Overview of Depreciation

The first part of this chapter gives you basic information on what property can be depreciated, when depreciation begins and ends, whether MACRS can be used to figure depreciation, what the basis of your depreciable property is, and how to treat improvements. It also explains whether you must file Form 4562 and how you can correct depreciation claimed incorrectly.

What Property Can Be Depreciated?

You can depreciate most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment. You can also depreciate certain intangible property, such as copyrights, patents, and computer software. To be depreciable, the property must meet all the following requirements.

• It must be property you own.
• It must be used in your business or income-producing activity.
• It must have a determinable useful life.
• It must be expected to last more than one year.
• It must not be excepted property.

The following discussions provide information about these requirements.

Property You Own

To claim depreciation, you usually must be the owner of the property. You are considered as owning property even if it is subject to a debt.

Leased property. You can depreciate leased property only if you retain the incidents of ownership for the property (explained later). This means you bear the burden of exhaustion of the capital investment in the property. Therefore, if you lease property to use in your trade or business or for the production of income, you cannot depreciate its cost. You can, however, depreciate any capital improvements you make to the leased property. See Additions and Improvements in chapter 3 of Publication 946.

If you lease property to someone, you generally can depreciate its cost even if the lessee (the person leasing from you) has agreed to preserve, replace, renew, and maintain the property. However, you cannot depreciate the cost of the property if the lease provides that the lessee is to maintain the property and return to you the same property or its equivalent in value at the expiration of the lease in as good condition and value as when leased.

Incidents of ownership. Incidents of ownership include the following.

• The legal title.
• The legal obligation to pay for it.
• The responsibility to pay its maintenance and operating expenses.
• The duty to pay any taxes.
• The risk of loss if the property is destroyed, condemned, or diminished in value through obsolescence or exhaustion.

Life tenant. Generally, if you hold business or investment property as a life tenant, you can depreciate it as if you were the absolute owner of the property. However, see Certain term interests in property under Excepted Property, later.

Property Used in Your Business or Income-Producing Activity

To claim depreciation on property, you must use it in your business or income-producing activity. If you use property to produce income (investment use), the income must be taxable. You cannot depreciate property that you use solely for personal activities.

Partial business or investment use. If you use property (including your car) for business or investment purposes and for personal purposes, you can deduct depreciation only on the part used for business or investment.

For example, if you use your car for farm business, you can deduct depreciation for the part you use in farming. If you also use it for investment purposes, you can depreciate the part used for investment.

If you use part of your home for business, you may be able to take a depreciation deduction for its business use. For more information, see Business Use of Your Home in chapter 5.

Inventory. You can never depreciate inventory because it is not held for use in your business. Inventory is any property you hold primarily for sale to customers in the ordinary course of your business.

Livestock. Livestock purchased for draft, breeding, or dairy purposes can be depreciated only if they are not kept in an inventory account.

Livestock you raise usually has no depreciable basis because the costs of raising them are deducted and not added to their basis. However, see Immature livestock under When Does Depreciation Begin and End, later.

Property Having a Determinable Useful Life

To be depreciable, your property must have a determinable useful life. This means it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.

Land. You can never depreciate the cost of land because land does not wear out, become obsolete, or get used up. The cost of land generally includes the cost of clearing, grading, planting, and landscaping because these expenses are all part of the cost of the land itself. For information on land preparation costs you may be able to depreciate, see chapter 1 of Publication 946.

Irrigation systems and water wells. Irrigation systems and wells used in a trade or business can be depreciated if their useful life can be determined. You can depreciate irrigation systems and wells composed of masonry, concrete, tile, metal, or wood. In addition, you can depreciate costs for moving dirt to make irrigation systems and water wells composed of these materials. However, land preparation costs for center pivot irrigation systems are not depreciable.

Dams, ponds, and terraces. In general, you cannot depreciate earthen dams, ponds, and terraces unless the structures have a determinable useful life.

Intangible property. The following are two types of intangible property that you can never depreciate.

Goodwill. You can never depreciate goodwill because its useful life cannot be determined. However, if you acquired a business after August 10, 1993 (July 25, 1991, if elected), and part of the price included goodwill, you may be able to amortize the cost of the goodwill over 15 years. For more information, see Amortization, later.

