In this video, we walk through 5 REG practice questions demonstrating how to calculate the basis of assets converted to business use. These questions are from REG content area 3 on the AICPA CPA exam blueprints: Taxation of Property Transactions.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
Also be sure to watch one of our free webinars on the 6 “key ingredients” to an extremely effective & efficient CPA study process here…
How to Calculate the Basis of Assets Converted to Business Use
When an asset is converted from personal use to business use, calculating its tax basis for depreciation purposes requires a specific approach. The tax basis for depreciation depends on the fair market value (FMV) of the asset at the time of conversion and its original cost. Here’s how to calculate it:
Determine the Lower of Fair Market Value or Original Cost at Conversion
- Fair Market Value (FMV) at Conversion: This is the value of the asset in the open market at the time it’s converted to business use. The FMV can be determined through an appraisal or by researching the selling prices of similar assets in similar conditions.
- Original Cost Basis: This is the initial purchase price of the asset plus any capital improvements made before conversion to business use. Capital improvements are expenditures that increase the asset’s value, extend its life, or adapt it to a new use. Regular maintenance and repairs are not included.
The tax basis for depreciation purposes is the lower of the asset’s FMV at the time of conversion or its original cost basis. This rule ensures that depreciation deductions are based on the asset’s value as it starts being used for business purposes, preventing taxpayers from claiming deductions based on inflated values.
Calculate Depreciation
After establishing the tax basis, you can begin depreciating the asset based on its converted tax basis using the appropriate depreciation method and recovery period according to IRS guidelines. The depreciation method and recovery period depend on the type of asset and how it’s used in the business.
Special Considerations
- Partial Business Use: If the asset is used for both personal and business purposes, such as a home office, only the portion of the asset’s basis attributable to business use can be depreciated. You’ll need to allocate the basis between personal and business use based on the percentage of business use.
- Capital Gains Tax: If the asset is eventually sold, the difference between the sale price and the depreciated basis of the asset could be subject to capital gains tax. Additionally, if the FMV at the time of conversion was lower than the original cost basis and the asset is sold at a price higher than the original cost, the calculation of gain or loss on sale may involve both recaptured depreciation and capital gains.
- Documentation: Keep detailed records of the original purchase price, costs of any improvements, the FMV at the time of conversion, and calculations for depreciation. This documentation will be essential for tax reporting and in case of an IRS audit.
Calculating the tax basis for an asset converted from personal to business use correctly is crucial for accurate tax reporting and compliance. Given the complexities involved, it may be advisable to consult with a tax professional to ensure proper handling and to maximize tax benefits.
Example of Converting a Computer from Personal Use to Business Use
Imagine you purchased a personal computer 2 years ago for $1,500. Since then, you haven’t made any capital improvements to it, just routine software updates that don’t count as capital improvements. You decide to start a home-based business and convert this computer into a business asset.
At the time of conversion, you find that the fair market value (FMV) of the computer, based on similar used computers in the market, is $900.
Step 1: Determine the Tax Basis for Depreciation
To calculate the tax basis for depreciation of the computer when converting it to business use, you need to compare the FMV at the time of conversion ($900) with the original cost basis ($1,500).
- Original Cost Basis: $1,500
- Fair Market Value (FMV) at Conversion: $900
Since the tax basis for depreciation is the lower of the FMV or the original cost basis at the time of conversion, the tax basis for depreciation of the computer for business use would be $900.
Step 2: Calculate Depreciation
Assuming the computer will be used 100% for business purposes after conversion, you would depreciate it based on the $900 tax basis. The IRS provides guidelines for the depreciation of business equipment, including computers, which often fall under a 5-year recovery period using the Modified Accelerated Cost Recovery System (MACRS).
You would begin depreciating the computer over its IRS-determined recovery period, starting from the date of conversion to business use.
Special Considerations
- Partial Use: If you use the computer for both personal and business activities, you can only depreciate the percentage of its use that is for business. For example, if 70% of the computer’s use is for business, then only 70% of the annual depreciation expense is deductible.
- Documentation and Record-Keeping: Keep records of the original purchase date and price, the date of conversion to business use, calculations of FMV at the time of conversion, and how you determined the business-use percentage. This documentation is important for tax purposes and potential IRS inquiries.
- Subsequent Capital Improvements: If, after converting the computer to business use, you make capital improvements (e.g., significant hardware upgrades), these costs can be added to the computer’s basis and depreciated over their own recovery periods.
This example simplifies the depreciation process to focus on the conversion aspect. Given the complexities of tax laws and potential for changes, consulting with a tax professional is advisable to ensure accurate tax treatment and to leverage tax benefits fully.
