Cost Recovery, Depreciation, and Amortization
Introduction
Cost recovery allows a taxpayer to deduct the cost of business or income-producing property over its useful life. The primary system for tangible property is the Modified Accelerated Cost Recovery System (MACRS). Additional provisions — Section 179 expensing, bonus depreciation, and Section 197 amortization — accelerate or simplify cost recovery. This chapter also covers depletion of natural resources and the interplay between cost recovery and depreciation recapture.
MACRS Depreciation
Overview
MACRS applies to most tangible property placed in service after 1986. It assigns each asset a recovery period and a depreciation method based on the asset's class. MACRS has two subsystems:
| System | Name | When Used |
|---|---|---|
| GDS | General Depreciation System | Default for most property |
| ADS | Alternative Depreciation System | Required for listed property failing the business-use test, property used predominantly outside the U.S., tax-exempt bond-financed property, and any property for which the taxpayer elects ADS |
ADS uses the straight-line method over a longer recovery period. It is also required for computing earnings and profits (E&P) and, historically, for AMT depreciation adjustments.
Recovery Periods — GDS
| Recovery Period | Property Examples |
|---|---|
| 3-year | Tractor units, racehorses (2+ years old), qualified rent-to-own property |
| 5-year | Automobiles, light trucks, computers, office equipment, research equipment |
| 7-year | Office furniture, fixtures, agricultural machinery, any property without a designated class |
| 10-year | Water transportation equipment, single-purpose agricultural structures |
| 15-year | Land improvements (sidewalks, fences, parking lots), qualified improvement property (QIP) |
| 20-year | Farm buildings, municipal sewers |
| 27.5-year | Residential rental property (apartments, rental houses) |
| 39-year | Nonresidential real property (offices, warehouses, retail buildings) |
Example: Gies Co. purchases office furniture for $70,000 and a warehouse for $500,000. The furniture is 7-year MACRS property; the warehouse is 39-year MACRS property.
Depreciation Methods — GDS
| Property Type | Method |
|---|---|
| 3-, 5-, 7-, 10-year property | 200% declining balance switching to straight-line |
| 15- and 20-year property | 150% declining balance switching to straight-line |
| 27.5- and 39-year real property | Straight-line |
ADS Recovery Periods (Selected)
| Property | ADS Life |
|---|---|
| Automobiles | 5 years |
| Computers | 5 years |
| Office furniture | 10 years |
| Residential rental property | 30 years |
| Nonresidential real property | 40 years |
| Qualified improvement property | 20 years |
Depreciation Conventions
A convention determines how much depreciation is allowed in the year property is placed in service and the year it is disposed of.
Half-Year Convention (Default)
All property placed in service (or disposed of) during the year is treated as placed in service (or disposed of) at the midpoint of the year. The taxpayer receives half a year's depreciation in Year 1.
Mid-Quarter Convention
Applies when more than 40% of the total depreciable basis of all MACRS personal property placed in service during the year is placed in service in the last quarter (Q4). Under this convention, each asset is treated as placed in service at the midpoint of the quarter in which it was actually placed in service.
:::tip Exam Tip
The mid-quarter convention can help or hurt a taxpayer. Property placed in service in Q1 gets 10.5 months of depreciation, while Q4 property gets only 1.5 months. Watch for exam questions with large Q4 purchases that trigger this convention.
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Example: MAS Inc. places $30,000 of equipment in service in March and $50,000 in November. Since $50,000 / $80,000 = 62.5% was placed in service in Q4 (exceeding 40%), the mid-quarter convention applies to all assets placed in service that year.
Mid-Month Convention
Applies to real property (27.5-year and 39-year). Property is treated as placed in service at the midpoint of the month it is actually placed in service.
Example: Kingfisher Industries places a commercial building in service on March 8. Under the mid-month convention, depreciation begins on March 15 — the taxpayer claims 9.5 months of depreciation in Year 1 (mid-March through December).
Section 179 Expensing Election
Overview
IRC §179 allows a taxpayer to expense (immediately deduct) the cost of qualifying tangible personal property and certain improvements in the year placed in service, rather than depreciating it over multiple years.
