Limits on First-Year Expensing

Three limits apply for first-year expensing: a dollar limit, an investment limit, and a taxable income limit.

Special Rules for Pass-Through Entities

The dollar limit, investment limit, and taxable income limit apply at both the entity and owner levels. This means that partnerships, as well as their partners, and S corporations, as well as their shareholders, must apply all the limits. The same is true for LLCs and members.

For fiscal-year entities, the dollar limit in effect at the start of their fiscal year applies. For owners of fiscal-year pass-through entities, the dollar limit at the owner level applies at the start of the owner's tax year.

Should the First-Year Expensing Election Be Made?

You don't automatically claim this deduction; you must elect it on Form 4562. While first-year expensing provides a great opportunity for matching your tax write-off with your cash outlay, it is not always advisable to take advantage of this opportunity. Consider forgoing the election in the following situations:

• You receive the write-off through a pass-through entity but could claim it for purchases made through your sole proprietorship (see the preceding example).

• You are in a low tax bracket this year but expect to be more profitable in the coming years so that depreciation deductions in those years will be more valuable.

• You want to report income to obtain credits for Social Security benefits.

• You are not profitable this year. The first-year expensing deduction cannot be used to create or increase a net operating loss. Note: The first-year expensing election on a federal income tax return does not automatically provide the same tax break for state income tax purposes. Some states restrict this deduction.

Making or Revoking an Expensing Election

Usually a first-year expensing election must be made on an original tax return for the year to which the election applies. However, you can make or revoke an election to use expensing without obtaining IRS permission. The change is made on an amended return that must specify the item and portion of its cost for which an election is being made or revoked. You have until the time limit for filing an amended return (e.g., April 15, 2020, for a 2016 return filed on April 18, 2017).

Dispositions of First-Year Expense Property

If you sell or otherwise dispose of property for which a first-year expense deduction was claimed, or cease using the property for business, there may be recapture of your deduction. This means that you must include in your income a portion of the deduction you previously claimed. The amount you must recapture depends on when you dispose of the property. The longer you hold it, the less recapture you have. If you sell property at a gain, recapture is not additional income; it is merely a reclassiflcation of income. If you realize gain on the sale of first-year expense property, instead of treating the gain as capital gain, the recapture amount is characterized as ordinary income.

Recapture is calculated by comparing your first-year expense deduction with the deduction you would have claimed had you instead taken ordinary depreciation.

If you transfer first-year expense property in a transaction that does not require recognition of gain or loss (e.g., if you make a tax-free exchange or contribute the property to a corporation in a tax-free incorporation), an adjustment is made in the basis of the property. The adjusted basis of the property is increased before the disposition by the amount of the first-year expense deduction that is disallowed. The new owner cannot claim a first-year expense deduction with respect to this disallowed portion.

Film or Television Productions

You can elect to deduct up to $15 million in production costs of a qualified film, television, or live theatrical production. A qualified production is one in which total costs do not exceed $15 million. However, under an exception, the dollar limit increases to $20 million for production costs incurred in certain economically depressed areas.

Special rules determine whether a theatrical production is qualified for this expensing rule in 2016.

Note: The special rule for expensing of these production costs expires at the end of 2016 unless Congress extends it. See the Supplement for any update.

Depreciable Property

Depreciation is a deduction allowed for certain property used in your business. It is designed to offset the cost of acquiring it, so you cannot depreciate leased property. To be depreciable, the property must be the kind that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes. The property must have a determinable useful life that is longer than one year.

As a practical matter, computations for depreciation are made by computer once the necessary information, such as basis, date of acquisition, and the applicability of any special depreciation rules, are entered in the tax preparation program. However, because depreciation is deduction that extends beyond the current tax year, it is necessary to keep track of depreciation deductions each year (again, something that is done automatically by tax preparation programs).

If you convert personal property to business use (explained later in this chapter), the basis for purposes of depreciation is the lower of its adjusted basis (generally cost) or fair market value at the time of the conversion to business use. If you acquire replacement property in a like-kind exchange or an involuntary conversion, special rules govern basis for purposes of depreciation (see IRS Publication 946, How to Depreciate Property).

