Calculating Depreciation

Calculating Depreciation Circular 658 Revised by Terry Crawford1 Cooperative Extension Service • College of Agricultural, Consumer and Environmental Sciences Performing the mathematical steps to calculate deprecia- taken. For a piece of property to have no basis, then, tion is not difficult, but small computational errors can means that nothing was directly paid for the property. have large tax consequences. As a result, each farmer and An example of property with no basis is raised livestock. rancher should know how depreciation is calculated and Technically, no raised livestock has a basis because noth- understand the effect depreciation methods can have on ing was actually paid for the newborn animal. Certainly taxable income, even if a professional tax practitioner there were costs attributable to the production of that recalculates the figures for the tax return. animal, such as the feed costs, veterinary bills, and other costs that went into maintaining its mother. But for a cash-basis taxpayer, those costs were written off as BASIS IN PROPERTY expenses in the year in which they were incurred. Con- Despite the fact that they have long lives, are require- sequently, no purchase price is left to be attached to the ments of production, and have fairly high purchase newborn animal. Because there is no purchase price, prices, certain long-lived assets cannot be depreciated for there really is nothing to depreciate. If the costs were income tax purposes, and should not be depreciated for accumulated on an accrual basis and not expensed in business analysis purposes. Nondepreciable, long-lived the year paid, then the amount of those costs could be assets generally fall into one of three major categories: depreciated. But for a cash-basis taxpayer, depreciation would not be taken. Although this may seem harsh at 1. Land the moment, the process really benefits the cash-basis 2. Personal or nonbusiness assets taxpayer in the long run because the costs are expensed 3. Assets that have no basis immediately rather than spread over a period of years. If you hold the gift as business property, your basis for Depreciation, for tax purposes and for analysis pur- figuring any depreciation, depletion, or amortization poses, is reserved for business assets with a determin- deduction is the same as the donor’s adjusted basis plus able or finite useful life. Thus, land is not depreciated or minus any required adjustments to basis while you because it is generally assumed to have an infinitely long hold the property. useful life. When we spread a finite cost over an infinite Basis in property is equal to the amount of money number of years, the amount to be allocated to any one and/or value of any other goods and services paid or year becomes zero. Nonbusiness assets such as personal given in exchange. It is the basis value that will be de- automobiles, personal residences, and furniture are not preciated, not just the amount of cash paid. depreciable, even though their resale value also declines Consider the following examples: through time. Assets that have no basis make up the third category Asset Purchase 1 of nondepreciable assets, and are probably the most Tractor purchased on September 1, 19X1. difficult to explain and understand. The first problem Original list price was $58,000. The seller agreed is to understand the concept of basis. The basis of any to accept $50,000 in cash, $4,000 in grain, and piece of property is equal to the amount of money and/ $2,000 in labor services for the tractor. or the value of any other goods and services paid or Basis: given in exchange for that property. The adjusted basis $50,000 cash2 + $4,000 goods + $2,000 services = is the original basis minus any accumulated depreciation $56,000 1Department Head and Professor, Department of Agricultural Economics and Agricultural Business, New Mexico State University. 2The amount of cash offered in this type of arrangement is often called the cash boot. To find more resources for your business, home, or family, visit the College of Agricultural, Consumer and Environmental Sciences on the World Wide Web at aces.nmsu.edu the dealer or to a third person, then later pays the dealer Asset Purchase 2 $72,000 in cash. Combine purchased on October 1, 19X1. Even under these circumstances, the basis in the new Original list price was $75,000. The seller agreed to combine is $64,000 because the Internal Revenue Ser- accept $60,000 in cash and a used combine, which vice sees this sale and purchase as being in fact a trade. was determined to have a fair market value of Generally, a sale and purchase of like-kind property oc- $12,000. The remaining value of the combine in curring within a 60-day period is viewed as a trade for the owner’s depreciation records was $4,000. tax purposes. Basis: $60,000 cash + $4,000 remaining value = $64,000 Asset Purchase 3 Plow purchased from a neighbor. The negotiated This basis calculation for asset purchase 2 seems at price was $5,000. The buyer paid $3,000 in cash first glance to be strange, but the reason for doing it and traded a bull having a fair market value of this way is to avoid paying tax on the gain on the old $2,000 and a book value of $1,000. combine. The owner’s depreciation records indicate Basis: $3,000 cash + $2,000 bull = $5,000 the remaining value of the combine is $4,000, but the owner could sell it for $12,000. There is, consequently, The purchase of asset 3 illustrates a limitation to an $8,000 gain, which would be taxable income if the the nontaxable exchange concept. Because the bull combine was sold. To avoid taxation of that gain, the and the plow are not like-kind property, the transac- farmer could roll over that gain into the new combine. tion is viewed as a sale and purchase and a taxable ex- In essence, this will recognize the gain at a later time. change. Therefore, the plow buyer would depreciate a The basis calculated can be viewed in an alternative way: $5,000 plow and pay tax on a $1,000 gain on the sale of the bull. Negotiated selling price = $72,000 The key to determining whether the trade was tax- Price paid in cash = $60,000 able or a nontaxable exchange lies in the definition of + Price paid in property = $12,000 like-kind property. Exchanges or trades of like-kind = Total price paid = $72,000 property are nontaxable, while trades of non-like-kind property are taxable. The IRS has defined like-kind to So the seller receives $72,000 worth of cash and ma- refer to the nature, character, use, or purpose of the chinery for the new machine. But, to avoid taxation of property. Any truck or any other machine is like-kind the gain, the buyer subtracts that gain: property as to any other machinery. A trade of farmland for apartment buildings or timberland is also a like-kind Total price paid = $72,000 exchange because all of these forms of property are held Minus gain = -$8,000 to generate income. However, a trade of machinery Basis = $64,000 for land, livestock of one sex for those of the other sex, an old bull for a young bull, and other such trades are The farmer would consequently place the new com- not like-kind. The IRS rules are strict and should be bine on the depreciation schedule at a basis of $64,000 checked before handling the transaction either as a tax- and calculate depreciation on that amount, but would able or a nontaxable exchange. list the market value of the machine at $72,000. This process of not recognizing gain on items traded in is called a nontaxable exchange. In most instances, OLD DEPRECIATION METHODS: PRE-1981 this process works to the advantage of the taxpayer, but Three major depreciation methods were recognized by it is not a matter of choice. That is, the owner of the the IRS for purchases of depreciable assets before 1981: property being traded in must handle the transaction in straight line, sum-of-years digits, and declining balance this manner; the owner cannot choose or elect to methods. To calculate depreciation under any of the recognize and pay tax on the $8,000 gain and depreciate methods, several pieces of information are needed, a $72,000 machine. The basis must be calculated to including date of purchase, salvage value, and useful life. be $64,000. It is also necessary to know whether additional first-year Suppose the farmer sees this trade coming and depreciation was taken. decides to recognize the gain and depreciate the full From this list, only the straight line method remains amount of the negotiated purchase price. The farmer an option for new purchases. Also, items bought before arranges to sell the old combine for $12,000, either to 1981 cannot be changed to the new depreciation methods that will be discussed later. However, it is likely that Circular 658 • Page 2 each established farm and ranch will continue to depre- Declining Balance Method ciate some items under the old methods. To calculate depreciation under the declining balance Because very few opportunities to make a choice method, you must first know the rate at which depre- remain under current law, it is no longer imperative to ciation was to take place. Those rates were specified as discuss the advantages and disadvantages of each meth- a maximum allowed for various classes of assets and od, or to discuss criteria for selecting the appropriate included 1, 1.25, 1.5, 2, or any rate less than those.

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