Key Limits (2024 Approx.)
| Provision | Amount |
|---|---|
| Maximum §179 deduction | $1,220,000 |
| Investment ceiling (phase-out begins) | $3,050,000 |
| Phase-out | Dollar-for-dollar reduction after ceiling |
Qualifying Property
- Tangible personal property purchased for use in the active conduct of a trade or business.
- Off-the-shelf computer software.
- Qualified improvement property (QIP) — interior improvements to nonresidential real property.
- Certain improvements to nonresidential real property: roofs, HVAC, fire protection, alarm systems, and security systems.
Limitations
- Business income limitation — The §179 deduction cannot exceed the taxpayer's aggregate taxable income from all active trades or businesses. Any excess carries forward indefinitely.
- Dollar-for-dollar phase-out — When total qualifying property placed in service exceeds the investment ceiling, the maximum deduction is reduced dollar-for-dollar.
Example: BIF Partners places $3,100,000 of qualifying equipment in service. The excess is $3,100,000 − $3,050,000 = $50,000. The maximum §179 deduction is reduced to $1,220,000 − $50,000 = $1,170,000.
Section 179 is an election — it is not automatic. The taxpayer specifies which assets and how much cost to expense on the return. The election may be revoked only with IRS consent.
Bonus Depreciation (IRC §168(k))
Overview
Bonus depreciation allows taxpayers to deduct a percentage of the cost of qualifying new (and used, post-TCJA) property in the year placed in service, before regular MACRS depreciation.
Phase-Down Schedule
| Year Placed in Service | Bonus Rate |
|---|---|
| 2020 – 2022 | 100% |
| 2023 | 80% |
| 2024 | 60% |
| 2025 | 40% |
| 2026 | 20% |
| 2027+ | 0% |
Qualifying Property
- MACRS property with a recovery period of 20 years or less.
- Qualified improvement property (QIP).
- Computer software depreciable over 3 years.
- Water utility property.
- Certain film, television, and live theatrical productions.
Unlike §179, bonus depreciation has no taxable income limitation and no investment ceiling. It can create or increase a net operating loss.
Interaction With Section 179
When a taxpayer claims both §179 and bonus depreciation on different assets, the order of deductions is:
- Section 179 deduction first (subject to income limitation).
- Bonus depreciation on remaining eligible basis.
- Regular MACRS depreciation on any remaining basis.
Example: Illini Entertainment purchases $200,000 of studio equipment (5-year MACRS) in 2024. It elects to expense $50,000 under §179 and claims 60% bonus on the remaining $150,000. Bonus = $90,000. The remaining $60,000 is depreciated under regular MACRS. Year 1 total deduction: $50,000 + $90,000 + $12,000 (half-year, 200% DB) = $152,000.
Listed Property
Listed property includes assets susceptible to personal use, such as passenger automobiles, entertainment property, and computers (if not used exclusively at a regular business establishment). Special rules apply:
- If business use is 50% or less, the taxpayer must use ADS straight-line depreciation instead of MACRS and cannot claim §179 or bonus depreciation.
- Passenger automobiles are subject to annual depreciation caps (luxury auto limits).
Luxury Auto Depreciation Caps (2024 Approx.)
| Year | With Bonus | Without Bonus |
|---|---|---|
| Year 1 | $20,400 | $12,400 |
| Year 2 | $19,800 | $19,800 |
| Year 3 | $11,900 | $11,900 |
| Year 4+ | $7,160 | $7,160 |
:::tip Exam Tip
SUVs with a gross vehicle weight rating (GVWR) exceeding 6,000 pounds are exempt from the luxury auto caps but are subject to a $28,900 (2024) Section 179 limit. These are not considered passenger automobiles for cap purposes.
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Example: Illini Security purchases a sedan for $55,000 used 100% for business in 2024 and claims bonus depreciation. The Year 1 deduction is limited to $20,400 despite the full cost being eligible.
Amortization of Intangibles — Section 197
Overview
Section 197 intangibles are amortized ratably over 15 years (180 months) using the straight-line method beginning in the month of acquisition.