Trademark or trade name. In general, a trademark or trade name does not have a determinable useful life and, therefore, you cannot depreciate its cost. However, you may be able to amortize its cost over 15 years if you acquired it after August 10, 1993 (after July 25, 1991, if elected). For more information, see Amortization, later.

Property Lasting More Than One Year

To be depreciable, property must have a useful life that extends substantially beyond the year you place it in service.

Excepted Property

Even if the requirements explained in the preceding discussions are met, you cannot depreciate the following property.

• Property placed in service and disposed of in the same year. Determining when property is placed in service is explained later.
• Equipment used to build capital improvements. You must add otherwise allowable depreciation on the equipment during the period of construction to the basis of your improvements. See Uniform Capitalization Rules in Publication 551.
• Section 197 intangibles.
• Certain term interests.

Section 197 intangibles. Intangible property that is a section 197 intangible, described later under Amortization, cannot be depreciated but can be amortized over a 15-year period.

Computer software. Computer software includes all programs designed to cause a computer to perform a desired function. It also includes any data base or similar item in the public domain and incidental to the operation of qualifying software.

Computer software is a section 197 intangible only if you acquired it in connection with the acquisition of assets constituting a business or a substantial part of a business. However, computer software is not a section 197 intangible and can be depreciated, even if acquired in connection with the acquisition of a business, if it meets all of the following tests.

• It is readily available for purchase by the general public.
• It is subject to a nonexclusive license.
• It has not been substantially modified.

Certain term interests in property. You cannot depreciate a term interest in property acquired by gift, bequest, or inheritance. In addition, you cannot depreciate a term interest in property created or acquired after July 27, 1989, for any period during which the remainder interest is held, directly or indirectly, by a person related to you. For more information, see Publication 946.

When Does Depreciation Begin and End?

You begin to depreciate your property when you place it in service for use in your trade or business or for the production of income. You stop depreciating property either when you have fully recovered your cost or other basis or when you retire it from service, whichever happens first.

Placed in Service

Property is placed in service when it is ready and available for a specific use, whether in a business activity, an income-producing activity, a tax-exempt activity, or a personal activity. Even if you are not using the property, it is in service when it is ready and available for its specific use.

Example 1. You bought a home and used it as your personal home for several years before you converted it to rental property. Although its specific use was personal and no depreciation was allowable, you placed the home in service when you began using it as your home. You can begin to claim depreciation in the year you converted it to rental property because its use changed to an income-producing use at that time.

Example 2. You bought a planter that was delivered for your farm business in December 2001 after harvest was over. You begin to depreciate the planter for 2001 because it was ready and available for its specific use in 2001, even though it will not be used until the spring of 2002.

Example 3. If your planter comes unassembled in December 2001 and is put together in February 2002, it is not placed in service until 2002. You begin to depreciate it in 2002.

Example 4. If your planter was delivered and assembled in February 2002 but not used until April 2002, it is placed in service in February 2002, since this is when the planter was ready for its specified use.

Fruit or nut trees and vines. If you acquire an orchard, grove, or vineyard before the trees or vines have reached the income-producing stage, and they have a preproductive period of more than 2 years, you must capitalize the preproductive-period costs under the uniform capitalization rules (unless you elect not to use these rules). See chapter 7 for information about the uniform capitalization rules. Your depreciation begins when the trees and vines reach the income-producing stage.

Immature livestock. If you acquire immature livestock for draft, dairy, or breeding purposes, your depreciation begins when they reach maturity. This means depreciation begins when the livestock reach the age when they can be worked, milked, or bred. When this occurs, your basis for depreciation is your initial cost for the immature livestock.

Idle Property

You must claim a deduction for depreciation on property used in your business or for the production of income even if it is temporarily idle. For example, if you stop using a machine because there is a temporary lack of market for a product made with that machine, you must continue to deduct depreciation on the machine.

Cost or Other Basis Fully Recovered

You stop depreciating property when you have fully recovered your cost or other basis. This happens when you have taken section 179 and depreciation deductions equal to your cost or investment in the property.

Retired From Service

You stop depreciating property when you retire it from service, even if you have not fully recovered its cost or other basis. You retire property from service when you permanently withdraw it from use in a trade or business or from use in the production of income because of any of the following events.

