8. Depreciation, Depletion, and Amortization
Important Changes
for 2002
Special depreciation allowance. You can take a special depreciation
allowance for qualified property you place in service during 2002. The allowance is an
additional deduction of 30% of the property's depreciable basis. See Claiming the
Special Depreciation Allowance, later.
Depreciation limits on business cars. The total section 179
deduction and depreciation (including the special depreciation allowance) you can take on
a car (that is not an electric vehicle) you use in your business and first place in
service in 2002 is generally $7,660. Special rules apply to electric vehicles. See Do
the Passenger Automobile Limits Apply? under Additional Rules for Listed Property.
Marginal production of oil and gas. The suspension of the taxable
income limit on percentage depletion from the marginal production of oil and natural gas
that was scheduled to expire for tax years beginning after 2001 has been extended to tax
years beginning before 2004. For more information on marginal production, see section
613A(c)(6) of the Internal Revenue Code.
Introduction
If you buy farm property such as machinery, equipment, livestock, or a structure with a
useful life of more than a year, you generally cannot deduct its entire cost in one year.
Instead, you must spread the cost over more than one year and deduct part of it each year.
For most types of property, this is called depreciation.
This chapter gives information on depreciation methods that generally apply to property
placed in service after 1986 but not to property placed in service before 1987. For
information on depreciating pre-1987 property, see Publication 534, Depreciating
Property Placed in Service Before 1987.
 For property
used in a farming business, you must use the 150% declining balance method rather than the
200% declining balance method, or you can elect an alternative method. The methods you can
use are discussed later under Which Depreciation Method Applies.
 To help you
understand depreciation and how to complete Form 4562, Depreciation and Amortization, see
the filled-in Form 4562 and related discussion in chapter 20.
This chapter also provides information on figuring both cost depletion (including
timber depletion) and percentage depletion.
The last section of this chapter discusses amortization of the costs of going into
business, reforestation costs, the costs of pollution control facilities, and the costs of
section 197 intangibles.
Topics
This chapter discusses:
- Overview of depreciation
- Section 179 deduction
- Special Depreciation Allowance
- Modified Accelerated Cost Recovery
System (MACRS)
- Listed property rules
- Basic information on depletion and
amortization
Useful Items
You may want to see:
Publication
- 463 Travel, Entertainment, Gift, and Car Expenses
- 534 Depreciating Property Placed in Service Before 1987
- 535 Business Expenses
- 544 Sales and Other Dispositions of Assets
- 551 Basis of Assets
- 946 How To Depreciate Property
Form (and Instructions)
- T Forest Activities Schedule
- 1040X Amended U.S. Individual Income Tax Return
- 3115 Application for Change in Accounting Method
- 4562 Depreciation and Amortization
- 4797 Sales of Business Property
See chapter 21 for information about getting publications and forms.
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, equipment, vehicles, certain livestock, and furniture. 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 generally cannot depreciate its cost. You can, however, depreciate any capital
improvements you make to the leased property. See Additions and Improvements in
chapter 4 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 of property
include the following.
- The legal title to the property.
- The legal obligation to pay for the property.
- The responsibility to pay maintenance and operating expenses.
- The duty to pay any taxes on the property.
- 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 based only on the business or investment use.
For example, if you use your car for farm business, you can deduct depreciation based
on the use in farming. If you also use it for investment purposes, you can depreciate it
based on the investment use.
If you use part of your home for business, you may be able to deduct depreciation on
that part based on 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. 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 construct 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 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. This rule does not apply to the holder of a
term interest in property acquired by gift, bequest, or inheritance. 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 for use in your farm business.
The planter was delivered in December 2002 after harvest was over. You begin to depreciate
the planter for 2002 because it was ready and available for its specific use in 2002, even
though it will not be used until the spring of 2003.
Example 3. If your planter comes unassembled in December 2002
and is put together in February 2003, it is not placed in service until 2003. You begin to
depreciate it in 2003.
Example 4. If your planter was delivered and assembled in
February 2003 but not used until April 2003, it is placed in service in February 2003,
because 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
Continue to 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 a market for a product made with that
machine, 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 your section 179 and allowed or allowable depreciation deductions equal
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.
- You transfer the property to a supplies or scrap account.
- 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 property owned or used in 1986.
- 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.
Property Owned or Used in 1986
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 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 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.
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.
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 as a gift or as an inheritance. If you acquired property in this or some
other way, see chapter 7 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 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.
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