TAXATION OF BUSINESS
ENTITIES 2016 EDITION 7TH
EDITION SPILKER
SOLUTIONS MANUAL
, Chapter 2
Property Acquisition and Cost Recovery
SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] Explain the reasoning why the tax laws require the cost of certain assets to be
capitalized and recovered over time rather than immediately expensed.
Assets with an expected life of more than one year must be capitalized and
recovered through depreciation, amortization, or depletion deductions—
depending on the type of underlying asset. The policy attempts to match the
revenues and expenses for these assets because the assets have a useful life
of more than one year.
2. [LO 1] Explain the differences and similarities between personal property, real
property, intangible property, and natural resources. Also, provide an example of
each type of asset.
Personal property, real property, and natural resources are all tangible
property than can be seen and touched. Natural resources are assets that
occur naturally (e.g. timber or coal). Real property is land and all property
that is attached to land (e.g. buildings). Personal property is all tangible
property that is not a natural resource or real property. Intangibles are all
intellectual property rights (e.g. patents and copyrights) and any other value
not assigned as a tangible asset during a purchase (e.g. goodwill). Each of
these has an expected useful life of more than one year.
Asset Type Examples
Personal property Automobiles, equipment, furniture, and machinery
Real property Land and items attached to land such as buildings
(warehouse, office building, and residential
dwellings)
Intangibles Start-up and organizational costs, copyrights,
patents, covenants not to compete and goodwill
Natural Resources Commodities such as oil, coal, copper, timber, and
gold
3. [LO 1] Explain the similarities and dissimilarities between depreciation,
amortization, and depletion. Describe the cost recovery method used for each of the
four asset types (personal property, real property, intangible property, and natural
resources).
There are three types of cost recovery: depreciation, amortization, and
depletion. Each is similar in that they recover the cost basis of long-lived
, assets. Depreciation for real property, amortization, and cost depletion are
on a straight-line basis. (Taxpayers may elect straight-line on tangible
personal property as well.) The primary difference is that they are used for
property with unique characteristics. Depreciation of tangible personal
property is done on an accelerated (most often double-declining balance)
method. Percentage depletion assigns a statutory rate that may recover
more than the original cost of the asset.
Asset Type Cost Recovery Type, Characteristics
Personal property MACRS depreciation, characterized by double
declining balance method (although 150% DB or
straight-line may be elected), half-year convention
(although mid-quarter may be required), and shorter
recovery periods.
Real property MACRS depreciation, characterized by straight-line
method, mid-month convention, and longer
recovery periods.
Intangibles Amortization, characterized by straight-line method,
full-month convention, various recovery periods
(usually not based on actual life) depending on
intangible type.
Natural Resources Depletion (cost or percentage), cost depletion
allocates the cost of a natural resource based on
resource estimates (tons, ounces, barrels, etc.),
straight-line method, based on actual extraction
quantities, percentage depletion allocates a statutory
expense (depending on resource type) based on
gross income, but limited to 50% of net income, and
is the only cost recovery method that allows a
taxpayer to recover more than the original basis of
an asset.
4. [LO 1] Is an asset’s initial or cost basis simply its purchase price? Explain.
The initial basis of any purchased business asset is historical cost. This is
generally the purchase price, plus any other expenses (e.g. sales tax and
installation costs) incurred to get the asset in working condition. This does
not include costs which substantially improve or extend the life of an asset
such as a building addition.
5. [LO 1] Compare and contrast the basis of property acquired via purchase, conversion
from personal use to business or rental use, a nontaxable exchange, gift, and
inheritance.
The basis of purchased assets is historical cost. The basis rules for other
acquisitions depend on whether the transaction was taxable or not. For
, taxable transactions there is usually a step-up in basis to fair market value.
For non-taxable transactions, there is usually a carryover basis. Conversion
of assets from personal use gets the lesser of the two values. The specific
rules are as follows:
Acquisition Type Basis Rules
Purchase The initial basis is historical cost plus all costs
incurred to get the asset to its destination and in
working order.
Conversion from The depreciable basis would be the lesser of the fair
personal use market value of the asset on the date of conversion
or the adjusted basis of the transferor.
Non-taxable The basis is a carryover basis of the transferor since
exchange there is no recognition of gain or loss on the transfer
(not a taxable transaction).
Gift The basis is generally a carryover basis, because
these transactions usually aren’t taxable. If gift tax
is paid, the basis may be increased by a portion of
the gift tax paid.
Inheritance The basis is the fair market value on the date of
death or the alternate valuation date six months later
(if elected by the estate). The fair market value is
used because the transfer arises from a taxable
transaction.
6. [LO 1] Explain why the expenses incurred to get an asset in place and operable
should be included in the asset’s basis.
Additional expenses, including sales tax, shipping, installation costs, and the
like are capitalized into an asset’s basis because all costs required to place
an asset into service are required to be included into its basis. That is,
without these costs, the taxpayer would not be able to place in service or use
the asset in a business.
7. [LO 1] Graber Corporation runs a long-haul trucking business. Graber incurs the
following expenses: replacement tires, oil changes, and a transmission overhaul.
Which of these expenditures may be deducted currently and which must be
capitalized? Explain.
An expense that extends the useful life of an asset will be capitalized as a
new asset—depreciated over the same MACRS recovery period of the
original asset rather than the remaining life of the existing asset.
Alternatively, expenses that constitute routine maintenance should be
expensed immediately. An engine overhaul is likely to be a capitalized
expense. Tires and oil changes are likely to be expensed currently.
However, all expenses are subject to a facts and circumstances test.
