What Is Depreciation Basis and How Is It Calculated?

An asset’s depreciation basis is the value used for tax purposes to calculate annual depreciation deductions and determine the gain or loss upon its sale. This figure represents your total investment in the property and serves as a starting point. The basis will be adjusted over the asset’s life due to events like improvements or deductions.

Determining Your Initial Basis

The initial basis of a purchased asset is its purchase price plus all costs required to place it into service. These additional costs, often called costs of acquisition, are important components of the final basis. Forgetting to include them can result in an understated basis and smaller depreciation deductions.

Costs included in the initial basis extend beyond the sticker price. You should add any sales tax, freight and shipping charges, and fees for installation or testing. For real estate, this can also encompass legal and accounting fees, recording fees, surveys, and transfer taxes.

For example, if a machine’s price is $50,000, and you pay $3,000 in sales tax, $1,500 for delivery, and $2,500 for installation, your initial basis is not $50,000. You would add these costs for a total initial basis of $57,000 ($50,000 + $3,000 + $1,500 + $2,500). This is the amount you will use to begin calculating depreciation.

Some costs are not included in the initial basis. Expenses for routine maintenance or repairs are treated as regular operating expenses that can be deducted in the year they are incurred. Costs associated with obtaining a loan to purchase the property are also not included in the asset’s basis.

Basis for Non-Purchased Assets

Property Converted from Personal to Business Use

When you convert property from personal to business use, a specific rule applies for determining its basis for depreciation. The basis is the lesser of the property’s fair market value (FMV) or its adjusted basis on the date of conversion. Your adjusted basis is your original cost, plus improvements, minus any casualty losses you deducted. This rule prevents taxpayers from claiming depreciation on a personal loss in value that occurred before the asset was used for business.

Inherited Property

For inherited property, the basis is the fair market value (FMV) of the asset on the date of the original owner’s death. This is called a “stepped-up” basis because the value is adjusted to the current market, which can forgive income tax on appreciation during the owner’s lifetime. An alternative valuation date, six months after death, can sometimes be used by the estate’s executor. If a federal estate tax return is not required, the basis is the property’s appraised value for state inheritance taxes.

Gifted Property

When you receive an asset as a gift, the rule for determining your basis depends on whether you sell it for a gain or a loss. To figure a gain, you use the donor’s adjusted basis at the time of the gift, known as a “carryover basis.” To figure a loss, you use the lesser of the donor’s adjusted basis or the asset’s FMV when the gift was given. This prevents transferring a built-in loss from the donor to the recipient.

Calculating Adjusted Basis

The initial basis of an asset is not static; it changes over the asset’s life to become the “adjusted basis.” This figure is calculated by starting with the initial basis and making upward or downward adjustments. Keeping accurate records of these adjustments is necessary for calculating annual depreciation and determining the final gain or loss when you dispose of the property.

Basis increases when you make capital improvements, which are expenditures that add to the asset’s value, prolong its useful life, or adapt it for a new use. For example, replacing the engine in a delivery truck is a capital improvement that increases the basis. In contrast, a routine oil change is a repair that would be deducted as a business expense without affecting the basis. Assessments for local improvements like paving roads can also increase basis.

An asset’s basis decreases for several reasons, most commonly due to depreciation deductions. Each year, you must reduce the basis by the amount of depreciation you deducted or could have deducted. Other events that decrease basis include deductions for casualty or theft losses and any insurance reimbursements for such losses. An asset’s basis can never be adjusted below zero.