• You sell or exchange the property.
• You convert the property to personal use.
• You abandon the property.
• The property is destroyed.

For information on abandonment of property, see chapter 10. For information on destroyed property, see chapter 13.

Can You Use MACRS To Depreciate Your Property?

You must use the Modified Accelerated Cost Recovery System (MACRS) to depreciate most property. MACRS is explained later under Figuring Depreciation Under MACRS. This part discusses the kinds of property that cannot be depreciated under MACRS and must be depreciated using other methods.

You cannot use MACRS to depreciate the following property.

• Property you placed in service before 1987.
• Certain pre-1987-use property.
• Intangible property.
• Films, video tapes, and recordings.
• Certain corporate or partnership property acquired in a nontaxable transfer.
• Property you elected to exclude from MACRS.

If your property is not described in the above list, figure the depreciation using MACRS.

Property You Placed in Service Before 1987

You cannot use MACRS for property you placed in service before 1987 (except property you placed in service after July 31, 1986, if MACRS was elected). Property placed in service before 1987 must be depreciated under the methods discussed in Publication 534, Depreciating Property Placed in Service Before 1987.

Use of real property changed. You generally must use MACRS to depreciate real property you acquired for personal use before 1987 and changed to business or income-producing use after 1986.

Pre-1987-Use Property

Under special rules, you may not be able to use MACRS for property you acquired and placed in service after 1986. These rules apply to both personal and real property owned or used before 1987. If you cannot use MACRS, the property must be depreciated under the methods discussed in Publication 534. For specific information, see chapter 1 in Publication 946.

Election To Exclude Property From MACRS

If you properly depreciate any property under a method not based on a term of years, such as the unit-of-production method, you can elect to exclude that property from MACRS. You make the election by reporting your depreciation for the property on line 18 of Part III of Form 4562 and attaching a statement as described in the instructions for Form 4562. You must make this election by the return due date (including extensions) for the year you place your property in service. However, if you timely filed your return for the year without making the election, you can still make the election by filing an amended return within 6 months of the due date of the return (excluding extensions). Attach the election to the amended return and write "Filed pursuant to section 301.9100-2" on the election statement. File the amended return at the same address you filed the original return.

Use of standard mileage rate. If you use the standard mileage rate to figure your tax deduction for your business automobile, you are treated as having made an election to exclude the automobile from MACRS. See Publication 463 for a discussion of the standard mileage rate.

What Is the Basis of Your Depreciable Property?

To figure your depreciation deduction, you must determine the basis of your property. To determine basis, you need to know the cost or other basis of your property.

Other basis. Other basis refers to basis that is determined by the way you received the property. For example, your basis is other than cost if you acquired the property in an exchange for other property, as payment for services you performed, as a gift, or as an inheritance. If you acquired property in this or some other way, see chapter 7 to determine your basis.

Cost as basis. The basis of property you buy is its cost plus amounts you paid for items such as sales tax, freight charges, and installation and testing fees. The cost includes the amount you pay in cash, in debt obligations, in other property, or in services.

Property changed from personal use. If you held property for personal use and later use it in your business or income-producing activity, your depreciable basis is the lesser of the following.

1. The fair market value (FMV) of the property on the date of the change in use.
2. Your original cost or other basis adjusted as follows.
1. Increased by the cost of any permanent improvements or additions and other costs that must be added to basis.
2. Decreased by any tax deductions you claimed for casualty and theft losses and other items that reduced your basis.

Adjusted basis. To find your property's basis for depreciation, you may have to make certain adjustments (increases and decreases) to the basis of the property for events occurring between the time you acquired the property and the time you placed it in service. These events could include the following.

• Installing utility lines.
• Paying legal fees for perfecting the title.
• Settling zoning issues.
• Receiving rebates.
• Incurring a casualty or theft loss.

For a discussion of adjustments to the basis of your property, see Adjusted Basis in chapter 7.

How Do You Treat Improvements?

If you improve depreciable property, you must treat the improvement as separate depreciable property. For more information on improvements, see Publication 946.

Repairs. You generally deduct the cost of repairing business property in the same way as any other business expense. However, if a repair or replacement increases the value of your property, makes it more useful, or lengthens its life, you must treat it as an improvement and depreciate it.

