How Does Depreciation Cause a Reduction in Basis?

When a business invests in an asset, such as equipment or a building, it can deduct a portion of the asset’s cost over several years through depreciation. These deductions reduce the asset’s value for tax purposes, a concept known as its basis. This reduced value is referred to as the “adjusted basis,” which is the figure used to calculate gain or loss when the asset is eventually sold.

Determining an Asset’s Initial Basis

Before any depreciation can be calculated, you must determine the asset’s initial basis. For purchased property, the basis is its cost, which includes the purchase price and all ordinary and necessary expenses to get the asset ready for its intended use. These capitalized costs become part of the asset’s value rather than being deducted as a current business expense.

The total cost includes the cash paid, any debt you take on, and amounts paid for sales tax, freight, and installation or testing fees. For example, if a business buys a manufacturing machine for $50,000, pays $3,000 in sales tax, $1,500 for shipping, and $2,500 for installation and setup, the initial basis of that machine is $57,000.

The Mechanics of Basis Reduction from Depreciation

Each year a business claims a depreciation deduction for an asset, the basis of that asset is reduced by the amount of the deduction. The core of this mechanism is the “allowed or allowable” rule, which mandates that you must decrease the basis by the depreciation you were entitled to take, regardless of whether you actually claimed it on your tax return. For instance, if you were permitted to deduct $5,000 in depreciation for a business vehicle but forgot to claim it, you are still required to reduce the vehicle’s basis by that $5,000.

The formula is: Initial Basis minus Accumulated Depreciation equals the Adjusted Basis. Taxpayers use Form 4562, Depreciation and Amortization, to calculate and claim the annual depreciation deduction. The IRS provides procedures that may allow a taxpayer to file for a change in accounting method to claim depreciation that was allowable but not taken in a prior year. If you claimed more depreciation than you were entitled to, the basis is reduced by the amount that should have been claimed, plus the portion of the excess deduction that actually lowered your tax liability.

Calculating Gain or Loss on Sale

The difference between the amount you receive from a sale and the asset’s adjusted basis determines your taxable gain or loss. The calculation is the sale price minus the adjusted basis; a positive result is a taxable gain, while a negative result is a deductible loss. This calculation is reported to the IRS on Form 4797, Sales of Business Property.

Following the previous example, imagine the machine with an initial basis of $57,000. If the business claimed $25,000 in total depreciation over five years, its adjusted basis would be reduced to $32,000. If the machine is then sold for $40,000, the taxable gain is $8,000 ($40,000 – $32,000). This gain exists for tax purposes even though the sale price is less than what was originally paid for the asset.

A consideration in this calculation is depreciation recapture. The portion of the gain that results from the depreciation deductions you’ve taken is taxed at ordinary income rates, not the more favorable capital gains rates. In the example above, the entire $8,000 gain is due to depreciation, so it would be “recaptured” and taxed as ordinary income. If the machine had been sold for $60,000, the gain would be $28,000, of which $25,000 would be recaptured as ordinary income and the remaining $3,000 treated as a capital gain.

Other Events Causing a Reduction in Basis

While annual depreciation is the most common way an asset’s basis is reduced, it is not the only one. Several other events can require a downward adjustment to your basis. A reduction can occur if the property is damaged or lost due to a casualty or theft. The basis is reduced by the amount of any insurance reimbursement you receive and by any deductible loss that you claim on your tax return.

Taking certain tax credits can also lead to a basis reduction. For example, claiming a tax credit for a qualified electric vehicle may require you to reduce the vehicle’s basis by the amount of the credit. Similarly, deductions for making a property more accessible to individuals with disabilities or the elderly also decrease the basis.