Cost Recovery Methods: Depreciation, Amortization, and Depletion
Cost recovery refers to the deduction of a portion of the cost of an asset, used in a business or for the production of income, over its useful life through depreciation, amortization, or depletion. The recovery of the cost of tangible property is through depreciation, whereas the recovery of the cost of intangible property, such as goodwill or patents, is through amortization, and the cost of natural resources is recovered through depletion. These deductions are allowed because of the recovery of capital doctrine, which holds that the return of the invested capital is not taxable.
Cost recovery methods only apply to assets that:
- are subject to exhaustion, wear and tear, or obsolescence;
- are used in a trade or business or other income-producing activity — personal property is not depreciable; and
- have a useful life greater than 1 year.
The cost of assets with an indeterminable life, such as antiques or undeveloped land can only be recovered by selling the property.
Depreciation is allowed for most tangible assets that are used in a trade or business or held for the production of income and that have a useful life greater than 1 year, including realty, which is land or buildings or other permanent structures on the land, and personalty, which includes all other tangible assets. Other methods of claiming a deduction for assets that have an extended life include amortization and depletion.
Amortization is necessary for claiming deductions on intangible assets used for business or for the production of income, including goodwill, covenants not to compete, licenses, copyrights, patents, and trademarks. Most of these assets, if acquired after August 10, 1993, are amortized over a 15 year period. Depletion is the allowed deduction for the extraction of certain natural resources.
The tax code distinguishes between allowed and allowable cost recovery. The allowed cost recovery is the amount that was actually deducted whereas the allowable cost recovery is the amount that could have been deducted. Usually, the allowed cost recovery is equal to the allowable recovery, but if the taxpayer does not claim the allowable deduction, then the tax basis of the property decreases by the amount of the allowable deduction, regardless of whether the taxpayer claimed it or not.
The tax basis of property is used both as a basis for determining depreciation, amortization, or depletion that is deductible in any given tax year and as a means to reflect the total amount of the allowable cost recovery that was claimable on the property for previous tax years. The original tax basis of most property is equal to its purchase price minus any direct costs of buying. Thereafter, the adjusted basis of the property continually declines by the amount of the allowable deduction that can be claimed for the property. If personal use property is converted to a business or income producing use, then the initial tax basis of the property is the lower of the taxpayer's adjusted basis or the fair market value (FMV) of the property. No deduction is allowed for the decline of FMV of any property that was used for personal use.
Depletion is used to deduct the cost of natural resources as they are used up. Depletion is a process by which the cost of the adjusted basis of a natural resource is recovered when the resources are extracted and sold. There are 2 methods to determine depletion allowance: cost and percentage methods. Cost depletion is where each unit of production is assigned a portion of the cost or basis of the interest, which is determined by dividing the basis by the total number of units expected to be recovered. For percentage depletion (aka statutory depletion) the tax law provides a specific percentage factor for different types of natural resources, which is multiplied by the gross income to arrive at the depletion allowance.