The following Types of Property Cannot be Depreciated:
(1) Inventory;
(2) Land;
(3) Property Not Subject to Wear and Tear, decay, obsolescence, or loss in value;
(4) Certain Nondepreciable Term Interests; and
(5) Other Nondepreciable Property.
Nondepreciable Inventory: Depreciation deductions are not available for inventory or stock in trade (Vidcam v. Commissioner, Tax Court Memorandum 1969-207; Regulation Section 1.167(a)-2).
It is not always clear whether Property is Held for Sale (inventory) or for use in the taxpayer’s business. In such cases, all the facts in the operation of the particular business must be examined.
A taxpayer engaged in the trade or business of selling motor vehicles is presumed to hold all such vehicles primarily for sale to customers in the ordinary course of the taxpayer’s trade or business (that is, as Nondepreciable Inventory).
To overcome this presumption, the taxpayer must show clearly that the motor vehicle was actually devoted to use in the business of the dealer and that the dealer looks to consumption through use of the vehicle in the ordinary course of business operation to recover the dealer’s cost. A vehicle is not property used in the business if it is used merely for demonstration purposes, or Temporarily Withdrawn from Stock in Trade or Inventory for business use (DuVal Motor Co. v. Commissioner, 264 Federal Supplement 2nd 548 (5th Curcuit 1959), affirming 28 Tax Court 42 (1957); Revenue Ruling 75-538).
Example:
BagofDonuts Corporation is in the business of leasing cars. At the end of their useful lives, when the cars are no longer profitable to lease, BagofDonuts Corp sells them. BagofDonuts Corp does not have a showroom, used car lot, or individuals to sell the cars. Instead, it sells them through wholesalers or by similar arrangements in which a dealer’s profit is not intended or considered. BagofDonuts Corp can depreciate the leased cars because the cars are not held primarily for sale to customers in the ordinary course of business, but are leased.
Example:
BagofDonuts Corp buys cars at wholesale prices, leases them for a short time, and then sells them at retail prices or in sales in which a Dealer’s Profit is intended. The cars are treated as inventory and are not depreciable property. The cars are held primarily for sale to customers in the ordinary course of business.
Similarly, where a home builder or developer temporarily uses certain homes as models and/or sales offices to assist in its sales activities, but expects to sell the houses in the same manner as it had been selling its other houses, such homes are essentially nondepreciable inventory (Revenue Ruling 89-25).
Example:
BagofDonuts Corp is in the business of building and selling residential houses. To assist in its sales activity, BagofDonuts Corp uses certain houses as models and/or sales offices temporarily (that is, for a small fraction of their expected useful life). This use generates no rental income to BagofDonuts Corp. During the period of that use, BagofDonuts Corp makes no effort to sell those houses. However, after this period of use, BagofDonuts Corp expects to sell the houses in the same manner as it has been selling its other houses. The essential purpose for which the houses were built — sale to customers — was never altered. Thus, although the houses were used temporarily as models and/or sales offices, and although BagofDonuts Corp may have been reluctant or unwilling to sell the houses while they were being used in this way, they remained property held by BagofDonuts Corp primarily for sale to customers in the ordinary course of its business (that is, as inventory) rather than property used in the Trade or Business. Thus, they may not be depreciated.
The IRS has invited comments on whether construction and agricultural equipment held simultaneously for sale or lease to customers (“Dual Use Property“) by a dealer in such equipment is properly treated as inventoriable property or as depreciable property (Notice 2013-13). Among the items on which the IRS has requested comments are the following list of factors that the IRS has previously considered to be relevant in determining whether construction and agricultural dual-use property is inventoriable or depreciable property:
(1) the dealer’s prior business experience with Dual Use Property, including the proportion of the dealer’s total dual-use property that is leased and the number of times the same property is leased or re-leased by the dealer before disposition;
(2) whether Dual Use Property may be leased (or held for subsequent lease) for a period exceeding its recovery period for depreciation purposes;
(3) the proportion of annual lease revenue to total revenue, the proportion of annual lease revenue to revenue from sales of leased property, and the proportion of revenue from sales of leased property to annual sales revenue;
(4) whether lease agreements customarily allow the dealer to terminate the lease and reacquire the property at any time without penalty (and, if so, the frequency with which the dealer exercises this option);
(5) for lease agreements that provide a Purchase Option, the frequency with which the lessee exercises this option and whether the lessee receives a price reduction;
(6) the manner in which Dual Use Property is typically disposed of (for example, sold to a lessee, sold at auction, or sold through a third-party); and
(7) the dealer’s initial classification of Dual Use Property (as inventoriable or depreciable property) for federal income tax and financial accounting purposes (Notice 2013-13).
Generally, Containers for the Products a Taxpayer Sells are Part of Inventory and the taxpayer cannot depreciate them. However, a taxpayer can depreciate containers used to ship its products if they have a life longer than one year, they qualify as property used in the taxpayer’s business, and title to the containers does not pass to the buyer on the sale of the product.