Property that can be expected to last for one year or less is simply deducted in full as some other type of deduction. For example, if you buy stationery that will be used up within the year, you simply deduct the cost of the stationery as supplies. In order to claim depreciation, you must be the owner of the property. If you lease property, like an office, you cannot depreciate it; only the owner can, since it is the owner who suffers the wear and tear on his or her investment.

Depreciable property may be tangible or intangible. Tangible property is property you can touch—office furniture, a machine, or a telephone. Tangible property may be personal property (a machine) or real property (a factory). Intangible property is property you cannot touch, such as copyrights, patents, and franchises. Personal property does not mean you use the property for personal purposes; it is a legal term for tangible property that is not real property.

If you use property for both business and personal purposes, you must make an allocation. You can claim depreciation only on the business portion of the property. For example, if you use your car 75% for business and 25% for personal purposes (including commuting), you can claim depreciation on only 75% of the property. However, special rules apply to a building that is used partly for residential rental and partly for commercial purposes (see later in this chapter).

Certain Property Can Never Be Depreciated

• Antiques generally cannot be depreciated because they do not have a determinable useful life; they can be expected to last indefinitely. The same is true for goodwill you build up in your business (though if you buy a business and pay for its goodwill, you may be able to amortize the cost, as explained later in this chapter).

• Inventory is property held primarily for sale to customers in the ordinary course of your business. Sometimes you may question whether an asset is really part of your inventory or if it is a separate asset that can be depreciated. For example, containers generally are treated as part of the cost of your inventory and cannot be separately depreciated. However, containers used to ship products can be depreciated if your invoice treats them as separate items, whether your sales contract shows that you retain title to the containers and whether your records properly state your basis in the containers.

• Land is not depreciable because it, too, can be expected to last indefinitely. Land includes not only the cost of the acreage but also the cost of clearing, grading, planting, and landscaping. However, some land preparation costs can be depreciated if they are closely associated with a building on the land rather than the land itself. For example, shrubs around the entry to a building may be depreciated; trees planted on the perimeter of the property are nondepreciable land costs. Also, the cost of the minerals on the land may not be depreciated but may be subject to depletion.

  When you own a building, you must allocate the basis of the property between the building and the land, since only the building portion is depreciable.

  There is no special rule for making an allocation of basis. Obviously you would prefer to allocate as much as possible to the building and as little as possible to the land. However, the allocation must have some logical basis. It should be based on the relative value of each portion. What is the land worth? What is the building worth? You may want to use the services of an appraiser to help you derive a fair yet favorable allocation that will withstand IRS scrutiny.

When to Claim Depreciation

You claim depreciation beginning with the year in which the property is  placed in service. You continue to claim depreciation throughout the life of the asset. The life of the asset is also called its recovery period. Different types of assets have different recovery periods. The length of the recovery period has nothing to do with how durable a particular item may be. You simply check the classifications of property to find the recovery period for a particular item.

You stop claiming depreciation on the item when the property's cost has been fully depreciated or when the property is retired from service. Property is retired from service when it is permanently withdrawn from use, by disposing of it (selling or exchanging it, abandoning it, or destroying it).

When you replace a roof or other building component, you have a choice of how to treat the undepreciated basis of the replaced component. This is explained in Chapter 10.

The amount of depreciation you can claim in the year in which property is placed in service or retired from service is limited and is discussed later in this chapter.

Even if you do not actually claim depreciation, you are treated as having done so for purposes of figuring the basis of property when you dispose of it.

If you failed to claim depreciation in the past, file an amended return to fix the error if the tax year is still open (the statute of limitations on amending the return has not expired). Alternatively, you can correct the underdepreciation (even for a closed tax year) by filing for a change in accounting method on Form 3115 (follow filing instructions to Form 3115). Under a special IRS procedure, you simply adjust your income in the current year. Be sure to write on Form 3115 “Automatic Method Change under Rev. Proc. 98-60.”

If you abandon property before it has been fully depreciated, you can deduct the balance of your depreciation deductions in the year of abandonment. For instance, if you have a machine with a 7-year recovery period that you abandon in the fifth year because it is obsolete, you can claim the depreciation that you would have claimed in the sixth, seventh, and eighth years in the fifth year along with depreciation allowable for that year.

