The issue relates to depreciation, which is defined as a reduction in the value of an asset with the passage of time, due in particular to wear and tear of the asset over time.
What most business owners don’t know is that, subject to IRS code, any depreciable asset – whether actually depreciated or not – legally has its basis adjusted for the allowed or allowable depreciation, regardless of the actual tax benefit received while placed in service. So what does that mean exactly?
According to IRS Publication 946: A basis adjustment must reduce the basis of the property by the depreciation allowed or allowable, whichever is greater.
Depreciation allowed is depreciation actually deducted when filing your taxes (from which you received a tax benefit). Depreciation allowable is depreciation you’re entitled to deduct, but didn’t necessarily deduct for tax purposes.
Furthermore, if you do not claim depreciation you’re entitled to deduct, you must still reduce the property’s basis by the full amount of allowable depreciation! That really changes the game plan for keeping or selling an asset, should the business owner have forgotten to depreciate any asset in question that’s allowable.
So for simplicity, let’s look at this example: Say your client purchased a building for $500,000 in which to operate his business, and didn’t depreciate the building’s cost as allowed, and then later decided to sell the building after 10 years and relocate. The basis for selling the building and reporting the gain wouldn’t actually be $500,000 as most would think; but rather $500,000 minus the allowable depreciation.
However, the good news is that the IRS created a catch-up provision to patch the one-sided depreciation rules for allowable depreciation. Rev. Proc 2007-16 allows a taxpayer who didn’t take allowable depreciation to obtain automatic consent for a change in the accounting method. What this does is permit a deduction for all of the omitted depreciation in the year of the accounting change, even if the property was sold. So while the details can be very technical, I think the key point is that should your client have a business asset that’s depreciable, it’s much simpler if they depreciate the asset in order to capture the allowed depreciation/tax deduction, and correctly adjust the asset’s basis. Otherwise, there’s a possibility they could get stuck later selling that asset without the tax benefit, as the catch-up provision or change in accounting method may not actually work within their business.