Welcome to the University of Illinois at Urbana-Champaign online course on federal taxation, focusing on property transactions as they relate to calculating cost recovery, gains and losses, and the taxation of those gains and losses. In this video, we'll examine general concepts related to cost recovery, basis, the nature of property, as well as talk about cost recovery methods related to depreciation, amortization, and depletion. So let's begin with some terminology around cost recovery. First for accounting purposes, businesses must, what's known as, capitalize the cost of assets, if the asset's useful life is more than one year. Capitalization means that the cost of the asset purchase must show up on the balance sheet rather than as an expense on the income statement. For example, if I purchase a computer for my business and I pay $2,000 for it, and I expect to use it for the next five years, I must record $2,000 on my balance sheet as an asset and not record the $2,000 that I spent as a deduction, as if were a simple cash-out flow like buying say short-lived office supplies like pens or paper. Now, what happens here is that I take that $2,000 asset and recover the cost by using depreciation deductions. That is, I'll spread the $2,000 costs across the five years, over which I use the computer and I get a deduction in each of the five years, until the value of the computer on my books is zero. In a simple example, if I use what's known as straight-line depreciation, I can allocate the $2,000 total cost equally across each of the five years I use the computer or claim a $400 deduction in year one, a $400 deduction in year two, a $400 in year three, year four, and year five. In this sense, I've recovered the full $2,000 cost of my asset through the five years of $400 depreciation deductions. Again, those deductions were spread out over time namely, over the useful life of the asset. This is the general concept of cost recovery that we'll dig into in this module. There are actually three different methods to recover the cost of assets. The first is through depreciation. The same method I led off with in my example. Technically however, when we talk about depreciation, we're referring to deducting the cost of tangible, personal, and real property other than land, over a specified period of time. So here, we're talking about recovering the cost of business use computers, office furniture, business automobiles, warehouses, and rental properties over time. The second method is amortization. Conceptually, this is the same approach taken for depreciation, in that, we're spreading out the cost of an asset over time and deducting that cost on our tax return. But for amortization, we're technically talking about intangible assets. Rest of depreciation, we're talking about tangible assets. So under amortization, the taxpayer is deducting the cost of intangible, personal, and real property, such as patents, trademarks, copyrights, or leasehold improvements over a specified time period. The last recovery method is depletion. Again conceptually, this is the same approach taken for depreciation and amortization, and that we're spreading out the cost of an asset over time and deducting that cost on our tax return. But for depletion, we're talking about deducting the cost of natural resources. For example, timber, gold, diamonds, or oil, over time. Another important concept here is known as basis. This is essentially, the cost, the dollar value, that you report on your balance sheet of the asset you're using. In our earlier example, I bought a computer for $2,000. At the start of year one, I reported $2,000 on my balance sheet as the book value of the computer. It is this $2,000 basis that I'm depreciating. When do I start depreciating the asset? I start once I begin using the asset, not when I purchase the asset. It might of course be the same date as I buy the asset and start using it, but technically, I cannot start recovering the cost of the asset until I place that asset into service, until I use it. Then over time, I will recover the cost of the asset through cost recovery deductions. Again, in our computer example, I will fully deduct the cost of the $2,000 computer through depreciation over the next five years. The basis that's left after applying the cost recovery deductions is called the adjusted basis or the tax basis of the asset. So back to our example where I bought a computer for $2,000. At the start of year one, my basis was $2,000, but after using the computer for one year out of the next five, I'll depreciate it by 20 percent or $400. Therefore, my adjusted basis at the end of year one is $1,600, or the original cost of $2,000 minus the depreciation deduction that I've claimed over the period I used the asset. In year two, my adjusted basis will reflect another $400 that I deducted from the original basis of the asset. So after year two, the adjusted basis of the computer is $1,200 or $2,000 original basis minus year one depreciation of $400 minus year two depreciation of $400. If we apply this logic to each year, then after year three, my adjusted basis will be $400 lower than in year two, or $800. Then after year four, my adjusted basis will be yet another $400 lower or $400. After year five, my adjusted basis will be zero. That is, after five years of using the computer, I have deducted the full $2,000 costs of the computer at $400 per year. Also note that the term accumulated depreciation simply denotes the sum of the annual depreciation deductions that have been claimed over the life of the asset. For example, after year three, I will have claimed three years of $400 in annual depreciation. Therefore, my accumulated depreciation will be three times $400, or $1,200. If my accumulated depreciation is $1,200 and my original basis was $2,000, then this means that at the end of year three, the adjusted basis in my computer is $800. A couple of other important notes here. First, we will establish basis and then reduce it through cost