Basic System

You can use the basic system (GDS) to depreciate any tangible property unless you are required to use the alternative system, elect to use the alternate system, or are required to use some other depreciation method. To calculate your depreciation deduction, you need to know:

• The property's basis. If you purchase property, basis is your cost. If you acquire property in some other way (get it by gift, inheritance, or in a tax-free exchange), basis is figured in another way. For example, if your corporation acquires property from you upon its formation in a tax-free incorporation, then the corporation steps into your shoes for purposes of basis.

A similar rule applies to property you contribute to a partnership or LLC upon its formation. If you are a sole proprietor or an employee and convert property from personal use to business use, your basis for depreciation is the lesser of the fair market value (FMV) on the date of conversion to business use or the adjusted basis of the property on that date.

The cost of property includes sales taxes. If you hire an architect to design a building, the fees are added to the basis of the property and recovered through depreciation. The following are more items to consider when calculating your depreciation deduction.

• The property's recovery period. Recovery periods are fixed according to the claim in which a property falls. In the past, recovery period was referred to as the useful life of the property, and you may occasionally see this old phrase still in use.

• The date the property is placed in service. Remember, this is the date the property is ready and available for its specific use.

• The applicable convention. These are special rules that govern the timing of deductions (explained later in this chapter).

• The depreciation method. MACRS has 5 different depreciation methods.

Recovery Periods

The class assigned to a property is designed to match the period over which the basis of property is recovered (e.g., cost is deducted). Five-year property allows the cost of certain equipment to be deducted over 5 years (subject to adjustment for conventions discussed later).

Property Acquired in a Like-Kind Exchange

The property acquired in a like-kind exchange is depreciated over the remaining recovery period of the old property. Thus, the new property, which has the basis of the old property, also has the old property's remaining recovery period. This enables you to write off the newly acquired asset more rapidly than if the recovery period of the new asset were used.

Conventions

There are 3 conventions that affect the timing of depreciation deductions. Two apply to property other than residential or nonresidential real property (essentially personal property such as equipment); the other applies to residential or nonresidential real property (rental units, offices, and factories).

Alternative Depreciation System

You must use the alternative system (ADS) (and not the basic system, GDS) for the following property (see Table 14.8):

• Listed property not used more than 50% for business. Listed property includes cars and other transportation vehicles, and computers and peripherals (unless used only at a regular business establishment).

• Tangible property used predominantly outside the United States.

• Tax-exempt use property.

• Tax-exempt bond-financed property.

• Imported property covered by an executive order of the president of the United States.

• Property used predominantly in farming and placed in service during any year in which you elect not to apply the uniform capitalization rules to certain farming costs.

The ADS requires depreciation to be calculated using the straight-line method. This is done by dividing the cost of the property by the alternative recovery period. In some cases, the recovery period is the same as for the basic system; in others, it is longer.

An election to use ADS may be helpful, for example, if you are first starting out and do not have sufficient income to offset large depreciation deductions. Use of ADS can help to avoid alternative minimum tax and the special depreciation computations required for alternative minimum tax.

You can calculate depreciation for regular tax purposes using the same recovery periods as required for alternative minimum tax purposes. This eliminates the need to make any adjustments for alternative minimum tax and to keep separate records of depreciation taken for regular and alternative minimum tax purposes.

Recapture of Depreciation

If you sell or otherwise dispose of depreciable or amortizable property at a gain, you may have to report all or some of your gain as ordinary income. The treatment of what would otherwise have been capital gain as ordinary income is called recapture. In effect, some of the tax benefit you enjoy from depreciation deductions may be offset later on by recapture.

Also, if you sell or otherwise dispose of real property (e.g., residence containing a home office) on which straight-line depreciation was claimed after May 6, 1997, all such depreciation is taxed as capital gain up to 25%. This taxable portion is referred to as unrecaptured depreciation. The treatment of income from depreciation recapture is explained in Chapter 6.

Recordkeeping for Depreciation

Since depreciation deductions go on for a number of years, it is important to keep good records of prior deductions. It is also necessary to maintain records since depreciation deductions may differ for regular income tax purposes and the alternative minimum tax. Recordkeeping is explained in Chapter 3.

Eligible Property

Generally, eligible property means tangible personal property with a recovery period of 20 years or less.

Computer software acquired separately from hardware also qualifies for bonus depreciation. However, software that is Section 197 property does not qualify for bonus depreciation.