An arrangement under which customers forfeit a deposit for failing to return a container does not make the container inventory where the primary purpose of this arrangement is to secure return of the container (Philadelphia Quartz Co. v. United States, 374 Federal Supplement 2nd 512 (The United States Court of Federal Claims Reporter 1967); Revenue Ruling 75-34).
Example:
BagofDonuts Corp manufactures cable that is sold to customers on steel reels that have a useful life of eight years. The customers are required to make a refundable deposit for the reels. BagofDonuts Corp’s contracts provide that if the reels are not returned within one year from the invoice date, title will pass to the customer and BagofDonuts Corp will retain the deposit as the agreed sales price for the reels. BagofDonuts Corp has capitalized its cost of the reels and maintains adequate records reflecting depreciation and other factors necessary in computing gain or loss on the sale of the reels. BagofDonuts Corp’s experience is that most of the reels are returned by the customers within the one-year period. Under these facts, the reels – including those that are “sold” – are depreciable property used in BagofDonuts Corp’s trade or business. Any gain or loss recognized by BagofDonuts Corp as a result of retaining customers deposits, because of nonreturn of the containers within the one-year period, is to be treated in accordance with the provisions of Code Section 1231(a) subject to the recapture provisions of Code Section 1245.
Nondepreciable Land: Depreciation deductions are not available for land, apart from the improvements or physical development added to it, because land does not wear out, become obsolete, or get used up (Regulation Section 1.167(a)-2).
The cost of land generally includes the cost of clearing, grading, planting, and landscaping. Thus, such costs generally are not depreciable. However, a taxpayer can depreciate certain land preparation costs, such as landscaping costs, incurred in preparing land for business use. To be depreciable, these costs must be so closely associated with other depreciable property that the taxpayer can determine a life for them along with the life of the associated property. A taxpayer can establish a useful life for land preparation if it the preparation will be replaced contemporaneously with a related depreciable asset (Revenue Ruling 72-96).
Whether land preparation will be replaced contemporaneously with a related depreciable asset is a question of fact, but if the replacement of the asset will require the physical destruction of the land preparation, this test will be considered satisfied (Revenue Ruling 74-265).
Example:
Joey BagofDonuts constructed a new building for use in his business and paid for grading, clearing, seeding, and planting bushes and trees. Some of the bushes and trees were planted right next to the building, while others were planted around the outer border of the lot. If Joey replaces the building, he would have to destroy the bushes and trees right next to it. These bushes and trees are closely associated with the building, so they have a determinable useful life. Therefore, Joey can depreciate them. Joey must add his other land preparation costs to the basis of the land because they have no determinable life and he cannot depreciate them.
Space in, on, or above land may constitute a property right that is separate from the land itself and as such may qualify for depreciation (Sexton v. Commissioner, 42 Tax Court 1094 (1964)). Thus, for example, taxpayers have been allowed to depreciate space consumed in the operation of a garbage dump on land purchased for that purpose (Sanders v. Commissioner, 75 Tax Court 157 (1980); Browning-Ferris Industries, Inc. v. Commissioner, Tax Court Memorandum 1987-147).
Property Not Subject to Wear and Tear, Decay, Obsolescence, or Loss in Value: Property not subject to wear and tear, decay, obsolescence, or loss in value from natural causes is not subject to depreciation. Further, the allowance for depreciation is limited in the case of tangible property to that part of the property that is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence. Thus, if an identifiable part of property used in a trade or business is recoverable – and is reasonably expected to be recovered – without loss of utility, the cost of that part is economically recoverable and does not enter into the depreciation allowance. In that case, the nonwasting part is accounted for separately from the wasting part (Regulation Section 1.167(a)-2).
If a part of an item of property represents more than half of the total cost of the item and that part is economically recoverable for reuse without a loss of utility, separate accounting treatment is necessary to clearly reflect income even though the recoverable part may have been “fabricated” (either by itself or with other materials) into an item of property with a determinable service life. Thus, economically recoverable precious metals fabricated into items used in a taxpayer’s trade or business are not depreciable if their cost is more than half the total cost of the item into which they are fabricated (Revenue Ruling 90-65).
Example:
Amy BagofDonuts is a contract jeweler who Fabricates Jewelry to customers’ specifications, using gold supplied by the customers. Amy does not maintain an inventory of gold or completed jewelry, but to assist customers she fabricates and maintains gold sample jewelry showing currently available styles. Amy’s samples are not held for sale. The cost of the gold used in each item of sample jewelry represents more than 50 percent of the total cost of the item. Every three years, Amy melts down the sample jewelry, recovering 100 percent of the gold content of the jewelry. For Amy’s purposes, the recovered gold is indistinguishable from gold that has not previously been used in sample jewelry, and she reuses it in fabricating new sample jewelry.