recovery if we purchase a business use asset or extend its useful life. We will not establish basis if we engage in routine maintenance. For example, if I buy a new hard drive from my computer, I will extend its useful life. Therefore, the cost of the new hard drive will increase my computer's basis, and thus I can depreciate it over time. However, if my laptop is just dirty and I take it in for professional cleaning, this is not considered to increase the useful life of the asset. I will not capitalize and then depreciate the cost of the cleaning. I'll simply deduct the cost of the cleaning immediately and all at once, as an ordinary and necessary business expense. There is no basis or cost recovery to deal with here. Second, basis must be reduced by cost recovery deductions allowed or allowable, even if the taxpayer fails to deduct the depreciation on his or her tax return. That is, even if the taxpayer does not claim depreciation deductions on his or her tax return, the IRS will assume the depreciation was taken and basically adjust the basis for you. Now, if they're doing that anyway, the smart thing is to go ahead and claim that depreciation, so you can actually get a deduction for it. Remember, in tax, deductions are good. Claim what you legally can. Deductions reduce income that would otherwise be taxed. A little bit more about basis. How do you establish basis? What's the basis in the asset you're using in your business? Well, there are actually a number of ways to establish basis. First, the most obvious way is just to go out and actually buy the asset through a normal exchange. That is, I pay money in exchange for a business use asset, like a computer. Here are the basis is the fair market value. That is, the price that I paid for the asset. So back to our example. I paid $2,000 to buy a computer. Therefore, this is a normal exchange. I record $2,000 as my initial basis on my balance sheet. However, another issue is that when you start a business, sometimes you're converting personal use assets to business use assets. Let's say, you have a personal laptop that you've owned for two years, but this year, you decide to start a business, but you need a computer for that business. Being cost-conscious, instead of going out and buying an expensive new computer, you simply start using your personal computer for business purposes. That is, you convert your computer from a personal use asset to a business use asset. In this scenario, what's the basis of this computer in your business? Well, in this case, the basis is the smaller of the cost basis, so what you originally paid for the computer, or the fair market value of the computer on the date you converted the computer from personal to business use. So if you bought your computer for $2,000 two years ago, and now it's only worth $,1000 when you convert it to business use, the basis on your business balance sheet for the computer is only $1,000 or the smaller of the original cost $2,000, or the fair market value on the date of the conversion, $1,000. Another way to establish basis in a business use asset, is when you acquire an asset through what's known as a non-taxable exchange. We'll talk about non-taxable exchanges in future videos. Finally, one way to acquire an asset for a business is through an inheritance. Let's say you inherit a computer from a relative who passed away, and you are using that computer in your business. What's your basis? You didn't actually buy the computer. Well, the basis here is simply the fair market value of the asset on the date of the person's death. This adjustment in basis is actually quite well-known when talking about inheriting stock from the deceased person. If for example, my grandfather bought stock for $10 20 years ago, and on the date of his death the fair market value of that stock is $200, and I inherit the stock from him, then my basis is $200. This is known as a step up in basis. Again, we'll talk about this basis issue in a future video. Finally, in terms of terminology, let's talk about the nature of property generally. There are basically two kinds of property, realty and personalty. Realty includes buildings, land, warehouses, apartments, stores, or other similar items that are permanently affixed to the land. Personalty is defined as any asset that is not real to you. So things like furniture, equipment, machinery, automobiles, computers, even tractors, dairy cattle, railroad, cars, and many other types of assets. Note that personalty does not suggest that the asset is used for personal purposes. Personal use property is any property whether realty or personalty, that has held for personal use rather than for use in a trade or business, or in an income producing activity. So in effect, you can have four kinds of property. You have business use realty like a warehouse, or business use personalty, like office furniture or a work computer, or you can have personal use realty like your house or apartment, or you can have personal use personalty, like a personal car or personal phone, or the refrigerator in your house, or you're bed, or your couch. These distinctions are important because there is no depreciation, amortization or depletion allowed for personal use assets. In general, you cannot depreciate your house, refrigerator, couch, bed, personal computer, and so on. If you use an asset for personal purposes, then the personal use portion is not eligible for cost recovery deductions. So for business use property, you can depreciate business use personalty and business use realty, although business use land is not technically depreciable because it is not subject to wear and tear or obsolescence. For a business owner, the depreciation deductions are FOR AGI deductions, meaning calculated before arriving at adjusted gross income. So in all, in this video, we discuss general terminology related to cost recovery, basis, adjusted basis, and the nature of property. These concepts will be important as we move forward with the next set of videos.