ENTITIES 2016 EDITION 7TH
EDITION SPILKER
SOLUTIONS MANUAL
, Chapter 2
Property Acquisition and Cost Recovery
SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] Explain the reasoning why the tax laws require the cost of certain assets to be
capitalized and recovered over time rather than immediately expensed.
Assets with an expected life of more than one year must be capitalized and
recovered through depreciation, amortization, or depletion deductions—
depending on the type of underlying asset. The policy attempts to match the
revenues and expenses for these assets because the assets have a useful life
of more than one year.
2. [LO 1] Explain the differences and similarities between personal property, real
property, intangible property, and natural resources. Also, provide an example of
each type of asset.
Personal property, real property, and natural resources are all tangible
property than can be seen and touched. Natural resources are assets that
occur naturally (e.g. timber or coal). Real property is land and all property
that is attached to land (e.g. buildings). Personal property is all tangible
property that is not a natural resource or real property. Intangibles are all
intellectual property rights (e.g. patents and copyrights) and any other value
not assigned as a tangible asset during a purchase (e.g. goodwill). Each of
these has an expected useful life of more than one year.
Asset Type Examples
Personal property Automobiles, equipment, furniture, and machinery
Real property Land and items attached to land such as buildings
(warehouse, office building, and residential
dwellings)
Intangibles Start-up and organizational costs, copyrights,
patents, covenants not to compete and goodwill
Natural Resources Commodities such as oil, coal, copper, timber, and
gold
3. [LO 1] Explain the similarities and dissimilarities between depreciation,
amortization, and depletion. Describe the cost recovery method used for each of the
four asset types (personal property, real property, intangible property, and natural
resources).
There are three types of cost recovery: depreciation, amortization, and
depletion. Each is similar in that they recover the cost basis of long-lived
, assets. Depreciation for real property, amortization, and cost depletion are
on a straight-line basis. (Taxpayers may elect straight-line on tangible
personal property as well.) The primary difference is that they are used for
property with unique characteristics. Depreciation of tangible personal
property is done on an accelerated (most often double-declining balance)
method. Percentage depletion assigns a statutory rate that may recover
more than the original cost of the asset.
Asset Type Cost Recovery Type, Characteristics
Personal property MACRS depreciation, characterized by double
declining balance method (although 150% DB or
straight-line may be elected), half-year convention
(although mid-quarter may be required), and shorter
recovery periods.
Real property MACRS depreciation, characterized by straight-line
method, mid-month convention, and longer
recovery periods.
Intangibles Amortization, characterized by straight-line method,
full-month convention, various recovery periods
(usually not based on actual life) depending on
intangible type.
Natural Resources Depletion (cost or percentage), cost depletion
allocates the cost of a natural resource based on
resource estimates (tons, ounces, barrels, etc.),
straight-line method, based on actual extraction
quantities, percentage depletion allocates a statutory
expense (depending on resource type) based on
gross income, but limited to 50% of net income, and
is the only cost recovery method that allows a
taxpayer to recover more than the original basis of
an asset.
4. [LO 1] Is an asset’s initial or cost basis simply its purchase price? Explain.
The initial basis of any purchased business asset is historical cost. This is
generally the purchase price, plus any other expenses (e.g. sales tax and
installation costs) incurred to get the asset in working condition. This does
not include costs which substantially improve or extend the life of an asset
such as a building addition.
5. [LO 1] Compare and contrast the basis of property acquired via purchase, conversion
from personal use to business or rental use, a nontaxable exchange, gift, and
inheritance.
The basis of purchased assets is historical cost. The basis rules for other
acquisitions depend on whether the transaction was taxable or not. For
, taxable transactions there is usually a step-up in basis to fair market value.
For non-taxable transactions, there is usually a carryover basis. Conversion
of assets from personal use gets the lesser of the two values. The specific
rules are as follows:
Acquisition Type Basis Rules
Purchase The initial basis is historical cost plus all costs
incurred to get the asset to its destination and in
working order.
Conversion from The depreciable basis would be the lesser of the fair
personal use market value of the asset on the date of conversion
or the adjusted basis of the transferor.
Non-taxable The basis is a carryover basis of the transferor since
exchange there is no recognition of gain or loss on the transfer
(not a taxable transaction).
Gift The basis is generally a carryover basis, because
these transactions usually aren’t taxable. If gift tax
is paid, the basis may be increased by a portion of
the gift tax paid.
Inheritance The basis is the fair market value on the date of
death or the alternate valuation date six months later
(if elected by the estate). The fair market value is
used because the transfer arises from a taxable
transaction.
6. [LO 1] Explain why the expenses incurred to get an asset in place and operable
should be included in the asset’s basis.
Additional expenses, including sales tax, shipping, installation costs, and the
like are capitalized into an asset’s basis because all costs required to place
an asset into service are required to be included into its basis. That is,
without these costs, the taxpayer would not be able to place in service or use
the asset in a business.
7. [LO 1] Graber Corporation runs a long-haul trucking business. Graber incurs the
following expenses: replacement tires, oil changes, and a transmission overhaul.
Which of these expenditures may be deducted currently and which must be
capitalized? Explain.
An expense that extends the useful life of an asset will be capitalized as a
new asset—depreciated over the same MACRS recovery period of the
original asset rather than the remaining life of the existing asset.
Alternatively, expenses that constitute routine maintenance should be
expensed immediately. An engine overhaul is likely to be a capitalized
expense. Tires and oil changes are likely to be expensed currently.
However, all expenses are subject to a facts and circumstances test.
