Daily Tax Tip Spotify Podcast and/or WordPress Blog Post and Property Subject to Depreciation

Don Fitch CPA Tax Tip
Property Subject to Depreciation
Property Subject to Depreciation

Most types of Tangible Property (except land and inventory) can be depreciated.

Property Subject to Depreciation
Property Subject to Depreciation

Thus, depreciable property includes buildings, machinery, vehicles, furniture, and equipment. Certain Intangible Property, such as patents, copyrights, and computer software also may be depreciated.

To be Depreciable Property it must meet all the following requirements:

(1) The Taxpayer Owns the Property.

(2) It must be used in the taxpayer’s business or Income Producing Activity, and

(3) It must have a Determinable Useful Life of more than one year.

Property Owned by Taxpayer: Depreciation deductions are based on an investment in and actual ownership of property rather than possession of bare legal title to property (Grant Creek Water Works, Limited v. Commissioner, 91 Tax Court 322 (1988); Narver v. Commissioner, 75 Tax Court 53 (1980), Affirmed 670 Federal Supplement 2nd 855 (9th Circuit 1982)).

The mere transfer of legal title does not transfer the Incidents of Taxation attributable to property ownership where the transferor retains significant control over the property (Frank Lyon Company v. United States, 435 United States 561 (1978); Arevalo v. Commissioner, 469 Federal Supplement 3rd 436 (5th Circuit 2006)).

A taxpayer is entitled to depreciation deductions with respect to property only if the Benefits and Burdens of owning the property have passed to the taxpayer. Whether the taxpayer has received the benefits and burdens of ownership is a question of fact that must be determined from the parties’ intent, as established by written agreements read in the light of the attending facts and circumstances (Grodt & McKay Realty, Inc. v. Commissioner, 77 Tax Court 1221 (1981)).

In determining whether a taxpayer has the Benefits and Burdens of ownership, the following factors are generally analyzed:

(3) whether an Equity Interest was acquired in the property;

(4) whether the Contract Creates a Present Obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments;

(5) whether the Right of Possession is Vested in the purchaser;

(6) Which Party Pays the Property Taxes;

(7) Which Party Bears the Risk of Loss or damage to the property;

(8) which party receives the Profits from the Operation and sale of the property (Grodt & McKay Realty, Inc. v. Commissioner, 77 Tax Court 1221 (1981); Arevalo v. Commissioner, 124 Tax Court 244 (2005), Affirmed 469 Federal Supplement 3rd 436 (5th Circuit 2006)).

For depreciation purposes, a taxpayer is considered as owning property even if it is Subject to a Debt.

Example:

Joey Bagofdonuts made a down payment to purchase rental property and assumed the previous owner’s mortgage. He is considered as owning the property and can depreciate it.

Where property held by one person for life (that is, the life tenant) with remainder to another person (that is, the remainderman), the deduction for depreciation is determined as if the Life Tenant were the absolute owner of the property so that he or she is entitled to the deduction during his or her life. Thereafter, the deduction, if any, is allowed to the remainderman (Regulation Section 1.167(h)-1(a)).

Generally, if property is held in trust, the allowable deduction is Apportioned Between the Income Beneficiaries and the trustee on the basis of the trust income allocable to each (Regulation Section 1.167(h)-1(b)).

Example:

Under the trust agreement governing the Jones Trust, the income of the trust computed without regard to depreciation is to be distributed to Jim, the sole named beneficiary of the trust. Jim is entitled to the depreciation deduction to the exclusion of the trustee.

However, if the Trust’s Governing Instrument or local law requires or allows the trustee to maintain a reserve for depreciation in any amount, the deduction is first allocated to the trustee to the extent income is set aside for a depreciation reserve, and any part of the deduction in excess of the income set aside for the reserve is apportioned between the income beneficiaries and the trustee on the basis of the trust income (in excess of the income set aside for the reserve) allocable to each (Regulation Section 1.167(h)-1(b)).

For example, if under the trust instrument or local law the income of a trust is to be distributed to a named beneficiary, but the trustee is directed to maintain a reserve for depreciation in any amount, the deduction is allowed to the trustee (except to the extent that income set aside for the reserve is less than the allowable deduction). The result would be the same if the trustee sets aside income for a depreciation reserve pursuant to discretionary authority to do so in the governing instrument (Regulation Section 1.167(h)-1(b)(2)).

In the case of an estate, the allowable deduction is apportioned between the estate and the heirs, legatees, and devisees on the basis of income of the estate that is allocable to each (Regulation Section 1.167(h)-1(c)).

