You must use the Modified Accelerated Cost Recovery System (MACRS) to depreciate most property. MACRS is explained in chapter 4.

The following discussions describe the types of property that cannot be depreciated using MACRS and explain what depreciation method should be used instead. You cannot use MACRS to depreciate the following property.

If your property is not described in the above list, figure the depreciation using MACRS. See chapter 4 for information.

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.

For a discussion of when property is placed in service, see When Does Depreciation Begin and End, earlier.

Property Owned or Used in 1986

You may not be able to use MACRS for property you acquired and placed in service after 1986 if any of the situations described in the following discussions apply. If you cannot use MACRS, the property must be depreciated under the methods discussed in Publication 534.

For the following discussions, do not treat property as owned before you placed it in service. If you owned property in 1986 but did not place it in service until 1987, you do not treat it as owned in 1986.

Intangible Property

Generally, if you can depreciate intangible property, you usually use the straight line method of depreciation. However, you can choose to depreciate certain intangible property under the income forecast method.

You cannot depreciate intangible property that is a section 197 intangible or that otherwise does not meet all the requirements discussed earlier under What Property Can Be Depreciated.

Straight Line Method

This method lets you deduct the same amount of depreciation each year over the useful life of the property. To figure your deduction, first determine the adjusted basis, salvage value, and estimated useful life of your property. Subtract the salvage value, if any, from the adjusted basis. The balance is the total depreciation you can take over the useful life of the property.

Divide the balance by the number of years in the useful life. This gives you your yearly depreciation deduction. Unless there is a big change in adjusted basis or useful life, this amount will stay the same throughout the time you depreciate the property. If, in the first year, you use the property for less than a full year, you must prorate your depreciation deduction for the number of months in use.

Income Forecast Method

You can choose to use the income forecast method instead of the straight line method to depreciate the following depreciable intangibles.

Under the income forecast method, each year's depreciation deduction is equal to the cost, less salvage value, of the property, multiplied by a fraction. The numerator of the fraction is the current year's net income from the property, and the denominator is the total income anticipated from the property through the end of the 10th taxable year following the taxable year the property is placed in service. For more information, see section 167(g) of the Internal Revenue Code.

Films, Video Tapes, and Recordings

You cannot use MACRS for motion picture films, video tapes, and sound recordings. For this purpose, sound recordings are discs, tapes, or other phonorecordings resulting from the fixation of a series of sounds. You can depreciate this property under the straight line method or the income forecast method (both discussed earlier under Intangible Property).

Corporate or Partnership Property Acquired in a Nontaxable Transfer

MACRS does not apply to property used before 1987 and transferred after 1986 to a corporation or partnership (except property the transferor placed in service after July 31, 1986, if MACRS was elected) to the extent its basis is carried over from the property's adjusted basis in the transferor's hands. You must continue to use the same depreciation method as the transferor and figure depreciation as if the transfer had not occurred. However, if MACRS would otherwise apply, you can use it to depreciate the part of the property's basis that exceeds the carried-over basis.

The nontaxable transfers covered by this rule include the following.

Election To Exclude Property
From MACRS

If you can 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 15 in Part II 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 tax 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 six 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.

What Is the Basis of Your Depreciable Property?

Terms you may need to know (see Glossary):

