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Adjusted Basis:
Depreciation & Improvements

Learn how to calculate the adjusted basis of property by accounting for depreciation deductions and capital improvements over time.

CPA Regulation (REG)

What is Basis?

In tax law, the basis of an asset is the amount of your investment in that property for tax purposes. It serves as the starting point for computing gain or loss on a sale and for calculating depreciation deductions.

Cost Basis
The original purchase price plus acquisition costs (closing costs, commissions, legal fees).
Adjusted Basis
The original basis modified by increases (improvements) and decreases (depreciation, casualty losses).

Why Adjusted Basis Matters

Adjusted basis is critical for two key tax calculations. Getting it wrong means reporting the wrong gain or loss on your tax return, which can trigger penalties and interest.

Gain/Loss on Sale
\( \text{Gain or Loss} = \text{Amount Realized} - \text{Adjusted Basis} \)
Depreciation Base
Depreciation is calculated on the depreciable basis, and each year's deduction reduces the adjusted basis further.
Tax Compliance
The IRS requires accurate basis tracking. Errors may result in overstatement of deductions or understatement of gains.

The Adjusted Basis Formula

Original Basis + Improvements − Accumulated Depreciation Adjusted Basis Purchase Improvement +$ Depreciation −$ Sale Use Adj. Basis

Increases to Basis

Certain expenditures increase your basis. These are generally capital improvements: they add value, prolong the useful life, or adapt the property to a new use.

1
Capital improvements: additions, renovations, or upgrades (new roof, HVAC system, room addition).
2
Restoration after casualty: amounts spent to restore property damaged by fire, storm, or theft (not covered by insurance).
3
Legal fees: costs to defend or perfect title to the property.
4
Assessments: local assessments for infrastructure (sidewalks, roads) that increase property value.

Decreases to Basis

Certain items reduce your adjusted basis. The most significant for the REG exam is depreciation, whether or not you actually claimed it on your return.

1
Depreciation allowed or allowable: the greater of depreciation actually claimed or depreciation you were entitled to claim.
2
Casualty/theft losses: deductible losses reduce basis by the amount of the loss plus any insurance reimbursement received.
3
Section 179 deductions: immediate expensing of qualifying assets reduces basis to zero (or remaining basis).
4
Tax credits taken: certain credits (e.g., rehabilitation credit) require a corresponding basis reduction.

Repairs vs. Improvements

This distinction is one of the most tested concepts on the CPA exam. Getting it wrong changes both your current-year deduction and your adjusted basis.

Repairs (Expense) Improvements (Capitalize)
Effect on Basis No change ✓ Increases basis
Tax Treatment Deducted currently Depreciated over time
Purpose Maintains current condition Adds value or extends life
Example Fixing a broken window Adding a new wing
IRS Standard Ordinary & necessary Betterment, restoration, adaptation

Allowed vs. Allowable Depreciation

Allowed
Depreciation actually claimed on prior tax returns. This is the amount you did deduct.
Allowable
Depreciation you could have claimed under the applicable method, whether or not you actually did.

This prevents taxpayers from "banking" unclaimed depreciation to inflate their basis at the time of sale.

How to Calculate Adjusted Basis

1
Determine original basis: purchase price plus acquisition costs (closing costs, title insurance, legal fees).
2
Add capital improvements: include all amounts that qualify as betterments, restorations, or adaptations.
3
Subtract depreciation (greater of allowed or allowable): compute total depreciation for all years the asset was held.
4
Subtract other decreases: casualty losses claimed, Section 179 expense, applicable tax credits.
5
Result = Adjusted Basis. Use this to compute gain or loss: \( \text{Gain/Loss} = \text{Amount Realized} - \text{Adjusted Basis} \).

Example 1: Basic Calculation

Baker purchased a rental building for \( \$200{,}000 \). Over 5 years, she claimed \( \$30{,}000 \) in depreciation and spent \( \$25{,}000 \) on a new roof (capital improvement).