Improvements to rented property. You can depreciate permanent improvements you make to business property you rent from someone else.

Do You Have To File Form 4562?

You must complete and attach Form 4562 to your tax return if you are claiming certain items, including any of the following.

• A section 179 deduction for the current year or a section 179 carryover from a prior year. The section 179 deduction is discussed later.
• Depreciation for property placed in service during the current year.
• Depreciation on any vehicle or other listed property, regardless of when it was placed in service. Listed property is discussed later.
• Amortization of costs that began in the current year. Amortization is discussed later.

For more information on whether you must file Form 4562, refer to its instructions.

It is important to keep good records for property you depreciate. Do not file these records with your return. Instead, you should keep them as part of the records of the depreciated property. They will help you verify the accuracy of the information on Form 4562. For general information on recordkeeping, see Publication 583, Starting a Business and Keeping Records. For specific information on keeping records for section 179 property and listed property, see Publication 946.

How Do You Correct Depreciation Deductions?

If you deducted an incorrect amount of depreciation in any year, you may be able to make a correction by filing an amended return for that year. See Filing an Amended Return, later. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. See Changing Your Accounting Method, later.

Basis adjustment. Even if you do not claim depreciation you are entitled to deduct, you must reduce the basis of the property by the full amount of depreciation you were entitled to deduct. If you deduct more depreciation than you should have, you must decrease your basis by any amount deducted from which you received a tax benefit.

Filing an Amended Return

You can file an amended return to correct the amount of depreciation claimed for any property in any of the following situations.

• You claimed the incorrect amount because of a mathematical error made in any year.
• You claimed the incorrect amount because of a posting error made in any year (for example, omitting an asset from the depreciation schedule).
• You have not adopted a method of accounting for the property.

You have adopted a method of accounting for the property if you deducted an incorrect amount of depreciation for it on two or more consecutively filed tax returns for reasons other than a mathematical or posting error.

When to file. If an amended return is allowed, you must file it by the later of the following dates.

• 3 years from the date you filed your original return for the year in which you deducted the incorrect amount. (A return filed early is considered filed on the due date.)
• 2 years from the time you paid your tax for that year.

Changing Your Accounting Method

If you deducted an incorrect amount of depreciation for property on two or more consecutively filed tax returns, you have adopted a method of accounting for that property. You can claim the correct amount of depreciation only by changing your method of accounting for depreciation for that property. You can then take into account any unclaimed or excess depreciation from years before the year of change.

Approval required. You must get IRS approval to change your method of accounting. File Form 3115, Application for Change in Accounting Method, to request a change to a permissible method of accounting for the depreciation. Revenue Procedure 97-27 in Cumulative Bulletin 1997-1 gives general instructions for getting approval.

Automatic approval. You may be able to get automatic approval from the IRS to change your method of accounting if you used an unallowable method of accounting for depreciation in at least the 2 years immediately before the year of change and the property for which you are changing the method meets all the following conditions.

1. It is property for which, under your unallowable method of accounting, you claimed either no depreciation or an incorrect amount.
2. It is property for which you figured depreciation using one of the following.
1. Pre-1981 rules.
2. Accelerated Cost Recovery System (ACRS).
3. Modified Accelerated Cost Recovery System (MACRS).
3. It is property you owned at the beginning of the year of change.

File Form 3115 to request a change to a permissible method of accounting for depreciation. Revenue Procedure 99-49 and section 2.01 of its Appendix in Cumulative Bulletin No. 1999-2 have instructions for getting automatic approval and list exceptions to the automatic approval procedures.

Exceptions. You generally cannot use the automatic approval procedure in any of the following situations.

• You are under examination by the IRS.
• You are before a federal court or an appeals office for any income tax issue and the method of accounting for depreciation to be changed is an issue under consideration by the federal court or appeals office.
• During the last 5 years (including the year of change), you changed the same method of accounting for depreciation (with or without obtaining IRS approval).
• During the last 5 years (including the year of change), you filed a Form 3115 to change the same method of accounting for depreciation but did not make the change because the Form 3115 was withdrawn, not perfected, denied, or not granted.

Also, see other exceptions listed in section 4.02 of Revenue Procedure 99-49 and section 2.01(2)(b) in the Appendix of this revenue procedure.

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