A taxpayer who is a tenant-shareholder in a cooperative housing corporation and uses his or her cooperative apartment in a business or for the production of income can depreciate his or her stock in the corporation, even though the corporation owns the apartment (Code Section 216(c)).

Property Used in Business or Income-Producing Activity: To claim depreciation on property, the taxpayer must use it in his or her business or income-producing activity. If the taxpayer uses property to produce income (that is, for investment purposes), depreciation is allowed only if the income from the property is taxable. No depreciation is allowed for property used solely for personal activities (Regulation Section 1.167(a)-2).

For example, a taxpayer cannot deduct depreciation on a car used only for commuting, personal shopping trips, family vacations, driving children to and from school, or similar activities.

To be depreciable, property acquired by a business must actually be used in the business (Steen v. Commissioner, 508 Federal Supplement 2nd 268 (5th Circuit 1975), affirming 61 Tax Court 298 (1973); Technical Advise Memorandum 9506002.

Example:

Joey Bagofdonuts buys a farm that he intends to operate as a business. Located on the farm property are a main house, a guest house, and a swimming pool and pool house. No one lives in the main house, guesthouse, or pool house, and Jack does not intend to use the buildings in operating the farm. Although the regulations provide that a reasonable allowance for depreciation may be claimed on farm buildings (except a dwelling occupied by the owner), farm machinery, and other physical property, the term “farm buildings” refers to buildings used in the business of farming and not merely buildings located on a farm. Thus, Joey Bagofdonuts cannot claim depreciation deductions for the main house, guest house, or pool house.

If property is used for both Business or Investment Purposes and personal purposes, the taxpayer can only deduct the portion of depreciation allocable to the business or investment use.

Compliance Tip: The taxpayer must keep Contemporaneous Records showing the business, investment, and personal use of the property.

Property with Determinable Useful Life of More Than One Year: Under pre-ACRS rules, to be depreciable, property had to have a determinable useful life. The concept of a property’s useful life means that the property being depreciated is something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes (Regulation Section 1.167(a)-1(a)). The “useful life” of property under pre-ACRS rules was the period over which the asset could reasonably be expected to be useful to the taxpayer in his or her trade or business, or in the production of his or her income (Massey Motors, Inc. v. United States, 364 United States 92 (1960); Fribourg Navigation Company v. Commissioner, 383 United States 272 (1966)).

ACRS introduced Accelerated Depreciation periods as a stimulus for economic growth. Under ACRS, the cost of an asset is recovered over a predetermined period unrelated to – and usually shorter than – the useful life of the asset. Moreover, the depreciation deductions do not assume consistent use throughout the asset’s life, instead assigning inflated deductions to the earlier years of use. Therefore, the purpose served by the determinable useful life requirement of the pre-ACRS scheme – allowing taxpayers to depreciate property over its actual use in the business – disappeared under the ACRS scheme.

There is some disagreement between the IRS and the courts as to the importance of a “Determinable” Useful Life.

In a pre-ACRS ruling, the IRS concluded that a valuable and treasured art piece did not have a determinable useful life. While the actual physical condition of the property may influence the value placed on the object, it will not ordinarily limit or determine the useful life. Thus, depreciation of works of art generally is not allowable (Revenue Ruling 68-232).

In Simon v. Commissioner, 68 Federal Supplement 3rd 41 (3d Circuit 1995), affirming 103 Tax Court 247 (1994), the Third Circuit upheld a Tax Court decision allowing depreciation deductions for violin bows, even though the musicians who owned the bows could not demonstrate that the bows had a determinable useful life. The IRS had argued that no depreciation deduction was appropriate since the useful lives of the bows were indeterminable because the bows were treasured works of art that appreciate in value. According to the IRS, the bows could only be depreciated under ACRS if the taxpayers proved the useful life of each bow under the law that applied before ACRS. The court cited the legislative history of the legislation that enacted ACRS, in concluding that, in addition to stimulating investment, Congress sought to simplify the depreciation rules by eliminating the need to adjudicate matters such as useful life and salvage value. Such matters, according to the court, are inherently uncertain and result in unproductive disagreements between taxpayers and the IRS. The court said that the IRS’s argument in Simon – that a taxpayer must first prove the useful life of personal property before he or she may depreciate it over a three-year or five-year period – would bring the courts back to pre-Economic Recovery Tax Act law and reintroduce the disagreements that the Congress intended to eliminate by its enactment of Economic Recovery Tax Act. In concluding that the taxpayers were entitled to depreciation deductions, the court said the musicians used the bows regularly in their trade and their use of the bows subjected the bows to substantial wear and tear. The Third Circuit reached a similar decision in Liddle v. Commissioner, 65 Federal Supplement 3rd 329 (3d Circuit 1995), affirming 103 Tax Court 285 (1994).

