 Hello and welcome to this session in which we will discuss the cost recovery concept or known to us in financial accounting as depreciation. Now when I say cost recovery, technically what it means is depreciation, but we use depreciation for financial accounting purposes, we use cost recovery for tax purposes, but they mean the same thing. So let's talk about depreciation first, since we are more comfortable with the term depreciation, if you are taking a tax course, it means you're ready to put your financial accounting and as a result, you are already familiar with the concept of depreciation. So what is depreciation? Well, I'm going to tell you what is not depreciation is not a decline in value. That's the first answer I get from my students when I ask them, what is depreciation? And I will wait until someone says it's a decline in value, the decline in fair market value. Well, that's market depreciation. That's not accounting depreciation. So what is accounting depreciation? Accounting depreciation is simply a form of a cost allocation to expense or cost reclassification from asset to expense. Well, let me go ahead and explain depreciation again from financial accounting purposes to kind of jot your memory because it's very important to understand the concept. Remember, cost depreciation is based on the matching principle. What are we matching? Well, let's start with a simple example. Let's assume we purchase a delivery vehicle, a delivery car and we paid $10,000. How do we treat this asset? How do we treat this vehicle? First, we are going to have an asset that's worth $10,000, basically the cost of this asset. And for the sake of simplicity, we're going to assume there is no salvage value. Then we're going to assume for financial accounting purposes, this asset would last us five years. So what we do is we'll divide $10,000 by five and we'll get an answer of 2000. What do we do? We're going to take this $2,000 every year from this asset. Remember, this is an asset. The car is an asset and expense, expense this $2,000 over a period of five years. So what did we do? We allocated the cost to expense or we reclassified the cost to expense. So every year, what's going to happen? $2,000 of the asset becomes an expense. This expense, we call it depreciation expense. Now, why did we allocate $2,000? Well, because we are assuming that this asset would service the company equally over five years. So we are matching the expense at the period that it's servicing over five years. Well, if you know the depreciation, we have many different type of depreciation method. I'm using here the straight line method. Now, so depreciation is the recovery of cost or business or income producing asset through deduction. So when it comes to taxes, it's the same concept except we are not doing any matching here. For tax purposes, we don't care about matching. What we care in taxes, we want to take the depreciation for the sole purpose of what? Of getting a deduction. We like deduction in taxes. Why do we like deduction? I know I'm going to repeat it. I'm going to be repeating myself because deduction, lower taxable income. What does that mean? Taxable income, lower our taxes. What does that mean? It's less money in our pocket, more money in our pocket, less money in the government pocket because we want to save on our taxes. Then we will take depreciation. That's why we like depreciation. So depreciation or cost recovery is the term that we use for tangible asset, what do we mean by tangible asset? Assets that we can see, we can touch computers, cars, furniture, office building. Those are actual asset you can touch, you can see. Then we have the term amortization. Amortization is the same concept. However, you are dealing with an intangible asset like a patent, a copyright. Then we have the term depletion. We use depletion for natural resources, a different type of assets. We don't depreciate them, we don't amortize them, we deplete them. Same concept. All these three terms are basically the same. They are a form of cost allocation to expense or a form of cost reclassification from an asset to an expense. Potato, potato, it's the same thing. So that's the concept of depreciation. Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. Now, how does depreciation or cost recovery affect our basis? So it's important to just kind of learn why depreciation is important. Well, for one thing, it's going to give us a tax deduction. True, but also depreciation will affect our tax basis. So depreciation gives you a deduction now, but it's going to reduce your basis. What does that mean? Remember the car that we purchased in the prior example? The car started at 10,000. After the first year, we took 2000 of depreciation. This 2000 of depreciation would reduce what we called in financial accounting, the book value to 8,000. Now for tax purposes, we call the 8,000 the basis. It reduces the basis. The basis was 10,000 initially. Then after the depreciation, it reduces the basis to 8,000. Now, in year two, we'll take another 2,000. We'll take another 2,000, and it's going to reduce the basis or the book value for financial accounting to 6,000. So as you are taking depreciation, you are enjoying the deduction, but you are reducing your basis. So what's going to happen in the future when you dispose of the asset? Let's assume just for the sake of illustration, after five years, the basis will be zero because you fully depreciate the asset. Now you're going to sell this asset for $3,000. Well, when you sell the asset for $3,000, your basis is zero because you used up all your basis. Therefore, the whole 3,000 will be a gain. So it's going to increase your gain when you dispose your asset. So simply put, once the depreciation is taken, it reduces your basis. How