Publication 946
How To Depreciate Property

Section 179 Deduction; Special Depreciation Allowance; MACRS Listed Property

For use in preparing 2002 Returns

What Is the Basis of Your Depreciable Property?

• 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.

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 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?

• 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 must 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?

• 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 Part I of Form 4562. (See chapter 2 for information on the section 179 deduction.)
• Depreciation for property placed in service during the current year. See Parts II and III of Form 4562.
• Depreciation on any vehicle or other listed property, regardless of when it was placed in service. See Part V of Form 4562.
• 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). See Part V of Form 4562.
• Amortization of costs that began in the current year. See Part VI of Form 4562.
• 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. See Parts II and III of Form 4562.

You must submit a separate Form 4562 for each business or activity on your return for which 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?

• Basis
•  

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, you must reduce 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.
• 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 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 then will be able to 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 to request a change to a permissible method of accounting for depreciation. Revenue Procedure 97-27 in Cumulative Bulletin 1997-1 gives general instructions for getting approval.

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.

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 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.

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