In Actions on Decisions-1996-009, the IRS took the position that the Simon and Liddle cases were wrongly decided. According to the IRS, the enactment of ACRS merely shortened the recovery period over which an asset is depreciated to stimulate economic growth but did not convert assets that formerly were not depreciable into assets that are depreciable. Thus, in the IRS’s view, to be depreciable under ACRS or MACRS, property must still have a determinable useful life.

While a taxpayer may or may not have to prove an asset’s useful life, an asset used in a trade or business must suffer exhaustion, wear and tear, or obsolescence in order to be depreciable. Thus, in Harrah’s Club v. United States, 661 Federal Supplement 2nd 303 (The United States Court of Federal Claims Reporter 1981), a business that displayed antique automobiles and kept them under near-ideal, humidity-controlled conditions, could not demonstrate the requisite exhaustion, wear and tear, or obsolescence necessary to depreciate the automobiles as recovery property. The court said there was no limit on the useful life of a restored car or other vehicle as a museum object and, with normal maintenance, the restored vehicles could have an indefinite life. Similarly, in Kilpatrick v. Commissioner, Tax Court Memo. 2016-166, the Tax Court held that a CPA wasn’t entitled to depreciation deductions for antique office furniture because it would retain its value.

In Associated Obstetricians and Gynecologists, P.C. v. Commissioner, 762 Federal Supplement 2nd 38 (1985), affirming Tax Court Memo. 1983-380, the Sixth Circuit affirmed the Tax Court and held that certain works of art displayed by the taxpayer in its medical offices were not subject to depreciation. The court found that artwork purchased as office ornamentation did not face exhaustion, wear and tear, or obsolescence in the business.

To be depreciable, property must have a Useful Life that extends substantially beyond the year it is placed in service.

Example:

Lizzy Bagofdonuts maintains a library for use in her medical practice. Liz can depreciate the library. However, she buys technical books, journals, or information services for use in her practice that have a useful life of one year or less, she cannot depreciate them. Instead, she deducts their cost as a business expense.

Leased Property: A taxpayer can depreciate leased property only if the taxpayer retains the incidents of ownership in the property – that is, the taxpayer bears the burden of exhaustion of the capital investment in the property. Therefore, if a taxpayer leases property from someone to use in the taxpayer’s trade or business or for the production of income, the taxpayer generally cannot depreciate its cost because he or she does not retain the incidents of ownership. The taxpayer can, however, depreciate any capital improvements he or she makes to the property (Revenue Ruling 57-361).

If a taxpayer leases property to someone, the taxpayer generally can depreciate its cost even if the lessee (the person leasing from the taxpayer) has agreed to preserve, replace, renew, and maintain the property (Alaska Realty Company v. Commissioner, 141 Federal Supplement 2nd 675 (6th Circuit 1944); Gulf, Mobile Northern Railroad Company v. Commissioner, 83 Federal Supplement 2nd 788 (5th Circuit 1936), Certiorari denied). However, if the lease provides that the lessee is to maintain the property and return to the taxpayer the same property or its equivalent in value at the expiration of the lease in as good condition and value as when leased, the taxpayer cannot depreciate the cost of the property (Royal St. Louis, Inc. v. United States, 578 Federal Supplement 2nd 1017 (5th Circuit 1978); Kern v. Commissioner, 432 Federal Supplement 2nd 961 (9th Circuit 1970)).

Example:

PropertyCorp leases a hotel to HotelCorp. Under the lease, PropertyCorp initially is to supply all furniture, appliances, carpets, draperies, silverware, china, glassware, kitchen utensils, fixtures and movable equipment for the bars, kitchen, restaurants, butcher and bakery shops, pantries and other movable fixtures and equipment required for the operation of the hotel. Under the lease Hotel is obligated to maintain and replace the furnishings and equipment in order to maintain them in “first class” condition. At the end of the lease, HotelCorp is required to return the furnishings and equipment to PropertyCorp in first class condition, subject to normal wear and tear. Under these facts, the lease exposes PropertyCorp to potential economic loss on the furnishings and equipment. Thus, PropertyCorp is entitled to depreciation deductions with respect to the furnishings and equipment.

