How to correct the cost basis of rental depreciation

[Christopher Chu]

I bought a house at 150K and rented it out in 2011. I used TurboTax  and mistakenly entered 45K as the cost basis for depreciation (perhaps I entered the "land"  amount or something like that). I have not noticed this mistake until now, March 2023. Note that I've used TurboTax all these years.

I have the closing statement in 2011 and the title as evidence of the actual house cost.

I know I have to use Form 3115 to make the change but I was completely overwhelmed with it.

I deeply appreciate it if the experts would please help guide me as how to fill out the critical parts of the form to change the cost basis from 45K to 150K.

And if you would, please tell me the possible consequences of my mistake.

Thanks so much in advance for your help.

[Mike9241]

Your interests may best be served by using a tax pro.  cost 150K - does that include closing costs that become part of the total basis? from that, you have to subtract out the value of the land in 2011 to come up with what the correct basis would be for deprecitaion purposes. then you would have to compute the correct 2011- 2021 depreciation that should have been taken and subtract out the amount you actually taken. that becomes your section 481 adjustment which would probably need to be included on the rental schedule for 2022.   an extremely rough estimate is that the adjustment would be about 36% to 40% of the difference in depreciable tax basis.  that's a huge deduction that may subject your rental to the passive loss rules. if you treat the rental as a qualified business for the 199A/QBI deduction then there's the issue of proper allocation of this adjustment to the years QBI was in effect. then if you have state income taxes what are its rules - do they follow the federal 

[Carl]

The 3115 is not simple by any stretch. Therefore you should seek professional help for this. Especially if your state taxes personal income.

[Christopher Chu]

Thanks so much for everyone's help. I found out that I entered wrong values into TurboTax for calculating the Depreciation.

[AmeliesUncle]

Form 3115 does NOT apply if you merely used the wrong Basis.  That is a "mathematical or posting error" that can only be corrected by amending.

If the event you were accidently depreciating the land and not depreciating the building, that may qualify for Form 3115.  *IF* that is the case, as was mentioned I recommend going to a good tax professional that is familiar with Form 3115.

[Christopher Chu]

Dear AmeliesUncle:

I had a wrong basis based on a wrong and extremely low improvement/building value. Would you please explained what you mean by "amending" in this case? Is there a form for this?

Best regards

Chris

[AmeliesUncle]

Amend your tax return.  If this was on your personal tax return (Form 1040) you amend it by filing Form 1040X for each year that was wrong.

[PatriciaV]

You "amend" your prior year by filing a corrected version of that return. Here's an article explaining the process: How do I amend my federal tax return for a prior year?  You have three years from the date you filed your return or two years after you paid the tax due (whichever is later) to file an amendment, which means you will probably amend your returns for 2019-2021.

When you amend the first year, remove the rental asset (not the property, just the asset). Then re-enter using the correct basis. TurboTax will calculate an estimate of accumulated depreciation, which will be incorrect. Because you have reported excess depreciation for this property, you need to enter the amount from the prior year Depreciation Report instead of accepting the calculated amount. 

If you keep this asset for the rest of its useful life, you'll actually stop depreciating it in the last few years because you've already taken that depreciation in earlier years.

Repeat the amending process for each year (2020-2021), entering the accumulated depreciation on the Depreciation Report from the amended return of the prior year. Then use the amount from 2021 (as amended) on your 2022 return.

[Christopher Chu]

Dear Patricia:

Thanks so much for the expert advice.

For clarification only: instead of claiming about $4000 depreciation each year for the rental, I've been claiming less than $1600 since 2011. This was due to the error where I mistakenly entered my own improvement amount of ~$10K (repairs and adding 2 rooms in the basement) before renting the house into the "building" amount ~100K into Turbo-tax. I believe I should get refunds for this and that's why I'm trying to fix this problem.

I have 2 questions:

Question 1:

If I don't do anything, I will loose approximately the following amount of depreciation deduction for 27.5 years (4000-1600) x 27.5 = $66000. Is this correct? In this case, after 27.5 years when I sell the rental, I assume the government only recapture the actual depreciation (1600x27.5). Is this also correct?

Question 2:

In case I want to amend, I think you're suggesting:

File 3 1040X forms for 2019, 2020 and 2021, one after another in the next 2 weeks and submit them all before submitting the 2022 taxes. Also, in the 2022 taxes, use the new depreciation values, overriding the default calculated by Turbo-tax. In this case, I can use Turbo-tax for these 3 years to amend each of them separately.

