Question

Assignment 1: Depreciation and Nontaxable Property

Companies buy, use, and sell many types of property as a part of business operations. The amount involved can be substantial as can be the tax implications.

Based on your readings for the module, respond to the following:

Describe the purpose of depreciation (or cost recovery) deductions. Give an example of how it benefits a company.

Describe the requirements to qualify for a nontaxable exchange of property.

When might it be in the best interest of a company not to qualify for a nontaxable exchange treatment? Give an example to explain your answer.

Answer 1

Depreciation expense is the periodically allocated cost of an asset’s original purchase value over the service life of the asset. When companies place a fixed asset in operations for use over multiple years, they cannot expense the asset in one single period, but must depreciate the value of the asset over time and charge related cost allocation to depreciation expense. Using depreciation expense helps companies better match asset uses with the benefits provided by an asset.

Cost Recovery
Depreciation expense provides a way for recovering the purchase cost of an asset. Unlike asset expensing by which companies can recover the cost of an asset immediately, using asset depreciation, companies recover total asset cost over the useful life of the asset through periodic depreciation expense. Depreciation expense is a non-cash charge against revenue, which allows companies to set aside part of the revenue as funds for future asset replacement. Without charges of depreciation expense, the portion of revenue might have been inappropriately used for other purposes.

Tax Deduction
Depreciation expense helps companies generate tax savings. Tax rules allow depreciation expense be used as tax deduction against revenue in arriving at taxable income. The higher the depreciation expense, the lower the taxable income and, thus, the more the tax savings. In fact, sometimes companies use accelerated depreciation to charge higher depreciation expense in certain periods when they expect to have higher revenue to purposely lower taxable income and achieve tax saving

Certain exchanges of property are not taxable. This means that any gain from the exchange is not taxed, and any loss cannot be deducted. Your gain or loss will not be recognized until you sell or otherwise dispose of the property you receive.

Like-Kind Exchanges
The exchange of property for the same kind of property is the most common type of nontaxable exchange. To be a like-kind exchange, the property traded and the property received must be both:

Qualifying property, and
Like property.
These two requirements are discussed later.
Additional requirements apply to exchanges in which the property received is not received immediately upon the transfer of the property given up. See Deferred Exchanges, later.

If the like-kind exchange includes the receipt of money or unlike property or the assumption of your liabilities, you may have a taxable gain. See Partially Nontaxable Exchanges, later.

Multiple-party transactions. The like-kind exchange rules also apply to property exchanges that involve three- and four-party transactions. Any part of these multiple-party transactions can qualify as a like-kind exchange if it meets all of the requirements described in this section.

Receipt of title from third party. If you receive property in a like-kind exchange and the other party who transfers the property to you does not give you the title but a third party does, you may still treat this transaction as a like-kind exchange, if it meets all the requirements.

Basis of property received. If you acquire property in a like-kind exchange, the basis of that property is the same as the basis of the property you transferred.

For the basis of property received in an exchange that is only partially nontaxable, see Partially Nontaxable Exchanges, later.

Example. You exchanged real estate held for investment having an adjusted basis of $25,000 for other real estate held for investment. The FMV of both properties is $50,000. The basis of your new property is the same as the basis of the old ($25,000).