Example:

The facts are the same as in the preceding example, except that the lease provides that at the end of the lease, HotelCorp is required to return the furnishings and equipment to PropertyCorp in the same condition as at the beginning of the lease, or its equivalent in value. Under these facts, PropertyCorp is fully protected the lessor from economic loss on the furnishings and equipment. Thus, PropertyCorp is not entitled to depreciation deductions with respect to the furnishings and equipment.

Under temporary regulations that apply to tax years beginning on or after January 1, 2014, capital expenditures made by either a lessee or lessor for the erection of a building or for other permanent improvements on leased property are recovered by the lessee or lessor under the provisions of the Code applicable to the cost recovery of building or improvements, if subject to depreciation or amortization, without regard to the period of the lease. For example, if the building or improvement is property to which Code Section 168 (that is, MACRS rules) applies, the lessee or lessor determines the depreciation deduction for the building or improvement under those provisions. If the improvement is property to which Code Section 167 or Code Section 197 applies, the lessee or lessor determines the Depreciation or Amortization Deduction for the improvement under those provisions, as applicable (Regulation Section 1.167(a)-4T(a); Code Section 168(i)(8)(A)).

Special rules apply to Leasehold Improvements placed in service after December 31, 1986, in tax years beginning before January 1, 2014. In such cases, a taxpayer may apply the above rules or depreciate any leasehold improvement to which Code Section 168 applies under the provisions of Code Section 168 and depreciate or amortize any leasehold improvement to which Code Section 168 does not apply under the provisions of the Code that are applicable to the cost recovery of that leasehold improvement, without regard to the period of the lease (Regulation Section 1.167(a)-4(b)(2)).

For leasehold improvements placed in service before January 1, 1987, the rules in Regulation Section 1.167(a)-4, in effect before January 1, 2012, apply (Regulation Section 1.167(a)-4(b)(3)).

Generally, a change to comply with the above rules for depreciable assets placed in service in a tax year ending on or after December 30, 2003, is a Change in Method of Accounting to which Code Section 446(e) and the related regulations apply. Generally, a taxpayer also may treat a change to comply with these rules for depreciable assets placed in service in a tax year ending before December 30, 2003, as a change in method of accounting to which the provisions of Code Section 446(e) and the related regulations apply.

Rent-to-Own Property: A taxpayer who is a rent-to-own dealer may be able to treat certain property held in its business as depreciable property rather than as inventory. A taxpayer is a rent-to-own dealer if:

(1) the taxpayer, in the ordinary course of its business, regularly enters into “Rent-to-own Contracts” for the use of “consumer property;”

(2) a substantial portion of these contracts end with the customer returning the property before making all the Payments Required to Transfer Ownership; and

(3) the property is Tangible Personal Property of a type generally used within the home for personal use (Revenue Procedure 95-38).

A Rent-to-Own Contract is any lease for the use of consumer property between a rent-to-own dealer and a customer who is an individual that:

(1) is titled “Rent-to-Own Agreement,” “Lease Agreement with Ownership Option,” or other similar language;

(2) provides a beginning date and a maximum period of time, not to exceed 156 Weeks or 36 Months from the beginning date, for which the contract can be in effect (including renewals or options to extend);

(3) provides for regular periodic (weekly or monthly) payments that can be either level or decreasing, and if the payments are decreasing, no payment can be less than 40 Percent of the Largest Payment;

(4) provides for total payments that generally exceed the Normal Retail Price of the Property plus Interest;

(5) provides for total payments that do not exceed $10,000 for Each Item of Property;

(8) provides that the customer has no right to sell, sublease, mortgage, pawn, pledge, or otherwise dispose of the property until all contract payments have been made (Revenue Procedure 95-38).

Consumer property is tangible personal property generally used in the home for personal use. It includes computers and peripheral equipment, televisions, stereos, camcorders, appliances, furniture, washing machines and dryers, refrigerators, and other similar consumer durable property. Consumer durable property does not include real property, aircraft, boats, motor vehicles, or trailers (Revenue Procedure 95-38).

For depreciation purposes, a Rent-to-Own Contract is treated as a lease rather than a sale, and the consumer products leased under the contract are subject to depreciation and are not treated as nondepreciable inventory (Revenue Ruling 95-52).

Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.

DON FITCH, CPA
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Palm Desert, CA 92260

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P.S. My firm is based upon referrals. Please feel free to refer my firm to anyone you know that is looking for a new CPA and/or tax preparer. Thank you in advance.

Property Subject to Depreciation
Property Subject to Depreciation
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