Qualifying Section 197 Intangibles
- Goodwill
- Going-concern value
- Covenants not to compete (acquired as part of a business)
- Customer lists, supplier relationships
- Franchises, trademarks, and trade names
- Patents and copyrights acquired as part of a business acquisition
- Workforce in place
- Licenses and permits granted by governmental units
Key Rules
- Self-created intangibles are generally not Section 197 property (e.g., internally developed patents are depreciated under their own rules or §167).
- A loss on disposition of a §197 intangible is not deductible if the taxpayer retains other §197 intangibles acquired in the same transaction — the disallowed loss is added to the basis of the retained intangibles.
Example: MSA Records acquires a competitor's business for $1,500,000. The allocation assigns $300,000 to a customer list (§197 intangible). Annual amortization = $300,000 / 15 = $20,000 per year.
Depletion
Depletion allows recovery of the cost of natural resources (oil, gas, minerals, timber) as they are extracted or harvested.
Cost Depletion
Cost depletion uses the formula:
(Adjusted basis of resource ÷ Estimated recoverable units) × Units sold during the year
Cost depletion is available to all taxpayers and reduces the basis of the resource.
Percentage Depletion
Percentage depletion applies a statutory percentage to gross income from the property. The deduction is limited to 50% of taxable income from the property (computed without the depletion deduction). For oil and gas, percentage depletion is generally available only to independent producers and royalty owners, not integrated oil companies.
| Resource | Percentage Rate |
|---|---|
| Oil and gas (independent producers) | 15% |
| Gold, silver, copper | 15% |
| Coal | 10% |
| Gravel, sand, stone | 5% |
Percentage depletion can exceed the adjusted basis of the property — it is not limited to cost basis. This distinguishes it from cost depletion.
Example: BIF Partners owns a sand quarry with gross income of $400,000 and taxable income (before depletion) of $180,000. Percentage depletion = 5% × $400,000 = $20,000. The 50%-of-income limit = 50% × $180,000 = $90,000. Since $20,000 is less than $90,000, the full $20,000 is allowed.
Depreciation Recapture — Conceptual Overview
When depreciable property is sold at a gain, part or all of the gain may be recharacterized as ordinary income rather than capital gain. The two main recapture provisions are:
| Section | Applies To | Recapture Rule |
|---|---|---|
| §1245 | Personal property (equipment, vehicles, furniture) | Gain is ordinary to the extent of all prior depreciation |
| §1250 | Real property | Gain is ordinary to the extent depreciation exceeded straight-line (rare post-1986); unrecaptured §1250 gain taxed at max 25% |
Since MACRS requires straight-line for real property, §1250 recapture is rare. However, the 25% rate on unrecaptured §1250 gain — the portion of gain attributable to straight-line depreciation — is frequently tested.
Example: Gies Co. sells office equipment with an original cost of $100,000 and accumulated depreciation of $65,000 (adjusted basis $35,000) for $80,000. Gain = $80,000 − $35,000 = $45,000. Under §1245, the gain is ordinary income to the extent of prior depreciation ($65,000). Since the gain ($45,000) is less than total depreciation, the entire $45,000 is ordinary income.
Summary
| Topic | Key Rule |
|---|---|
| MACRS GDS | 200% DB for 3–10 yr; 150% DB for 15–20 yr; SL for real property |
| Half-year convention | Default; half-year depreciation in Year 1 |
| Mid-quarter convention | Triggered when >40% of basis placed in service in Q4 |
| Mid-month convention | Real property; begins at midpoint of placed-in-service month |
| Section 179 | Expense up to $1,220,000; limited by business income |
| Bonus depreciation (2024) | 60%; no income limit; can create NOL |
| Listed property (under 50% business use) | Must use ADS straight-line |
| Section 197 intangibles | 15-year straight-line amortization |
| Cost depletion | Based on units extracted; limited to basis |
| Percentage depletion | Statutory % of gross income; can exceed basis |
| §1245 recapture | Ordinary income to extent of all prior depreciation |
| Unrecaptured §1250 gain | Taxed at maximum 25% rate |
The CPA exam tests cost recovery across multiple question formats. Be prepared to calculate depreciation for a specific asset given its class, convention, and method — and to determine the tax impact of disposition through recapture rules.