Can Depreciation Be Added to Cost Basis When Selling an Asset?
Understand how depreciation affects an asset's cost basis and what it means for taxes when selling. Learn key considerations for accurate reporting.
When selling an asset, determining the correct cost basis is essential for calculating capital gains taxes. Depreciation complicates this calculation by reducing the asset’s tax basis over time, potentially leading to unexpected liabilities. Understanding how depreciation affects the adjusted basis and tax obligations helps prevent surprises.
Assets Eligible for Depreciation
Depreciation applies to business and investment assets, allowing owners to recover costs over time. The IRS sets rules for different asset types, specifying depreciation methods and schedules.
Real Estate
Buildings used for business or rental purposes qualify for depreciation, but land does not. Residential rental properties are depreciated over 27.5 years using the straight-line method, while commercial properties follow a 39-year schedule. Improvements such as a new roof or HVAC system have separate recovery periods under the Modified Accelerated Cost Recovery System (MACRS).
Cost segregation studies can accelerate deductions by identifying components that qualify for shorter depreciation periods. For example, appliances and carpeting in a rental unit may be depreciated over five or seven years instead of 27.5 years. This strategy helps property owners maximize deductions while staying compliant with tax regulations.
Machinery and Equipment
Manufacturing machines, tools, and office equipment are depreciated based on useful life. Under MACRS, most machinery falls under a five- or seven-year schedule. Accelerated depreciation methods, such as the double-declining balance, allow larger deductions in the early years.
Section 179 permits businesses to deduct the full purchase price of qualifying equipment in the year it is placed in service, up to an annual limit of $1.22 million for 2024. Bonus depreciation, which was 100% for assets placed in service before 2023, is phasing out, with an 80% deduction allowed in 2024. These provisions help businesses manage taxable income and cash flow.
Vehicles
Business-use vehicles qualify for depreciation, though passenger vehicles face annual deduction limits. For 2024, the maximum first-year depreciation is $20,200 with bonus depreciation or $12,200 without it.
Heavy SUVs, trucks, and vans with a gross vehicle weight rating (GVWR) over 6,000 pounds may qualify for full expensing under Section 179, subject to the annual deduction limit. Business owners must maintain mileage logs to document business use, as personal use affects deductions and tax treatment upon sale.
Calculating the Adjusted Basis
The adjusted basis of an asset reflects its original cost, modified by depreciation, capital improvements, and certain ownership costs. This figure determines taxable gain or loss upon sale.
Depreciation lowers the adjusted basis each year. If a business buys equipment for $50,000 and claims $10,000 in depreciation over five years, the adjusted basis becomes $0. This reduction applies even if the asset’s market value differs.
Capital improvements, such as upgrading a building’s electrical system or adding an extension, increase the adjusted basis. If a property purchased for $300,000 undergoes $50,000 in improvements, the adjusted basis rises to $350,000, offsetting some depreciation effects.
Transaction costs also impact the adjusted basis. Legal fees, title insurance, and brokerage commissions paid at purchase are added to the initial cost, while similar expenses at sale reduce the amount realized, affecting capital gains tax liability.
Depreciation Recapture at Sale
When selling a depreciated asset, the IRS requires taxpayers to account for prior depreciation deductions. Depreciation recapture taxes the portion of the gain attributable to depreciation at ordinary income rates.
For real estate, Section 1250 of the Internal Revenue Code caps recapture tax at 25%. Business assets like equipment and vehicles fall under Section 1245, taxing recaptured depreciation at the seller’s marginal income tax rate.
If the sale price exceeds the adjusted basis but not the original purchase price, the gain is entirely due to depreciation recapture. If the sale price surpasses the original cost, the excess is treated as a capital gain, taxed at lower rates.
Strategies to reduce recapture tax include a Section 1031 like-kind exchange, which allows investment or business property to be swapped for similar property without immediate tax consequences. Installment sales, where payments are received over multiple years, can also spread tax liability, potentially keeping the seller in a lower tax bracket. Proper structuring is necessary to avoid triggering the full recapture amount in a single year.
Documenting Depreciation for Tax Purposes
Accurate records ensure compliance with IRS regulations and prevent errors during audits or asset sales. Form 4562, filed annually, reports depreciation expenses, detailing the asset’s description, date placed in service, depreciation method, and total deductions.
Supporting documents such as purchase invoices, financing agreements, and property tax assessments establish an asset’s original cost and ownership history. Depreciation schedules, maintained in accounting software or spreadsheets, track accumulated depreciation and adjusted basis calculations. For businesses using MACRS, maintaining records of asset classifications and recovery periods is essential to avoid miscalculations and penalties.