Calculating Cost Basis and Depreciation
Learn the principles for establishing an asset's tax value, from its initial cost to the adjustments that determine the final gain or loss upon its sale.
Cost basis is the total investment in an asset for tax purposes, including its purchase price and other acquisition costs. Depreciation is the method used to deduct an asset’s cost over its useful life. Understanding both concepts is fundamental for business or investment property owners to ensure the correct gain or loss is recognized upon sale and that annual tax deductions are claimed correctly.
Determining the Initial Cost Basis of an Asset
The initial cost basis is the total amount invested to acquire an asset and place it into service, not just its sticker price. For business equipment, this includes the purchase price plus costs like sales tax, freight, installation, and testing fees. For example, if a business buys a machine for $50,000, pays $3,000 in sales tax, $1,000 for delivery, and $2,000 for installation, the initial cost basis is $56,000.
For real estate, the basis begins with the contract price and includes settlement fees like legal and recording fees, abstract fees, surveys, and title insurance. Costs like prorated property taxes are not added to the basis and are instead deducted as an expense. Improvements and repairs also affect the basis differently. An improvement adds value, prolongs the property’s life, or adapts it to new uses, and is added to the cost basis, such as a new roof. A repair just keeps the asset in operating condition and is a deductible expense.
The acquisition method also determines the basis. For an inherited asset, the basis is “stepped-up” to its fair market value on the date of the previous owner’s death. If an asset is received as a gift, the recipient’s basis is the same as the donor’s adjusted basis at the time of the gift.
Calculating the Depreciable Basis
After establishing the initial cost basis, the next step is to find the depreciable basis, which is the portion of the cost that can be depreciated. This figure is often different from the initial cost basis, especially for real estate. The most significant adjustment is excluding the value of land, which cannot be depreciated because it does not wear out.
A common way to allocate the cost between land and the building is by using the property’s assessed values from the local tax assessor. If the tax assessor values a property at $400,000 for the building and $100,000 for the land, then 80% of the total purchase price would be allocated to the building as its depreciable basis.
For assets used for both business and personal reasons, only the business-use percentage can be included in the depreciable basis. If a vehicle is used 70% for business, only 70% of its initial cost basis can be depreciated.
Applying Depreciation Methods
For most tangible property placed in service after 1986, the IRS requires using the Modified Accelerated Cost Recovery System (MACRS). MACRS categorizes assets into classes, each with a recovery period over which the cost is deducted. For example, computers are 5-year property, office furniture is 7-year property, and residential rental properties have a 27.5-year recovery period.
MACRS uses specific methods, like the 200% declining balance method for larger early-year deductions, and the straight-line method, which spreads the deduction evenly over the recovery period. The system also uses conventions, like the half-year convention. This treats all property as placed in service mid-year, regardless of the purchase date, meaning the first-year deduction is for half a year. To simplify calculations, the IRS provides percentage tables in Publication 946 that combine the method, recovery period, and convention.
For a $10,000 piece of 7-year property subject to the half-year convention, the first-year depreciation rate is 14.29%, for a deduction of $1,429. In the second year, the rate is 24.49%, resulting in a deduction of $2,449.
Businesses may also use special provisions to accelerate deductions. The Section 179 deduction allows a business to expense the full purchase price of qualifying equipment in the year of purchase, up to a limit. For 2025, the maximum Section 179 deduction is $1,250,000, with a phase-out threshold for total equipment purchases of $3,130,000. Bonus depreciation is another provision for an additional first-year deduction; for 2025, it is 40% of the qualifying property’s cost.
Understanding Adjusted Basis and Depreciation Recapture
Depreciation deductions directly impact an asset’s basis, which is relevant when the asset is sold. An asset’s initial basis is reduced by the cumulative depreciation taken, resulting in the “adjusted basis.” This new value is used to calculate the taxable gain or loss upon sale.
When a depreciable asset is sold for more than its adjusted basis, a gain is realized. Part of this gain may be subject to “depreciation recapture,” a rule that reclaims the tax benefit from prior depreciation deductions. The part of the gain attributable to the depreciation claimed is taxed at ordinary income rates, not the more favorable long-term capital gains rates. For real estate, recapture on straight-line depreciation is taxed at a maximum rate of 25%.
Consider an asset purchased for $50,000. Over several years, $30,000 in depreciation deductions are taken, reducing the adjusted basis to $20,000 ($50,000 – $30,000).
The asset is then sold for $60,000, resulting in a total gain of $40,000 ($60,000 sale price – $20,000 adjusted basis). The first $30,000 of this gain, equal to the total depreciation taken, is “recaptured” and taxed as ordinary income. The remaining $10,000 of the gain is treated as a capital gain.