Eligible property also includes qualified improvement property (see Chapter 12).

To qualify for bonus depreciation in 2016, you must meet 3 conditions:

1. The original use of the property must commence with you (i.e., bonus depreciation cannot be claimed for used property). There is a limited exception for sale-leaseback arrangements.

2. The acquisition must be made in 2016 (i.e., after December 31, 2015, and before January 1, 2017). If you manufacture, construct, or produce property for your own use, the manufacturing, construction, or production must have begun in this same period.

3. The property must be placed in service before January 1, 2017.

Intangibles Acquired on the Purchase of a Business

If you buy a business, a portion of your cost may be allocated to certain intangible items:

• Goodwill

• Going concern value

• Workforce in place

• Patents, copyrights, formulas, processes, designs, patterns, and know-how

• Customer-based intangibles

• Supplier-based intangibles

• Licenses, permits, and other rights granted by a governmental unit or agency

• Covenants not to compete

• Trademarks or trade names

• Franchises (including sports franchises) (but ongoing franchise fees are currently deductible)

These items are called Section 197 intangibles, named after a section in the Internal Revenue Code. You may deduct the portion of the cost allocated to these items ratably over a period of 15 years.

Section 197 intangibles do not include interests in a corporation, partnership, trust or estate, interests in land, certain computer software, and certain other excluded items. Also, you cannot amortize the cost of self-created items. Thus, if you generate your own customer list, you cannot claim an amortization deduction.

There is a special rule for domain names that you buy in the secondary market. How you treat the cost to acquire a domain name depends on whether the name is generic (describes a product or service in terms that people associate with the topic) or nongeneric (usually a company name or product which is or functions like a trademark to identify goods or services and to distinguish them from those provided by others). More specifically, if the domain name is similar to a Section 197 intangible, it can be treated as such (see Chief Counsel Memorandum 201543014 for more details).

If a domain name is not a Section 197 intangible, the 15-year amortization rule for Section 197 intangibles doesn't apply and the domain name's cost can be amortized only if you can show there is a limited useful life to it. If not (as will usually be the case), it's just an asset carried on your books with no tax write-off.

Self-Created Intangibles

If you create an intangible, such as a trademark, you cannot amortize the costs you incur (e.g., registration fees to the U.S. Patent and Trademark Office and attorney's fees). These costs are capitalized (carried on the company's books as an asset).

Business Start-Up Costs and Organizational Expenses

When you start up a business, you may incur a variety of expenses. Ordinarily these are capital expenditures that are not currently deductible. They are expenses incurred to acquire a capital asset, namely, your business. However, the tax law allows you to write off start-up costs. The timing of your deduction depends on when you started your business.

• For start-up costs paid or incurred after October 22, 2004, and before January 1, 2010, and after December 31, 2010—you can elect to deduct $5,000 in the first year, with the balance of start-up costs amortized over 180 months. However, if costs exceed $50,000, the $5,000 immediate deduction is reduced dollar-for-dollar, so that no immediate deduction can be claimed when start-up costs exceed $55,000. In this case, all start-up costs must be amortized over 180 months.

• For start-up costs paid or incurred in 2010 only—you were able to elect to deduct $10,000 in the first year, with the balance of start-up costs amortized over 180 months. However, if costs exceeded $60,000, the $10,000 immediate deduction was reduced dollar-for-dollar, so that no immediate deduction could have been claimed when start-up costs exceeded $70,000. In this case, all start-up costs must be amortized over 180 months.

Note: Congress is considering favorable changes in the tax treatment of start-up costs. See the Supplement for details.

If you sell your business before the end of the amortization period or the business folds before that time, you can deduct the unamortized amount in your final year.

Computer Software

There are several different rules for treating the cost of software:

• If it is purchased separately from the purchase of a computer (i.e., it is not bundled with the hardware), the cost can be expensed. Alternatively, if expensing is not elected, the cost can be amortized over 36 months. However, if the useful life of the software is less than 36 months, amortize it over its useful life. If it has a useful life of less than one year (e.g., an annual tax preparation program), deduct it in full in the year of purchase (in effect, the same write-off as expensing, but there is no taxable income limitation in this instance as there is for expensing).

