Property Received as a Gift

To figure the basis of property you receive as a gift, you must know its adjusted basis (defined earlier) to the donor just before it was given to you. You also must know its FMV at the time it was given to you and any gift tax paid on it.

FMV equal to or more than donor's adjusted basis.   If the FMV of the property is equal to or more than the donor's adjusted basis, your basis is the donor's adjusted basis when you received the gift. Increase your basis by all or part of any gift tax paid, depending on the date of the gift.

Also, for figuring gain or loss from a sale or other disposition of the property, or for figuring depreciation, depletion, or amortization deductions on business property, you must increase or decrease your basis (the donor's adjusted basis) by any required adjustments to basis while you held the property. See Adjusted Basis, earlier.

Gift received before 1977.   If you received a gift before 1977, increase your basis in the gift (the donor's adjusted basis) by any gift tax paid on it. However, do not increase your basis above the FMV of the gift when it was given to you.

Example 1.   You were given a house in 1976 with an FMV of $21,000. The donor's adjusted basis was $20,000. The donor paid a gift tax of $500. Your basis is $20,500, the donor's adjusted basis plus the gift tax paid.

Example 2.   If, in Example 1, the gift tax paid had been $1,500, your basis would be $21,000. This is the donor's adjusted basis plus the gift tax paid, limited to the FMV of the house at the time you received the gift.

Gift received after 1976.   If you received a gift after 1976, increase your basis in the gift (the donor's adjusted basis) by the part of the gift tax paid on it that is due to the net increase in value of the gift. Figure the increase by multiplying the gift tax paid by the following fraction.

Net increase in value of the gift

Amount of the gift

The net increase in value of the gift is the FMV of the gift minus the donor's adjusted basis. The amount of the gift is its value for gift tax purposes after reduction by any annual exclusion and marital or charitable deduction that applies to the gift. For information on the gift tax, see Publication 950, Introduction to Estate and Gift Taxes.

Example.   In 2002, you received a gift of property from your mother that had an FMV of $50,000. Her adjusted basis was $20,000. The amount of the gift for gift tax purposes was $39,000 ($50,000 minus the $11,000 annual exclusion). She paid a gift tax of $9,000. Your basis, $26,930, is figured as follows:

Fair market value	$50,000
Minus: Adjusted basis	- 20,000
Net increase in value	$30,000
Gift tax paid	$9,000
Multiplied by ($30,000 ÷ $39,000)	× .77
Gift tax due to net increase in value	$6,930
Adjusted basis of property to your mother	+20,000
Your basis in the property	$26,930

FMV less than donor's adjusted basis.   If the FMV of the property at the time of the gift is less than the donor's adjusted basis, your basis depends on whether you have a gain or a loss when you dispose of the property. Your basis for figuring gain is the donor's adjusted basis plus or minus any required adjustment to basis while you held the property. Your basis for figuring loss is its FMV when you received the gift plus or minus any required adjustment to basis while you held the property. (See Adjusted Basis, earlier.)

If you use the donor's adjusted basis for figuring a gain and get a loss, and then use the FMV for figuring a loss and get a gain, you have neither gain nor loss on the sale or other disposition of the property.

Example.   You received farm land as a gift from your parents when they retired from farming. At the time of the gift, the land had an FMV of $80,000. Your parents' adjusted basis was $100,000. After you received the land, no events occurred that would increase or decrease your basis.

If you sell the land for $120,000, you will have a $20,000 gain because you must use the donor's adjusted basis at the time of the gift ($100,000) as your basis to figure a gain. If you sell the land for $70,000, you will have a $10,000 loss because you must use the FMV at the time of the gift ($80,000) as your basis to figure a loss.

If the sales price is between $80,000 and $100,000, you have neither gain nor loss. For instance, if the sales price was $90,000 and you tried to figure a gain using the donor's adjusted basis ($100,000), you would get a $10,000 loss. If you then tried to figure a loss using the FMV ($80,000), you would get a $10,000 gain.