$200,000 Original Basis + $25,000 New Roof − $30,000 Depreciation = $195,000
\( \text{Adjusted Basis} = \$200{,}000 + \$25{,}000 - \$30{,}000 = \$195{,}000 \)

Example 2: Allowed vs. Allowable

Chen bought equipment for \( \$100{,}000 \). The allowable depreciation over 3 years was \( \$45{,}000 \), but Chen only claimed \( \$30{,}000 \) on his returns.

Allowed
\( \$30{,}000 \) (what Chen claimed)
Allowable
\( \$45{,}000 \) (what Chen could have claimed)

Example 3: Multiple Adjustments

Davis purchased a commercial building for \( \$500{,}000 \). Over the years: added parking lot (\( \$40{,}000 \)), installed new electrical system (\( \$35{,}000 \)), took total depreciation of \( \$120{,}000 \), and claimed a casualty loss deduction of \( \$15{,}000 \).

1
Start: Original basis = \( \$500{,}000 \)
2
Add improvements: \( \$40{,}000 + \$35{,}000 = \$75{,}000 \)
3
Subtract depreciation: \( -\$120{,}000 \)
4
Subtract casualty loss: \( -\$15{,}000 \)
5
Adjusted basis: \( \$500{,}000 + \$75{,}000 - \$120{,}000 - \$15{,}000 = \) \( \$440{,}000 \)

Section 179 & Bonus Depreciation

These accelerated depreciation methods allow immediate expensing of qualifying assets. They have a significant impact on adjusted basis because they front-load the basis reduction.

Section 179
Elect to expense the cost of qualifying business property in the year placed in service, up to the annual limit. Reduces basis immediately.
Bonus Depreciation
Allows an additional first-year depreciation deduction (100% for qualifying property placed in service through 2022, phasing down after). Reduces basis dollar-for-dollar.

Land Does Not Depreciate

When purchasing real property, you must allocate the purchase price between the land and the building. Only the building portion is depreciable.

Total Cost: $300,000 Land: $60,000 NOT depreciable Building: $240,000 Depreciable Allocation: 20% Land / 80% Building Based on FMV at time of purchase

Common Mistakes

✕ Confusing Repairs and Improvements
Treating a routine repair (painting, patching) as a capital improvement inflates basis. Only betterments, restorations, and adaptations are capitalized.
✕ Using Allowed Instead of Allowable
If you forgot to claim depreciation, your basis is still reduced by the allowable amount. Many students use only the amount actually deducted.
✕ Depreciating Land
Land is never depreciable. Failing to allocate between land and building leads to overstated depreciation deductions and incorrect basis.

Summary: Basis Adjustments

Adjustment Increases Basis Decreases Basis
Capital Improvements ✓
Depreciation (allowed/allowable) ✓
Section 179 Expense ✓
Casualty Loss Deduction ✓
Restoration After Casualty ✓
Legal Fees (title defense) ✓
Routine Repairs No effect No effect
Land Value No depreciation No depreciation

Question 1 of 5

A taxpayer purchased a building for \( \$400{,}000 \), added a new roof for \( \$50{,}000 \), and claimed \( \$80{,}000 \) in depreciation. What is the adjusted basis?

Question 2 of 5

A taxpayer's allowable depreciation was \( \$60{,}000 \) but only \( \$40{,}000 \) was actually claimed. By how much must the basis be reduced?

Question 3 of 5

Which of the following expenditures would increase the adjusted basis of a building?

Question 4 of 5

A taxpayer bought property for \( \$250{,}000 \) (land: \( \$50{,}000 \), building: \( \$200{,}000 \)). After \( \$60{,}000 \) in total depreciation, what is the adjusted basis of the entire property?

Question 5 of 5

Equipment costing \( \$80{,}000 \) was fully expensed under Section 179 in Year 1. If the taxpayer sells it in Year 3 for \( \$25{,}000 \), what is the recognized gain?