• If it is bundled with hardware, depreciate as part of the hardware (generally over 5 years as explained earlier in this chapter).

• If it is purchased as part of the acquisition of a business, it is amortized as a Section 197 asset over 15 years.

• If it is developed by you for use in your business, treat it as a research and development cost (explained later).

• If it is leased, deduct the lease payments over the term of the lease as you would any other rental expense.

Research and Experimentation Costs

If you have research and experimentation costs, you have a choice of ways to deduct them. You can claim a current deduction for amounts paid or incurred in the year.

Alternatively, you can elect to amortize them over a period of not less than 60 months. Where you do not have current income to offset the deduction, it may be advisable to elect amortization.

You may be able to claim a tax credit for increasing your research and experimentation program (see Chapter 23). For further information on this credit, see instructions for Form 6765, Credit for Increasing Research Activities. The research is further explained in Chapter 23.

Bond Premiums

If you pay a premium to buy bonds (a cost above the face amount of the bonds), you may be required to—or can elect to—amortize the premium. For taxable bonds, there is an election. You can amortize the bond premium or instead treat the unamortized premium as part of the basis of the bond. The bond premium is calculated with the amount that the bond issuer will pay at maturity or the earlier call date if it results in a smaller amortizable bond premium attributable to the period ending on the call date. Do not take into account any premium paid for a conversion feature. (Dealers in taxable bonds cannot deduct the amortizable bond premium.)

For tax-exempt bonds you must amortize the premium. However, you do not deduct the amortizable premium in calculating taxable income.

If you are required or elect to amortize the bond premium, decrease the basis of the bond by the amortizable premium.

Reforestation Costs

If you spend money on forestation or reforestation—planting and seeding, site preparation, and the costs of seeds, tools, and labor—you can elect to deduct up to $10,000 ($5,000 for married persons filing separate returns) in the year paid or incurred.

Costs in excess of the amount deducted are amortized over 84 months. The 84-month period begins on the first day of the first month of the second half of the tax year in which the amortizable basis is acquired.

Costs of Acquiring a Lease

If you pay a fee to obtain a lease, you can amortize the cost over the term of the lease. The lease term includes all renewal options if less than 75% of the cost is attributable to the term of the lease remaining on the acquisition date. The remaining term of the lease on the acquisition date does not include any period for which the lease may be subsequently renewed, extended, or continued under an option exercisable by the lessee.

Qualified Improvement Property

In some cases, these improvements have a 15-year recovery period over which eligible costs can be amortized if not written off using bonus depreciation or the Section 179 deduction. For details, see Chapter 10.

Methods of Depletion

There are 2 ways to calculate depletion: cost depletion and percentage depletion.

Partnership Oil and Gas Properties

The depletion allowance, whether cost depletion or percentage depletion, must be calculated separately for each partner and not by the partnership. Each partner can decide on the depletion method. The partnership simply allocates to the partner his or her proportionate share of the adjusted basis of each oil and gas property. Each partner must keep this information separately.

In separate records the partner must reduce the share of the adjusted basis of each property by the depletion taken on the property each year by that partner. The partner will use this reduced adjusted basis to figure gain or loss if the partnership later disposes of the property. (This partnership rule also applies to members in LLCs.)

S Corporation Oil and Gas Properties

The depletion allowance, whether by cost or by percentage, must be computed separately by each shareholder and not by the S corporation. The same rules apply to S corporations that apply to partnerships, with some modifications. To enable a shareholder to calculate cost depletion, the S corporation must allocate to each shareholder his or her adjusted basis of each oil and gas property held by the S corporation. This allocation is made on the date the corporation acquires the property. The shareholder's share of the adjusted basis of each oil and gas property is adjusted by the S corporation for any capital expenditures made for each property. Again, each shareholder must separately keep records of his or her pro rata share of the adjusted basis of each property and must reduce that share by depletion taken on the property. The reduced adjusted basis is used by the shareholder to determine gain or loss on the disposition of the property by the S corporation.

All Taxpayers

In general, depreciation, including any first-year expense deduction, is computed on Form 4562, Depreciation and Amortization, regardless of your form of business organization. If you qualify for a higher dollar limit, simply cross out the preprinted dollar limit on Form 4562 and write your applicable dollar limit in the margin. However, special rules apply to different entities.