Abstract fees

Adjusted basis

Basis

Exchange

Fair market value 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. 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, debt obligations, other property, or services. Assumed debt.   If you buy property and assume (or buy subject to) an existing mortgage or other debt on the property, your basis includes the amount you pay for the property plus the amount of the assumed debt. Example. You make a $20,000 down payment on property and assume the seller's mortgage of $120,000. Your total cost is $140,000, the cash you paid plus the mortgage you assumed. Settlement costs.   The basis of real property also includes certain fees and charges you pay in addition to the purchase price. These generally are shown on your settlement statement and include the following. Legal and recording fees. Abstract fees. Survey charges. Owner's title insurance. Amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.   For fees and charges you cannot include in the basis of property, see Real Property in Publication 551. Property you construct or build.   If you construct, build, or otherwise produce property for use in your business, you may have to use the uniform capitalization rules to determine the basis of your property. For information about the uniform capitalization rules, see Publication 551 and the regulations under section 263A of the Internal Revenue Code. 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 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 Publication 551 to determine your basis. 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. The fair market value (FMV) of the property on the date of the change in use. Your original cost or other basis adjusted as follows. Increased by the cost of any permanent improvements or additions and other costs that must be added to basis. Decreased by any deductions you claimed for casualty and theft losses and other items that reduced your basis. Example. Several years ago, Nia paid $160,000 to have her home built on a lot that cost her $25,000. Before changing the property to rental use last year, she paid $20,000 for permanent improvements to the house and claimed a $2,000 casualty loss deduction for damage to the house. Land is not depreciable, so she includes only the cost of the house when figuring the basis for depreciation. Nia's adjusted basis in the house when she changed its use was $178,000 ($160,000 + $20,000 - $2,000). On the same date, her property had an FMV of $180,000, of which $15,000 was for the land and $165,000 was for the house. The basis for depreciation on the house is the FMV on the date of change ($165,000), because it is less than her adjusted basis ($178,000). 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 Publication 551. If you depreciate your property under MACRS, you also may have to reduce your basis by certain deductions and credits with respect to the property. For more information, see What Is the Basis For Depreciation? in chapter 4. How Do You Treat Improvements? Terms you may need to know (see Glossary): Improvement If you improve depreciable property, you must treat the improvement as separate depreciable property. For more information, see Additions and Improvements under Which Recovery Period Applies? in chapter 4. 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. Example. You repair a small section on one corner of the roof of a rental house. You deduct the cost of the repair as a rental expense. However, if you completely replace the roof, the new roof is an improvement because it increases the value and lengthens the life of the property. You depreciate the cost of the new roof. 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? Terms you may need to know (see Glossary): Amortization Listed property Placed in service Standard mileage rate You must complete and attach Form 4562 to your tax return if you are claiming any of the following items. A section 179 deduction for the current year or a section 179 carryover from a prior year. (See chapter 2 for information on the section 179 deduction.) 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. A deduction for any vehicle if the deduction is reported on a form other than Schedule C (Form 1040) or Schedule C-EZ (Form 1040). Amortization of costs that began in the current year. Depreciation on any asset on a corporate income tax return (other than Form 1120S, U.S. Income Tax Return for an S Corporation) regardless of when it was placed in service. You must submit a separate Form 4562 for each business or activity on your return for which a Form 4562 is required. Table 1–1 presents an overview of the purpose of the various parts of Form 4562. Employee.   Do not use Form 4562 if you are an employee and you deduct job-related vehicle expenses using either actual expenses (including depreciation) or the standard mileage rate. Instead, use either Form 2106 or Form 2106-EZ. Use Form 2106-EZ if you are claiming the standard mileage rate and you are not reimbursed by your employer for any expenses. How Do You Correct Depreciation Deductions? Terms you may need to know (see Glossary): Basis As this publication was being prepared for print, the Treasury Department and the IRS proposed new rules on how to make changes in computing depreciation which result in a change in accounting method. These new rules may affect the 2003 tax year. For information about these rules and other new tax laws and regulations that will be reflected in future versions of Publication 946, see the business-related articles posted on the IRS website at www.irs.gov/formspubs. 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 for depreciation allowed or allowable.   You must reduce the basis of property by the depreciation allowed or allowable, whichever is greater. Depreciation allowed is depreciation you actually deducted (from which you received a tax benefit). Depreciation allowable is depreciation you are entitled to deduct.   