What I'm unclear about is that the house was rented out in 2011 and I'm amending now in 2022. I think I must consider the deductions for the last 8 years from 2011-2018 irrecoverably fixed (unchanged) and in the amending 1040X starting 2019, subtracting the total depreciation of those 8 years from the correct total building value to be entered into Turbo-tax 2019 and let Turbo-tax recalculate the new depreciation in the next 16.5 years. If this is correct, the new/correct depreciation for this rental will be the same in the new value for 1040X for 2019, 2020 and 2021 and also in the upcoming 2022 taxes, even though the accumulated values are different.

Your response and clarifications are deeply appreciated since time is running out for me for the 2022 tax filing.

Again, thanks so much for your help.

Best regards,

Chris

[AmeliesUncle]

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@Christopher Chu wrote:

This was due to the error where I mistakenly entered my own improvement amount of ~$10K (repairs and adding 2 rooms in the basement) before renting the house into the "building" amount ~100K into Turbo-tax. 

Question 1:

If I don't do anything, I will loose approximately the following amount of depreciation deduction for 27.5 years (4000-1600) x 27.5 = $66000. Is this correct? In this case, after 27.5 years when I sell the rental, I assume the government only recapture the actual depreciation (1600x27.5). Is this also correct?

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Can you clarify and expand on your mistake?  I'm just trying to figure out if there is any legal way to use Form 3115 (which would be MUCH better).

Yes, you would lose that much depreciation.  But NO, the 'recapture' is on the depreciation that you COULD have taken.   That is why it is important to try to correct as much as possible.

I'll respond to your second question after you expand a bit on the mistake (in case you can handle this differently).

On a related note, from 2011-2018, did your rental have losses?  If so, were they allowed to be used, or have they been carried forward on Form 8582 (and have they EVER been able to be used)?  That could possibly also affect who you proceed with amending.

[Christopher Chu]

Dear AmeliesUncle:

Thanks for helping. Below are answers to your questions so you can continue helping me.

1. I hadn't had losses on this rental from 2011 through 2018.

2. My mistake on 2011 was:

TurboTax prompted me to enter the "land "value. Since this rental was a new purchase and I did not have the exact info at the time, I read somewhere as how to approximate and entered an approximate 20% of the total purchase (24K - last week, I found out the correct 2011 land value from the county). Then, at the prompt for Improvement (e.g., the building value), I mistakenly thought TurboTax asked for the Improvement that I'd made to build 2 small rooms in the basement, I enter 10K instead of the (actual purchased value - 24K). Thus, I missed more than 50K of rental building value since 2011. After these, TurboTax told me my depreciation is a bit more than $1400. I didn't notice this depreciation amount until 2022.

[AmeliesUncle]

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@Christopher Chu wrote:

Then, at the prompt for Improvement (e.g., the building value), I mistakenly thought TurboTax asked for the Improvement that I'd made to build 2 small rooms in the basement, I enter 10K instead of the (actual purchased value - 24K).

Depending on your perspective, that could be viewed as you did NOT depreciate the main building at all.  You only deprecated the separate 'improvement' (the two rooms).  It is an arguable point, but I think I would try it

IF that is the case, then you can use Form 3115 to 'catch up' on all of the depreciation.

I recommend to file an extension, and contact a tax professional in May about filing this year's tax return.  When looking for a tax professional, ask if they know how to use Form 3115 to 'catch up' on missed depreciation.

[Christopher Chu]

Dear AmeliesUncle:

thanks for the suggestion. I have 2 more questions. 

Would it make any significant difference if I do the form 3115 next tax year rather than doing an extension for this year with it? 

Secondly, why amending with 1040x specifying the change just once and recalculating the correct and remaining depreciation for the rest 15.5 years won’t work so that we have to do form 3115?

I appreciate your help deeply?

Best regards 

chrid

[Carl]

Would it make any significant difference if I do the form 3115 next tax year rather than doing an extension for this year with it?

It could. But considering it's been wrong for over 10 years, I don't think it will be that much of a difference to matter really. But it does depend on the numbers. Overall, since the 3115 is not simple and really needs to be done by a professional, you may find it difficult (if not impossible) to find an experienced CPA this late in the tax filing season. It might be more realistic to tackle it next year with the 2023 taxes, which allows you time to set up things with a CPA to get it done quick and early in the 2023 filing season for next year.

Secondly, why amending with 1040x specifying the change just once and recalculating the correct and remaining depreciation for the rest 15.5 years won’t work so that we have to do form 3115?

Because by not depreciating the property, you have used what the IRS calls an "impermissible method". When using an impermissible method for depreciation for 2 or more consecutive years, the IRS requires the 3115 to make it right.

This is convered in IRS Publication 946 at https://www.irs.gov/pub/irs-pdf/p946.pdf starting on page 13 under "Change your accounting method".  One of the examples shown where the 3115 is required is, "A change in the treatment of an asset from nondepreciable to depreciable or vice versa."  So based on what it says in the pub, you are required to fix this with the form 3115.