If an election is made to use the 150% rate for property that could have used the 200% rate, you make the election by entering “150DB” in column (f) of Part III of Form 4562.

An election to use ADS is made by completing line 20a, b, or c of Part III of Form 4562.

If depletion is taken for timber, you must attach Form T to your return.

In general, recapture of the depreciation and the first-year expense deduction is computed on Form 4797, Sales of Business Property, regardless of your form of business organization (explained in Chapter 6).

See Figure 14.1 for a worksheet to show depreciation and a completed Form 4562 for a florist shop business that placed equipment in service in both the current year and in prior years (Table 14.10).

Employees

You complete Form 4562 only if you place depreciable property in service in the current year or have amortization costs that begin in the current year. For example, if you buy a tablet this year for your work and you want to claim a first-year expense deduction, you must file Form 4562. You do not have to complete Form 4562 if you are deducting job-related car expenses using either the standard mileage rate or actual mileage rate; you need only complete Form 2106, Employee Business Expenses, or Form 2106-EZ, Unreimbursed Employee Business Expenses. Your deductions are then entered on Schedule A as miscellaneous itemized deductions subject to the 2%-of-AGI rule and the itemized deduction reduction for high-income taxpayers explained in Chapter 1.

Self-Employed

You complete Form 4562 only if you place depreciable property in service in the current year or have amortization costs that begin in the current year. Your deductions are then entered on Part II of Schedule C or Schedule C-EZ (or Schedule F). Depreciation and first-year expensing not included in Part II of Schedule C (for cost of goods sold) are entered on a specific line in Part I of Schedule C or as part of total expenses on Schedule C-EZ. You do not have to file Form 4562 if you only need to provide information on vehicle use. You can enter this information on Schedule C (Part IV) or Schedule C-EZ.

Partnerships and LLCs

You complete Form 4562 only if you place depreciable property in service in the current year, are claiming depreciation on a car (regardless of when it was placed in service), or have amortization costs that begin in the current year. The partnership or LLC decides on the depreciation method and whether to claim a first-year expense deduction. Ordinary depreciation is then entered on Form 1065 and is taken into account in calculating a partnership's or LLC's ordinary income or loss. Depreciation is reported on a specific line on Form 1065 and is reduced by depreciation included in the cost of goods sold. Similarly, depletion (other than on oil and gas properties) is part of a partnership's or LLC's ordinary income or loss and is reported on the specific line provided for depletion.

Amortization items, such as a deduction for organizational expenses, are part of other deductions. An explanation for these items is included in a separate statement attached to the return.

First-year expense deduction is a separately stated item reported on Schedule K, and the allocable portion is passed through separately to partners or members on Schedule K-1.

Depletion of oil and gas properties is also a separately stated item reported on Schedule K. The allocable portion is passed through separately to partners and/or members on Schedule K-1.

S Corporations

You complete Form 4562 only if the corporation placed depreciable property in service in the current year, is claiming depreciation on a car (regardless of when it was placed in service), or has amortization costs that begin in the current year. The S corporation decides on the depreciation method and whether to claim a first-year expense deduction. Ordinary depreciation is then entered on Form 1120S and is taken into account in calculating an S corporation's ordinary income or loss. Depreciation is reported on a specific line on Form 1120S and is reduced by depreciation included in the cost of goods sold. Similarly, depletion (other than of oil and gas properties) is part of an S corporation's ordinary income or loss and is reported on the specific line provided for depletion.

Amortization items, such as a deduction for organizational expenses, are part of other deductions. An explanation for these items is included in a separate statement attached to the return.

The first-year expense deduction is a separately stated item reported on Schedule K, and the allocable portion is passed through separately to shareholders on Schedule K-1.

Depletion of oil and gas properties is also a separately stated item reported on Schedule K. The allocable portion is passed through separately to shareholders on Schedule K-1.

C Corporations

Form 4562 must be completed if any depreciation is claimed (regardless of the year in which the property is placed in service) or if amortization of costs begins in the current year. The depreciation deduction is then entered on Form 1120 on the specific line provided for depreciation. This deduction must be reduced by depreciation claimed in the cost of goods sold or elsewhere on the return. Depletion is entered on the specific line provided for depletion. Amortization is part of other deductions, an explanation of which must be attached to the return.