Knowing an asset's basis (which is often its cost with certain additions or subtractions) is critical in determining depreciation deductions and in establishing gain or loss when you dispose of it.
The cost of capital assets cannot be recovered in the year it is purchased (unless you are able to do so via bonus depreciation or the expensing election). Generally, you recover the cost of a capital asset over time, using depreciation deductions.
The first step in determining your depreciation deduction is to determine the depreciable basis of the asset. Different rules apply depending upon how you acquired the property.
Property acquired by purchase. The depreciable basis is equal to the asset's purchase price, minus any discounts, and plus any sales taxes, delivery charges, and installation fees.
For real estate, you can also include costs of legal and accounting fees, revenue stamps, recording fees, title abstracts/insurance, surveys, and real estate taxes assumed for the seller. Remember you can only depreciate the buildings—land is never depreciable.
Property acquired by gift. If you acquire property by gift, your depreciable basis is same as the donor's basis at the time of the gift.
Personal-use property converted to business use. If you convert personal property to business use, the basis will be the lower of:
- the fair market value at the time of the conversion, or
- the cost plus any additions or improvements, and minus any deducted casualty losses, up to the time of the conversion.
Allocation required for partially depreciable assets
If the purchase price of property included both depreciable property and non-depreciable property (for example, land and a building) or if you use the property for both business and personal use you are required to allocate the basis.
Land and building acquired in a single transaction. A business will frequently acquire both land and an office building. In these cases, only the portion of the price that is attributed to the building is depreciable.
Example: Raymond Johns buys a property for use in his auto repair business for $100,000. On the lot is a building that was formerly used as a gas station. Considering the size and location of the property, and the size and repair of the building, a fair allocation of the price paid for the property might be $70,000 for the building and $30,000 for the land.
In this example, the $70,000 paid for the building could be recovered through depreciation, while the $30,000 paid for the land could not, because land is not depreciable. But wouldn't it be better to allocate as much as possible to the building (say, $90,000), so Raymond's depreciation deductions would be larger and his tax bill would be lower?
Absolutely. But, you can expect the IRS to attack your allocation if it doesn't reflect economic reality.
If an IRS auditor raises objections, you may need to bring in a real estate appraisal to support the allocation you use. In some states, real estate tax bills will show a separate assessment of the buildings and the land on a piece of property, which can be useful evidence in an IRS audit.
Ideally, the allocation should have been made as part of the sales contract with which you originally acquired the property, and you should be prepared to prove that the allocation was a part of good faith negotiations between yourself and the seller.
Mixed-use property—personal use and business use. You must allocate basis if you have an asset that is used partly for business and partly for personal purposes, according to the percentage of business use. The allocation method, whether by percentage of space, by number of miles or by amount of time, varies based upon the type of asset.
For most business assets, the allocation would ordinarily be based on the amount of time you used the asset for business, compared to the amount of time you used it for personal or family purposes. (Special rules apply for determining the home office allocation and for allocating vehicle expenses.)
Example: Although you don't qualify for the home office deduction, you have a computer at home on which you keep a backup copy of your accounting records, and which you use for other business purposes in the evenings.
Your computer time log shows that you've spent approximately 10 hours per week on the computer for business reasons, and approximately 5 hours per week for other purposes. (Other members of your family do not use this computer.) Therefore, you can depreciate 2/3 of the cost of the computer.
Basis allocation required among multiple assets
If you acquire a number of assets at the same time (for example, you acquire a number of business assets in the course of buying a business), you need to allocate the purchase price among the various assets you purchased. The IRS provides special rules for doing this and these rules are tricky, so consult your tax adviser for more details.
Be aware of the need for basis adjustments
Your basis in an asset generally does not change over time. A different percentage is applied to the original basis calculation to determine each year's depreciation deduction.
Example: Benjamin bought a heat transfer machine for his tee-shirt design business. The machine cost $1,000 and he paid eight percent in sales tax. It cost $200 to deliver the item. The machine's depreciable basis is $1,280. this is the amount that will be recovered through depreciation over the life of the asset.
However, certain events, such as casualty losses, improvements or trade-ins can require you to make a basis adjustment.
Although the depreciable basis is usually the cost you incurred to acquire the property, you may need to make some basis adjustments, under these circumstances:
- Adjustments triggered by events. During the period you use the asset, you may have to adjust for additions or improvements, or casualty losses to the asset.
- Trade-in of the original asset. If you receive an asset in exchange for another, the basis of the new asset is related to the adjusted basis of the old asset.
If, like most taxpayers, you use the standard depreciation charts to compute your depreciation expense each year, your tax basis for the asset at the time you begin depreciating it will generally remain the same. You will multiply your original basis by a fraction that may change each year.
But in addition to the original basis of the asset, you may also need to know your adjusted basis if you sell, trade or dispose of the asset, or suffer a casualty loss.
Once you've claimed some depreciation on a piece of business property, the depreciation is deducted from the cost to arrive at the adjusted basis. It's important that you (or your accountant) keep capital asset records that include the amount of accumulated depreciation you've claimed for each asset over the years, so you can easily compute the adjusted basis when the need arises. These records should be retained as long as you own the asset.
Warning: Make sure you claim the proper amount of depreciation. The IRS will reduce your basis by the proper amount, so if you don't claim depreciation you will lose out twice. First, you will lose the benefit of the annual depreciation allowance. And, you will have a greater amount of gain on the sale because of the basis reduction.
