Depreciation & reduced basis through casualty gain

[Gretel]

When basis is reduced after a casualty gain, does that effect the basis for depreciation as well in that year? Or do you continue with the original basis and stop depreciation once you have reached a basis of zero taking the casualty gain into account?

On another note: how to you keep track of these things? It's easy enough to adjust a dollar amount but who remembers some years later why things have been done?

[Roland Slugg]

In order to have a gain on a casualty loss, the insurance proceeds must have been greater than the remaining basis of the property lost. In that case the basis is reduced to zero, and there is no further depreciation to deduct. If the property was replaced with similar property within the time allowed, generally two years, the gain is not taxable. Instead it reduces the basis of the replacement property. (Code §1033(a))

If the property was not replaced, the gain is taxable under Code §1231. Report the transaction on F-4797 as if it were a sale. If the property was §1245 property, the recapture rules will apply, converting most (or probably all) of the gain into ordinary income.

[Gretel]

In order to have a gain on a casualty loss, the insurance proceeds must have been greater than the remaining basis of the property lost. In that case the basis is reduced to zero, and there is no further depreciation to deduct. If the property was replaced with similar property within the time allowed, generally two years, the gain is not taxable. Instead it reduces the basis of the replacement property. (Code §1033(a))

If the property was not replaced, the gain is taxable under Code §1231. Report the transaction on F-4797 as if it were a sale. If the property was §1245 property, the recapture rules will apply, converting most (or probably all) of the gain into ordinary income.

Thank you, Roland, I agree and my choice of words was not very clear. Let me use number to illustrate my question.

Adjusted basis at time of loss is $500,000, insurance proceeds are $200,000 of which $50,000 is used for replacement property leaving $150,000 excess replacement property. There is no gain since this amount is higher than the basis. But the basis must be reduced to $350,000, right? If so, is $350,000 used for further depreciation?

[Roland Slugg]

Aahhh, so you meant "loss" not "gain." That does make a difference.

Using the numbers you quoted, the basis is now $350k. Depreciation of this reduced amount continues on, but the calculation must be made manually each year, starting with the year in which the basis adjustment took place. You can't use the table percentages any more, because when basis changes mid-stream, the percentages no longer work. If you apply them to the original $500k basis, you will end-up overdepreciating the asset, and if you apply them to the reduced $350k basis, you will end-up underdepreciating the asset.

I believe this exact point is covered in one of the IRS's Pubs ... probably Pub 946 on depreciating property.