If you do not claim the depreciation allowable, you must still reduce the basis of the property by the full amount of depreciation allowable.   If you deduct more depreciation than you should, you must reduce your basis by any amount deducted from which you received a tax benefit (the depreciation allowed). 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. 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. 3 years from the date you filed your original return for the year in which you did not deduct the correct amount. (A return filed before an unextended due date is considered filed on that 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 then will be able to take into account any unclaimed or excess depreciation for years before the year of change. See Section 481(a) adjustment, later. Approval required.   You must get IRS approval to change your method of accounting. File Form 3115 to request a change to a permissible method of accounting for depreciation. Revenue Procedure 97–27 in Internal Revenue Bulletin 1997–21 gives general instructions for getting approval. Table 1–1. Purpose of Form 4562 This table describes the purpose of the various parts of Form 4562. For more information about the form, see Do You Have to File Form 4562. Part Purpose I • Electing the section 179 deduction • Figuring the maximum section 179 deduction for the current year • Figuring any section 179 deduction carryover to the next year II • Reporting the special depreciation allowance (or Liberty Zone depreciation allowance) for property (other than listed property) placed in service during the tax year • Reporting depreciation deductions on property being depreciated under any method other than Modified Accelerated Cost Recovery System (MACRS) III • Reporting MACRS depreciation deductions for property placed in service before this year • Reporting MACRS depreciation deductions for property (other than listed property) placed in service during the current year IV • Summarizing other parts V • Reporting the special depreciation allowance (or Liberty Zone depreciation allowance) for automobiles and other listed property • Reporting MACRS depreciation on automobiles and other listed property • Reporting the section 179 cost elected for automobiles and other listed property • Reporting information on the use of automobiles and other transportation vehicles VI • Reporting amortization deductions Automatic approval.   You may be able to get automatic approval from the IRS to change your method of accounting if you used an impermissible 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. It is property for which, under your impermissible method of accounting, you claimed either no depreciation or an incorrect amount. It is property for which you figured depreciation using one of the following. Pre-1981 rules. Accelerated Cost Recovery System (ACRS). Modified Accelerated Cost Recovery System (MACRS). 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 2002–9 and section 2.01 of its Appendix in Internal Revenue Bulletin 2002–3 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. During the last five years (including the year of change), you changed the same method of accounting for depreciation (with or without obtaining IRS approval). During the last five 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. See other exceptions listed in section 4.02 and section 2.01(2)(c) of the Appendix of Revenue Procedure 2002–9. Section 481(a) adjustment.   If you file Form 3115 and change to a permissible method of accounting for depreciation, you can make a section 481(a) adjustment for any unclaimed or excess amount of allowable depreciation. The adjustment is the difference between the total depreciation actually deducted for the property and the total amount allowable prior to the year of change. If no depreciation was deducted, the adjustment is the total depreciation allowable prior to the year of change. A negative section 481(a) adjustment results in a decrease in taxable income. It is taken into account in the year of change and is reported on your business tax returns as “other expenses.” A positive section 481(a) adjustment results in an increase in taxable income. It is generally taken into account over 4 tax years and is reported on your business tax returns as “other income.” However, you can elect to use a one-year adjustment period and report the adjustment in the year of change if the total adjustment is less than $25,000. Make the election by completing the appropriate line on Form 3115. Example 1. In February 1999, Ron purchased and placed in service a passenger vehicle costing $20,000. He has been using it exclusively for business use in his sole proprietorship since 1999. He did not elect a section 179 deduction for the property and did not claim any depreciation at all. In 2003, he still owns the vehicle and has decided that he would like to start depreciating it. The allowable depreciation amounts for the years 1999 to 2002 are as follows. Year Allowable depreciation 1999 3,060 2000 5,000 2001 2,950 2002 1,775 Total $12,785 The total allowable depreciation prior to the year of change (2003) is $12,785. This is a negative section 481(a) adjustment. To claim this amount, Ron must file Form 3115 for 2003 and include the entire $12,785 as “other expenses” on his 2003 Schedule C (Form 1040). In addition, Ron's allowable depreciation for 2003 is $1,775, which he shows on his 2003 Form 4562. Example 2. The facts are the same as in Example 1, except that Ron correctly took a depreciation deduction of $3,060 for 1999, but did not take a depreciation deduction for the other years. Ron's negative section 481(a) adjustment would be $9,725 ($12,785 - $3,060), which is the difference between the total depreciation allowable prior to 2003 and the actual amount deducted. He shows this amount and his allowable depreciation for 2003 ($1,775) in the same manner discussed in Example 1. 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