is that going to affect you when I sell the asset in the future? It's going to increase my gain. So it's subject to recapture. So eventually, when I sell it at a gain above the basis, some of that gain will be taxable. If I don't, it will be a recover of basis. If I don't sell it more than the basis, then I'm recovering my basis. It's called recover of asset. Now how do we compute the depreciation? We're going to take the basis of the asset, which is usually the first year is the cost. Time is a depreciation rate, some percentage, some depreciation rate. Where do we get this depreciation rate from? Don't worry, we're going to get to that in order to get depreciation expense. So the rate in contrast to financial accounting for tax purposes, the rate will be given to us, just give me a few minutes until I get to that slide to get the depreciation expense. And depreciation starts when the property is placed in service. Usually when the company buys an asset, they usually place it in service almost immediately. Now there's an important concept we need to understand for depreciation for tax purposes. That's a little bit different than financial accounting. The first is we need to differentiate between two types of property. We have realty property and we have personality property. I don't know if I'm pronouncing them right or wrong, but here's what's going to happen. Realty property, I'm going to call it real property and personality property, I'm going to call it personal property. So we have two types of property, real property and personal property. So we need to know what each one is. What is real property? Real property include land and buildings and anything that's permanently affixed to the land like a warehouse, an office building, a regular building, a rental building. These are real property. Means you cannot, they're not movable. Sometime another term that they use not movable means you cannot move them. You cannot move them. So what is personal property? Well easy. Anything that's not real property is personal property. Anything that's not real. This include furniture, machinery, equipment and many other assets, vehicles, computers, so on and so forth. Personal property should not be confused with the term that we were going to be using later. Personal use property. So notice the word use here. It's very important to understand the word use. Personal use is something totally different. Personal use is held for personal use rather than use in a trade or a business or any income producing activity. So what does that mean? Well I could have two cars. I could have this car and this car could be for personal use where I can go on vacation, take my family on vacation, just go to the grocery store, shop for personal use, so on and so forth. Or this same car could be used as a personal property which is for business purposes. So if it's a personal use property we don't, we don't depreciate personal use property because we cannot take a deduction for that. But if the same car could be used for business purpose then it's called personal property that's subject to depreciation. Now let's talk about briefly about converting a personal use asset to a business. So sometime you might have this vehicle, you borrow it, you are using it for personal use, then you switch from personal to business. This could happen. When the asset intended for personal use are repurposed. Repurposed means now it's used for business or income generating activities. The basis for the recovery or loss deduction, so now we need to depreciate this asset. How do we determine this? Or if we need to sell it, how do we determine the loss? We determine it by, by using the lesser of, you would look at the adjusted basis, how much you paid for it or the fair market at the time of the conversion. Because when you convert this car, let's assume I bought this car for, for the sake of illustration $25,000. And we're going to consider this my basis. By the time I converted this car from a personal use to a business use car, the value was $13,000. Well, I would use the lower of the two. I would start saying $13,000 and taken depreciation based on the $13,000. So tax recognition cannot be applied to losses incurred before. So I'm going to start basically saying this is my asset $13,000 starting to depreciate the asset and account for any losses down the road based on this basis. Now, a main difference between tax purpose depreciation or cost recovery and gap financial depreciation is the way we come up with that amount. For gap, remember for gap, we estimate. Estimate means we, we determine what's the life of the asset, how long it's going to service us if there's any salvage value or not, so on and so forth. Well, guess what IRS, the internal revenue service, which is the cost recovery system, you cannot use your own estimate. The government for personal asset, they have one, two, three, four, five, six classes of assets, three year asset, five year asset, seven year asset, 10 year, 15 and 20. So you cannot choose how many years, for example, an automobile service you. Okay, you cannot choose that. The IRS will tell you, for example, computers is a, it has a five year life. They will tell you now, what happened if you have an asset that's not listed? Well, for example, a computer, the closest thing to a computer is a tablet, I would say a tablet is a computer, therefore it's five years. If they don't have tablets specifically, or I can call the IRS and say, look, I have this asset, what's the closest thing to it? So the point you have to understand here is they will tell you what's the property class of the asset. That's one. Also, as I said, we have three, five, seven, 10, 15 and 20 years. We also have to know for the asset that are three, five, seven and 10 