Other events that can require an adjustment to the basis are casualty losses for which you've claimed a tax deduction, or additions or improvements to the property. You'll need to keep a record of these items, too, and save them until you eventually dispose of the property.
When you file your tax return, additions or improvements are treated like separate, depreciable assets that have the same depreciation period as the underlying property. However, when the underlying property is sold, any undepreciated value of the additions or improvements must be added to the asset's tax basis to compute your taxable gains.
Casualty losses reduce basis
Casualty loss deductions are subtracted from your adjusted tax basis in the property as of the year the loss occurred. Once you have a deductible casualty loss, you must use the new, adjusted basis of the property, instead of the original basis, for depreciation purposes. What's more, you can no longer use the tables to compute your depreciation expense. Instead, you'll have to use the actual formulas on which the tables are based. Consult your tax adviser or the IRS's free Publication 946, How to Depreciate Property, for details on how this is done.
Trade-ins will affect tax basis
If you trade in some business equipment that was used 100 percent for business, in exchange for new business equipment of the same asset category, the transaction will not be a taxable event because it will be treated as a "like-kind exchange."
However, the tax basis of the new equipment will be equivalent to the adjusted basis of the old equipment, plus any additional cash you paid for the new equipment. This tax basis represents the maximum amount you can claim as depreciation for the item, for tax purposes.
Vehicle trade-ins have special rules. If you trade in a vehicle that was used partly for business and acquire another vehicle that will be used in your business, you must use the following computation to determine the depreciable basis of the replacement vehicle. (If your old vehicle was acquired before June 18, 1984, consult your tax adviser for the proper method to use.)
The basis for figuring depreciation for the replacement vehicle is:
- the adjusted basis of the old vehicle, plus
- any additional amount paid for the replacement vehicle, minus
- the excess, if any, of the total amount of depreciation that would have been allowable during the years before the trade if 100 percent of the use of the vehicle had been business and investment use, over the total amounts actually allowable as depreciation during those years.
How to claim depreciation
Depreciation deductions are initially calculated using IRS Form 4562, Depreciation and Amortization>, and the totals are transferred to the return you use to report your business income and expenses (such as Form 1040, Schedule C).
If you're completing your own tax returns, you may want a little more detailed explanation of exactly how to report depreciation deductions.
In most cases, your depreciation deductions will be entered on IRS Form 4562, Depreciation and Amortization, and then the total amount will be carried to your Schedule C if you are a sole proprietor, or to Form 1120 for a C corporation, Form 1120S for an S corporation, or to Form 1065 for a partnership or LLC.
You must file a Form 4562 under these circumstances:
- for the first year you claim depreciation or amortization on any particular piece of property,
- for any year you claim a Section 179 expensing election (including an amount carried over from a previous year), and
- for every year you claim depreciation on a car, other vehicle, or any other type of listed property.
You don't have to file this form if you are simply claiming continued depreciation on property that is not considered listed property, or if you are claiming auto expenses based on the standard mileage rate.
Do not combine depreciation expenses for more than one business or investment activity on the same Form 4562. If you operate more than one business, or if you conduct some other type of activity for which you can deduct depreciation (e.g., you own some rental real estate that will be reported on Schedule E), you'll need to consider each activity's expenses separately in determining whether you need to file a Form 4562 for that business.
It's very common to include several Forms 4562 in the same tax return. Just be sure that, at the top of the form, you write the name of the business or activity to which that copy of the form relates, along with its employer identification number if you have one.
If you (and your spouse, if filing jointly) are filing more than one Form 4562, you should use one of the forms as a "master" and complete Part I on that form only. This section of the form computes your Section 179 expensing election and applies the dollar limit and since the limit applies "per taxpayer" rather than "per business activity," you need to total up all your elected amounts in one place.
Part V of the form relates to cars and other listed property and should generally be completed first. The total section 179 expensing election claimed for this type of property, if any, is entered on Line 29 and carried over to the front of the form to Line 7. The total bonus depreciation (referred to as the "special depreciation allowance" by the IRS) for all listed property is reported on Line 25. The total amount of bonus and regular depreciation on listed property is entered on Line 28 and is carried over to the front of the form to Line 21.
Once you've taken care of Part V of the form, you can go back and complete Part I, which helps you to compute your Section 179 expensing election for any new property placed in service during the year, or any carryover of an elected amount from previous years.
Then, complete Parts II and III for any new property other than cars and listed property placed in service during the year that were reported in Part V. Report bonus depreciation and other depreciation (excluding listed property reported in Part V) in Part II. In Part III, if you have more than one piece of property in an asset class (for instance, you purchased several pieces of office furniture which are considered seven-year property), your entry for column (c) in Part III will be the total basis for all items in the class, and your entry for column (g) will be the total depreciation deductions for all items in the class.
Part III asks you to total up your depreciation deductions for "old" property - that is, any property not first placed in service during the current tax year. The total for property placed in service in 1987 or later is entered on Line 17.
The grand total of your depreciation deductions are calculated on Line 22, and then carried over to the appropriate Schedule C (or other form).
Amortization deductions are treated separately, on Part VI of the Form 4562 (Lines 42-44). Once entered here, they are not added to the rest of your depreciation deductions. Instead, they are carried over as "other expenses" to your Schedule C, and must be listed separately on the back of that form. See our discussion of how to computer your amortization expenses, in the context of business startup expenses.