3.1 – Property Acquisition and Cost Recovery
Every question about the tax treatment of property, from a piece of equipment bought for a business to a rental building held for years, starts with the same number: the property’s basis. Basis is the taxpayer’s investment in the asset for tax purposes, and it is the figure that eventually determines taxable gain or loss on disposition and, for many kinds of business property, how much can be deducted year by year as the asset’s cost is recovered through depreciation, amortization, or depletion. This note covers how basis is established at acquisition, how it changes over time, and the main cost recovery systems the Internal Revenue Code provides for tangible property, intangible property, and natural resources.
What Basis Means and Why It Matters
The basis of purchased property is generally its cost, and that cost includes more than the sticker price – sales tax, freight, installation, testing, and other expenses needed to acquire the asset and place it in service all become part of basis. For real estate, basis also picks up closing costs such as title insurance, recording fees, and attorney fees. Basis is not fixed once set: it becomes adjusted basis over time, increasing for capital improvements that add useful life beyond one year and decreasing for depreciation, amortization, casualty losses, and similar items that reduce the taxpayer’s remaining investment in the property.
Depreciation Under MACRS
Most tangible property placed in service after 1986 is depreciated under the Modified Accelerated Cost Recovery System, which assigns each type of property a recovery period, a depreciation method, and a convention governing how much can be claimed in the year of acquisition and disposal. Recovery periods range from five years for computers and certain vehicles, to seven years for office furniture and equipment, to 27.5 years for residential rental property and 39 years for nonresidential real property. MACRS allows accelerated methods such as the 200% and 150% declining balance methods for many kinds of personal property, in addition to straight-line depreciation, and applies a half-year, mid-quarter, or mid-month convention depending on the property type and when it was placed in service.
Section 179 and Bonus Depreciation
Two provisions let a business accelerate cost recovery well beyond ordinary MACRS schedules. A Section 179 election allows a taxpayer to deduct the full cost of qualifying new or used tangible personal property in the year it is placed in service rather than depreciating it over several years, subject to an annual dollar limit that phases out once total qualifying purchases for the year exceed a set threshold. Bonus depreciation, when in effect, permits an additional percentage of the cost of qualifying property to be deducted immediately, on top of any Section 179 deduction, though the percentage has varied significantly by law and by the year the property was placed in service, so the applicable rate always needs to be confirmed for the specific tax year.
Amortizing Intangible Assets
Intangible assets – goodwill, going concern value, covenants not to compete, franchises, trademarks, and patents acquired in connection with a trade or business – are recovered through amortization rather than depreciation. Section 197 intangibles are generally amortized in equal amounts over a fixed fifteen-year period, starting with the month the intangible was acquired, regardless of the asset’s actual useful life or whether it might reasonably be expected to lose value faster or slower than that schedule suggests.
Depletion for Natural Resources
Natural resources such as oil, gas, timber, and minerals are recovered through depletion instead of depreciation, since the underlying asset is used up through extraction rather than through wear over time. The Code allows depletion to be calculated under either a cost method, which allocates basis across the units expected to be extracted, or a percentage method, which deducts a set percentage of gross income from the property regardless of the property’s remaining basis, subject to its own set of limitations.
Special Rules for Listed Property
Certain depreciable assets – passenger automobiles, other transportation equipment, property used for entertainment or recreation, and computers – fall under stricter rules as listed property because they are commonly used for both business and personal purposes. Listed property must be used more than half the time for qualified business purposes to qualify for accelerated MACRS methods or a Section 179 deduction; falling short of that threshold forces the taxpayer onto slower straight-line depreciation and requires detailed records substantiating the business-use percentage claimed.
Reporting Cost Recovery
Depreciation, amortization, and the Section 179 election are all reported on Form 4562, which is filed with the taxpayer’s return for any year new depreciable or amortizable property is placed in service or an election is made. Because basis, depreciation method, and business-use percentage all interact to determine both the current deduction and the eventual gain or loss on sale, keeping detailed records of every acquisition, improvement, and cost recovery deduction taken is essential – a mistake made in an early year compounds through every later year the property is held.
Quick revision summary
- Basis is generally the cost of acquiring property, including related acquisition expenses, and becomes adjusted basis as improvements, depreciation, and other events change it over time.
- Most tangible business property is depreciated under MACRS, which assigns a recovery period, method, and convention based on the type of property.
- Section 179 and bonus depreciation both allow accelerated, often immediate, deduction of qualifying property costs beyond regular MACRS schedules, subject to annual limits.
- Intangible assets such as goodwill and patents acquired in a business are generally amortized in equal amounts over fifteen years under Section 197.
- Natural resources are recovered through cost or percentage depletion rather than depreciation.
- Listed property such as cars and computers faces stricter depreciation rules unless business use exceeds 50%, and all cost recovery is reported on Form 4562.