Business property.   If you hold the gift as business property, your basis for figuring any depreciation, depletion, or amortization deductions is the same as the donor's adjusted basis plus or minus any required adjustments to basis while you hold the property.

Property Transferred From a Spouse

The basis of property transferred to you or transferred in trust for your benefit by your spouse is the same as your spouse's adjusted basis. The same rule applies to a transfer by your former spouse if the transfer is incident to divorce. However, adjust your basis for any gain recognized by your spouse or former spouse on property transferred in trust. This rule applies only to a transfer of property in trust in which the liabilities assumed plus the liabilities to which the property is subject are more than the adjusted basis of the property transferred.

The transferor must give you records needed to determine the adjusted basis and holding period of the property as of the date of the transfer.

For more information, see Property Settlements in Publication 504, Divorced or Separated Individuals.

Inherited Property

Your basis in property you inherit is generally one of the following.

• The FMV of the property at the date of the individual's death.
• The FMV on the alternate valuation date, if the personal representative for the estate chooses to use alternate valuation. For information on the alternate valuation date, see the instructions for Form 706.
• The decedent's adjusted basis in land to the extent of the value that is excluded from the decedent's taxable estate as a qualified conservation easement. For information on a qualified conservation easement, see the instructions for Form 706.
• The value under the special-use valuation method for real property used in farming or other closely held business, if chosen for estate tax purposes. This method is discussed next.

If a federal estate tax return does not have to be filed, your basis in the inherited property is its appraised value at the date of death for state inheritance or transmission taxes.

Special use valuation.   Under certain conditions, when a person dies, the executor or personal representative of that person's estate may choose to value the qualified real property at other than its FMV. If so, the executor or personal representative values the qualified real property based on its use as a farm or other closely held business. If the executor or personal representative chooses this method of valuation for estate tax purposes, this value is the basis of the property for the heirs. The qualified heirs should be able to get the necessary value from the executor or personal representative of the estate.

If you are a qualified heir who received special-use valuation property, increase your basis by any gain recognized by the estate or trust because of post-death appreciation. Post-death appreciation is the property's FMV on the date of distribution minus the property's FMV either on the date of the individual's death or on the alternate valuation date. Figure all FMVs without regard to the special-use valuation.

You may be liable for the additional estate tax if, within 10 years after the death of the decedent, you transfer the property or the property stops being used as a farm. This tax may apply if you dispose of the property in a like-kind exchange or involuntary conversion. The tax does not apply if you transfer the property to a member of your family and certain requirements are met. See Form 706-A and its instructions for more information on this tax.

You can elect to increase your basis in special-use valuation property if it becomes subject to the additional estate tax. To increase your basis, you must make an irrevocable election and pay interest on the additional estate tax figured from the date 9 months after the decedent's death until the date of payment of the additional estate tax. If you meet these requirements, increase your basis in the property to its FMV on the date of the decedent's death or the alternate valuation date. The increase in your basis is considered to have occurred immediately before the event that resulted in the additional estate tax.

You make the election by filing with Form 706-A, a statement that does all the following.

• Contains your (and the estate's) name, address, and taxpayer identification number.
• Identifies the election as an election under section 1016(c) of the Internal Revenue Code.
• Specifies the property for which you are making the election.
• Provides any additional information required by the Form 706-A instructions.

Community property.   In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), husband and wife are each usually considered to own half the community property. When either spouse dies, the total value of the community property, even the part belonging to the surviving spouse, generally becomes the basis of the entire property. For this rule to apply, at least half the value of the community property interest must be includible in the decedent's gross estate, whether or not the estate must file a return.

Example.   You and your spouse owned community property that had a basis of $80,000. When your spouse died, half the FMV of the community interest was includible in your spouse's estate. The FMV of the community interest was $100,000. The basis of your half of the property after the death of your spouse is $50,000 (half of the $100,000 FMV). The basis of the other half to your spouse's heirs is also $50,000.

For more information about community property, see Publication 555, Community Property.

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.

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