Amy’s costs associated with acquiring the gold and the fabrication of the jewelry must be capitalized. The Capitalized Cost of the gold represents more than half of the total cost of the sample jewelry. It is economically feasible to recover the gold from the sample jewelry, and, once recovered, the gold is usable in Amy’s business in a manner that is indistinguishable from the use of gold that had never been fabricated, used, and recovered. The utility of the gold does not diminish as a result of its fabrication into sample jewelry. Thus, it is not subject to exhaustion, wear and tear, or obsolescence, and is not depreciable.
In contrast, the platinum in a car’s catalytic converter is not accounted for separately because its cost does not represent more than half of the total cost of the car (Revenue Ruling 90-65).
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.
Certain Nondepreciable Term Interests: A taxpayer cannot depreciate a term interest in property created or acquired after July 27, 1989, for any period during which the remainder interest is held, directly or indirectly, by a person related to the taxpayer (Code Section 167(e)(1)).
A term interest in property means a life interest in property, an interest in property for a term of years, or an income interest in a trust (Code Sections 167(e)(5)(A), 1001(e)(2)).
For purposes of the Term Interest Rule, the following are related persons:
(1) an individual and a member of his or her family, including only a spouse, child, parent, brother, sister, half-brother, half-sister, ancestor, and Lineal Descendant;
(2) a corporation and an individual who directly or indirectly owns more than 50 Percent of the Value of the Outstanding Stock of that corporation;
(3) two corporations that are members of the same Controlled Group;
(4) a trust fiduciary and a corporation if more than 50 Percent of the Value of the Outstanding Stock is directly or indirectly owned by or for the trust or grantor of the trust;
(5) the grantor and fiduciary, and the Fiduciary and Beneficiary, of any trust;
(6) the fiduciaries of two different trusts, and the Fiduciaries and Beneficiaries of Two Different Trusts, if the same person is the grantor of both trusts;
(7) a Tax Exempt Educational or Charitable Organization and any person (or, if that person is an individual, a member of that person’s family) who directly or indirectly controls the organization;
(8) two S corporations, and an S corporation and a regular corporation, if the same persons own more than 50 Percent of the Value of the Outstanding Stock of each corporation;
(9) a Corporation and a Partnership if the same persons own both of the following.
(a) more than 50 Percent of the Value of the Outstanding Stock of the corporation.
(b) more than 50 Percent of the Capital or Profits interest in the partnership; and
(10) the executor and beneficiary of any estate (Code Section 167(e)(5)(B)).
If the taxpayer would be allowed a depreciation deduction for a term interest in property except that the holder of the remainder interest is related to the taxpayer, the taxpayer generally must reduce its basis in the term interest by any depreciation or amortization not allowed (Code Section 167(e)(3)(A)).
If the taxpayer holds the remainder interest, the taxpayer generally must increase its basis in that interest by the depreciation not allowed to the term interest holder (Code Section 167(e)(3)(B)).
However, the taxpayer does not increase its basis for depreciation not allowed for periods during which either the term interest is held by a tax-exempt organization, or the term interest is held by a nonresident alien individual or foreign corporation and the income from the term interest is not effectively connected with the conduct of a trade or business in the United States (Code Section 167(e)(4)(A)).
The rules on nondepreciable term interests do not apply to the holder of a term interest in property acquired by gift, bequest, or inheritance (Code Section 167(e)(2)(A)). They also do not apply to the holder of dividend rights that were separated from any stripped preferred stock if the rights were purchased after April 30, 1993, or to a person whose basis in the stock is determined by reference to the basis in the hands of the purchaser (Code Section 167(e)(2)(B)).
Other Nondepreciable Property: Depreciation does not apply to natural resources that are subject to the allowance for depletion (Regulation Section 1.167(a)-2).
No deduction for depreciation is allowed on Automobiles or Other Vehicles used solely for pleasure, on a building used by the taxpayer solely as his residence, or on furniture or furnishings therein, personal effects, or clothing.
However, properties and costumes used exclusively in a business, such as a theatrical business, may be depreciated (Regulation Section 1.167(a)-2).
In addition, a Taxpayer Cannot Depreciate the following property:
(1) Property Placed in Service and Disposed of in the Same Year.
(2) Equipment used to build capital improvements. Under the uniform capitalization rules, the taxpayer must add otherwise allowable depreciation on the equipment during the period of construction to the basis of the improvements (Regulation Section 1.263A-10(b)(4)).
(3) Code Section 197 Intangibles. The taxpayer must amortize these costs. Intangible property, such as certain computer software, that is not Code Section 197 intangible property, can be depreciated if it meets certain requirements.
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
74478 Highway 111 #3
Palm Desert, CA 92260
Toll Free: (877)CPA-Help or (877)272-4357
Cell: (760)567-3110
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Email: DonFitchCPA@paylesstax.com
Website: https://www.paylesstax.com
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.
(Updated 06172021-1 94-103)