years, we would use the 200% double declining balance. What does that mean? If you remember the double declining balance from financial accounting, you will take one divided by the life of the asset times two, you'll get to the double, double, double base, double declining base, double declining base. You'll find the rate for that. For the asset that are 15 and 20 years asset, you will take one divided by the life and you multiply it by 150. You don't have to know the rules or the formulas because the IRS will give you the tables. So remember, three, five, seven and 10 years would use the 200% double declining balance, or declining balance, and the 15 and the 20 years they would use the 150 declining balance. Then we have to learn about convention. What convention do we use? Don't worry, I'm going to cover one of the convention here, but we either have the half a year convention or the mid-quarter convention. What are those? Just wait a few more minutes. On the next slide, we'll start to work with this. Now, the double declining balance is used with a switch to the straight line may be elected. So what does that mean? It means after you double declining balance, after it goes down, the double declining balance take more depreciation up front. Let's first look at the straight line. If we're talking about straight line, we have year one, year two, year three, year four. If we're using the straight line and let's assume the depreciation per year is 2000, go back to that original car. Every year is 2000 for five years. This is the straight line method because it's a straight line. It's the same amount every year. If we are using the double declining, the double declining, the depreciation will start high, then we'll go down. We'll go down quickly, but it will start high. You'll take more depreciation early on in the life of the asset. What they're saying is once you get to a point where straight line is greater than your figure, you could switch to the straight line. Just you need to know this. Why? They want you to max your depreciation. That's what they want you to do. Now, let's talk about the concept of half a year depreciation. Half a year depreciation is a convention and the rule is this. The general rule is for personal property, we assume it's a half a year convention unless it's not half a year. What does that mean? We assume that assets are put into service or disposed of in the middle of the year, irrespective, regardless of the time they were placed in service or disposed of. So what we assume is this. We assume then when the asset is purchased, so we have a year here. This is a year. We purchase an asset in February. We assume the asset was placed in service mid-year. Again, in a particular year we sold the asset in July. We assume it's sold mid-year, June 30th. So we assume this is the half a year convention. Purchase and place an asset in service on March 15th. If the tax year is December 31st, it's assumed as we placed it in service June 30th. Simply put, the first year will take a half a year. Six months of cost recovery in year one and six months of recovery in the other half of the year when we sell it. Let's work an example to see how this works. On March 23rd, John purchased an asset in the five-year class. This is the five-year class paying 100,000 and that's the only acquisition that John made. Determined the cost recovery deduction for X2 and X3. Now let's assume John sold the asset in X3. How much depreciation we will take. So how do we compute the depreciation? We're going to take 100,000 times a five-year asset. This is year one and it's 20% equal to 20,000. Hold on a second. If we look at the double declining balance, if we'll take one divided by five times two, the rate should be 40%. Why is the rate 20%? The rate is computed for you. Don't worry about this. Why? Because in the first year we assume it's a half a year. So that's why it's 20%. Don't worry. The IRS gave you the table. I'm just in case you're wondering why it's 20% and not 40% if I'm using the double declining 200 balance because the first year it's a half a year. The second year, how much depreciation do I take 100,000 times 32% which is 32,000. Whether I get the 32% here. Okay. So the first year they computed for you. Let's assume John sold the asset in 20x3. How much depreciation do we take in 20x3? 100,000 times 16%. Why 16%? 16% is half of 32. Remember the year that we sell the asset, we assume we sold it half in the middle of the year. Therefore, if it's in the middle of the year, we take half a year of depreciation, half a year of depreciation, half of 32 is 16. So don't worry. The IRS will make the adjustments. But remember, they only make the adjustments for the first year and the last year. So if you sell the asset in the middle of the other year, year two, three, four, and five, and why do we go to year six? Because we take half a year in year one and we'll catch up half a year in year six. In the other years, they're giving you a full year. So remember, if they're giving you a full year, you have to multiply the full year percentage by 50%. So I took 32% times 50% or times one half gave me the 16% which I used in case I sold the asset, in case John sold the asset in year X3. So this is the half a year convention. Is this the only convention? No, we have a half a year. We have a mid-quarter convention. We have to learn about this. So in the next session, this is what I would cover. But what should you do now? Go to Farhat Lectures, look at additional MCQs through false notes that's going to help you understand cost recovery or depreciation. The technical word is cost recovery for tax purposes. Good luck. Study hard. Invest in yourself whether you are a CPA candidate, enrolled agent or an accounting student and stay safe.