What is Basis from a Tax Perspective?

Basis is the amount paid for an asset plus other related costs to acquire the asset, such as sales tax, shipping, and installation, less depreciation taken. The basis will change over time and is used to figure the gain or loss upon asset disposal.

For example, if a taxpayer purchases a piece of equipment to be used in a business and it costs $100,000 but has $5,000 in shipping and installation costs and $3,500 in sales tax. The property’s basis is $108,500 ($100,000 + $5,000 + $3,500).

When a taxpayer depreciates the property and adjusts the basis downward, this asset has a lower adjusted basis or tax basis of the asset. As time passes, the adjusted basis will continue to decline unless an improvement is made to the asset.

If an improvement occurs to an asset, the amount must be capitalized if it results in a betterment to the asset. The same occurs for when an asset adapts to a new or difference use or results in a restoration of the asset.

These changes will affect the basis of all Section 1231, 1245, and 1250 property.

What Are the Requirements for Depreciating Tangible and Intangible Property?

Depreciation also counts as an income tax deduction on most types of tangible property (except land) such as buildings, machinery, vehicles, furniture, and equipment. Likewise, certain intangible property, such as patents, patient and customer lists, copyrights, and off-the-shelf computer software qualify for depreciation and amortization expense.

In order for a taxpayer to claim a depreciation deduction for property, it must meet the following requirements:

Taxpayer must own the property (qualified leasehold improvements made to leased property also qualify for depreciation treatment)

Taxpayer must use the property in a trade or business which seeks to produce income (claiming depreciation expense has a “more than 50 percent business-use requirement and therefore the taxpayer may only deduct the portion associated with business use)

Property must have a determinable useful life of one year or more

What is the Section 179 Deduction?

Think of the Section 179 deduction as a form of accelerated depreciation. Instead of the taxpayer waiting multiple years to deduct depreciation expense from taxable income, the taxpayer may depreciate the entire cost in the year of purchase, subject to limitations.

Section 179 allows taxpayers employed in a trade or business to deduct the cost of certain property as an expense when placed in-service during the tax year. Traditionally, Section 179 expense capped at $500,000 and had a phase-out limit of $2,000,000.

However, these limits increased under tax reform in 2018 to $1,000,000 and $2,500,000, respectively. Further, these amounts index for inflation each year.

This deduction applies to new and used equipment as well as off-the-shelf software. To claim the deduction in tax year 2019, the equipment must be financed or purchased and placed in-service during 2019.

This expense can be claimed by businesses and taken as a self-employment tax deduction. Form W-2 employees may not claim this deduction as any asset would be considered for personal use.

What is Section 168 Depreciation (MACRS and Bonus)?

The depreciation deduction provided by Section 167(a) for tangible property placed in service after 1986 generally falls under IRC Section 168 (MACRS). These provisions exist for firms unable to claim the Section 179 allowance and may recover the cost of qualified assets over longer periods of time.

Section 168 (MACRS) prescribes two methods of accounting for determining depreciation allowances:

General depreciation system (GDS) in Section 168(a) Alternative depreciation system (ADS) under Section 168(g)

Under either system, the taxpayer calculates the depreciation deduction by using a prescribed depreciation method, recovery period, and convention.

Another option, Section 168(k) (bonus depreciation), allows taxpayers to expense 100% of the cost of qualified assets bought and placed in service between September 28, 2017 and December 31, 2022.

These separate sections may seem to overlap. This is because, under current law, new and used tangible property, as specified in Section 1245(a)(3), qualifies for the allowance if it is depreciable under Section 168 (which contains the MACRS) and acquired for use in the active conduct of a trade or business.

In the example below, I step through the specific order a taxpayer should claim these allowances.

What are the Section 179 Limit Deductions for 2018 and 2019?

Each tax year, a taxpayer may deduct as an expense in lieu of depreciation, a fixed amount of depreciable property (e.g., machinery, equipment, computer software, etc.). Under tax reform, the limit for 2018 and 2019 is $1,000,000 for new or used personal property acquired from an unrelated party.

Specific to the Section 179 deduction, it reduces dollar-for-dollar on an asset placed in service during the taxable year which exceeds $2,500,000 in value.

For example, when a taxpayer places a $2,600,000 asset in-service, the $100,000 excess over the investment limit reduces the available Section 179 deduction to $900,000 ($1,000,000 limit – $100,000).

Following this math to its conclusion, the Section 179 deduction investment limit caps out on equipment at or above $3,500,000. Above this threshold, the taxpayer cannot claim a Section 179 deduction on the property.

In this case, use of bonus depreciation and MACRS depreciation will apply.

Also, taxpayers cannot take the 179 deduction when a net operating loss exists or if the deduction would create a loss.

For historical context, the maximum expensing allowances and investment limitations from 1987 to 2018 are shown in the table below.