000
Value of entire asset $300,000 100% $250,000
Cost of equipment $500,000 $500,000
% allocable to disposal 20% 20%
$ allocable to disposal $100,000 $100,000
$ to remaining asset $400,000 $400,000
Accumulated depreciation $200,000 $250,000
% allocable to disposal 20% 20%
$ allocable to disposal $ 40,000 $50,000
$ to remaining asset $160,000 $200,000
The asset to be disposed of has a net value of $60,000 ($100,000 – $40,000) for book and $50,000 ($100,000 – $50,000) for tax.
The remaining asset has a net value of $240,000 ($400,000 – $160,000) for book and $200,000 ($400,000 – $200,000) for tax.
Depreciation will have to be recalculated ($240,000 book, $200,000 tax / years remaining).
What is the correct classification for site preparation costs?
Land/site preparation costs can be classified as land, land improvements, or another depreciable asset. Land, apart from improvements or other physical developments added to it, is not depreciable. Land improvements are generally considered 15-year depreciable property and include parking lots, canals, fences, sidewalks, and driveways.
Distinguishing between land and improvements is not always clear. If a cost is inextricably associated with landâ€, it increases the landâ value and will continue to be useful when the property on it is replaced or rebuilt. The IRS has repeatedly concluded that the costs of grading, excavating and removing earth in leveling land for general purposes is inextricably associated with the land. For example, reshaping and leveling mountainous land into a flat area to construct a building is a permanent land cost because the expense would not have to be incurred again to replace the building (Eastwood Mall Inc V. United Sates, U.S. Court of Appeals, Sixth Circuit). However, if the land will have to be reshaped in the future, then the costs would be depreciable as a land improvement with a 15-year life (Trailmont Park Inc vs. Commissioner, United States Tax Court).
To be deemed to be a depreciable improvement, land preparation costs must have a limited life. According to the IRS, this is found when the improvements:
- Will be abandoned at the end of the useful life of a related depreciable asset
- Will be physically destroyed or rebuilt when a depreciable assets is replaced or retired, or
- Are subject to wear, tear, or exhaustion
Other aspects of tax depreciation to keep in mind
Section 179 An election can be made to recover all or part of the cost of certain qualifying property, up to a limit, by deducting it in the year the property is placed in service. The section 179 deduction can be chosen instead of recovering the cost by taking depreciation deductions. This section 179 deduction is only available for tax purposes. The deduction limit is $500,000 for 2013 and $25,000 for tax years 2014 and thereafter. Costs exceeding $2,000,000 of qualifying equipment are reduced dollar for dollar for the excess. For example, for 2013 qualifying equipment of $2,500,000 exceeds the $2,000,000 limit by $500,000. Dollar for dollar the $500,000 is eliminated and the Section 179 deduction allowed would be zero. See IRS Publication 946 pages 15-24 for eligibility requirements and dollar limitations.
Special Depreciation Allowance Special depreciation allowance can be taken to recover part of the cost of qualified property placed in service during the tax year. The allowance applies on the first year the property is placed in service. For qualified property placed in service during the current tax year, an additional 50% special allowance can be taken. The allowance is an additional deduction taken after any section 179 deduction and before regular depreciation is calculated under MACRS for the year the property is placed in service. See IRS Publication 946 pages 24-31 for a list of qualified property and rules regarding how to figure the allowance.
- Credits / Incentives to consider
Investment Credit (Federal)“ Investment credit property is any depreciable or amortizable property that qualifies for the rehabilitation, energy, qualifying advanced coal project, qualifying gasification project, or qualifying advanced energy project credit. See IRS Form 3468 Instructions for property requirements and how to take the credit.
Industrial Machinery Tax Credit (Tennessee Franchise and Excise) A credit equal to 1% of the cost of industrial machinery purchased or leased during the tax year and located in Tennessee may be taken against both the franchise and excise tax liability. See Tennessee Department of Revenue Franchise and Excise Tax Guide page 25 for more information.
Jobs Tax Credit (Tennessee Franchise and Excise) A qualified business enterprise that makes the required capital investment may obtain a jobs tax credit equal to $4,500 for each qualified job created during the investment period. See Tennessee Department of Revenue Franchise and Excise Tax Guide page 26 for more information.
TVA Incentive Program The EnergyRight Solutions for Business Program helps businesses offset some of their investment costs. These incentives are available for those projects that help reduce TVA’s power demand. Two types of financial assistance, Standard Rebates and Custom Incentives, are available to help reduce project cost and accelerate payback. These rebates and incentives are offered through participating local power companies in partnership with TVA. TVA offers a lump-sum incentive amount of $0.10 per kWh on firstâ€“year savings or 70 percent of project cost, whichever is less, for the implementation of approved energy efficiency projects that result in energy savings. Contact your local power company to find out if it participates in the incentive program. If so, the distributor can provide more information on program details, the process for subscribing and whether the business qualifies for the efficiency incentive.
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