How to Determine Depreciable Basis for an Asset

Depreciation allows a business to deduct an asset’s cost over its useful life. To claim this deduction, a business must establish the asset’s basis, which is the total investment value used to calculate annual depreciation. The rules for determining basis depend on how the asset was acquired and if its use changes over time.

Calculating the Initial Basis of an Asset

For a purchased asset, its initial basis is the total cost to obtain and prepare it for use. This includes the purchase price, less any discounts, plus costs like sales tax, freight charges, and installation fees. For example, if a business buys a machine for $10,000, pays $800 in sales tax, and incurs $200 in delivery fees, the depreciable basis is $11,000.

The acquisition method affects how the basis is determined. If an asset is inherited, its basis is its fair market value (FMV) on the date of the original owner’s death, which is known as a “stepped-up basis.” This adjusts the value to the current market, potentially increasing it from the original cost.

If an asset is received as a gift, the recipient’s basis for depreciation is the same as the donor’s adjusted basis. This amount is then increased by any gift tax paid on the net increase in the asset’s value.

Making Adjustments to Basis

An asset’s basis can change over its life. Increases result from capital improvements, which are investments that add to the asset’s value, prolong its useful life, or adapt it to new uses. For example, adding a new roof to a building is a capital improvement that increases the property’s basis.

Repairs and maintenance, like fixing a leaky pipe, are ordinary business expenses deducted in the year they occur and are not added to the basis. These activities keep an asset in normal operating condition but do not materially increase its value or extend its life.

The basis of an asset also decreases. Each year a business claims depreciation, the cumulative amount deducted is subtracted from the asset’s original basis, creating the “adjusted basis.” Other events can also lead to a decrease, such as deductions for casualty or theft losses or any insurance reimbursements received.

Allocating Basis Between Land and Building

When a business purchases real estate, the total cost must be divided between the land and the building. Land is not a depreciable asset because it has an indefinite useful life. Only the portion of the price assigned to the building can be depreciated over its recovery period, which is 27.5 years for residential rental property and 39 years for nonresidential property.

One method for allocating the basis is to use the property tax assessor’s valuation. The ratio of the assessed value of the land to the building is applied to the total purchase price. For instance, if an assessment values land at $50,000 and a building at $150,000, the building is 75% of the total value. If the property was purchased for $200,000, the building’s basis would be $150,000.

Another method is to obtain a formal appraisal from a qualified, independent appraiser. An appraisal can provide a detailed and defensible valuation for both the land and building components of the property.

Basis of Property Converted to Business Use

When personal property is converted to business use, its depreciable basis is the lesser of the property’s adjusted basis or its fair market value (FMV) on the conversion date. The adjusted basis is the original cost, while the FMV is its market value when placed in service. This rule prevents deducting any decline in value that occurred during personal use.

For example, if a car was purchased for personal use for $30,000 and is worth only $18,000 (its FMV) when converted to business use, the depreciable basis is $18,000. The $12,000 loss in value that happened while it was a personal asset cannot be recovered through business depreciation.

Conversely, if the same car’s FMV at the time of conversion was $32,000, the depreciable basis would be capped at its original adjusted basis of $30,000. A taxpayer cannot depreciate the appreciation that occurred during its personal use. This ensures depreciation is limited to the taxpayer’s cost investment.