Thank you.

[Vick]

Thank you for this messaging board. You've all been very helpful. 

[Mike9241]

the depreciation you didn't take is relevant. you have to recapture it even though you didn't take it. that's the law.  do you want to pay takes on income generated by a deduction you never took? if you feel you can properly prepare the 3115 and reporting on your 1040 go for it. however, I would suggest using a pro considering how much was involved.   

[Vick]

Thanks Mike. Is the relevant question then whether it is less expensive to pay back the depreciation on assets I never took a depreciation for, versus paying taxes on $650k in extra capital gains? Between federal & state taxes (we're in California), that amounts to roughly $215k in taxes (~33% combined effective tax)?

Am I thinking about this correctly?

[Critter-3]

You MUST file a correct return and using the form 3115 to do it is your ONLY option to fix this error.  Please seek local professional assistance  or upgrade to one of the LIVE CPA options in the online program. 

[Vick]

Got it. Will do. Thank you. Can anyone tell me if I thinking correctly about the process however? I will effectively file Form 3115 to pay back depreciation I did not take in the first place? But that will allow me to at least add back the capital improvements we've made from prior years, without going back to amend prior years' tax returns?

[lhowell1]

To correct an error in the basis of rental property, you must amend the returns. 

Form 3115, doesn't "pay back" depreciation, it "gives" you the depreciation expense when you haven't taken any during the rental period.

Explained:

If you filed Schedule E, claiming your rental income and expenses, and you depreciated any of the rental property, you should have Form 4562, Depreciation and Amortization Report in your tax return copies.  Form 4562 (not filed with returns) will show the cost/value/basis of the property and the non-depreciable land.  If the cost basis is wrong, then you would amend the prior year returns to show the correct basis, which would offset your rental real estate income for each year of rental, frequently resulting in a refund.  (Generally, you must file an amended return within 3 years after the date you filed your original return or within 2 years after you paid the tax, whichever is later.) In the year of the sale, you use the (corrected) totals for basis and prior depreciation when entering the amounts in TurboTax. 

If you filed Schedule E, but you never took depreciation, then you would file Form 3115, Application for a change in Accounting Method, with your tax return.  (You are changing from an impermissible method of accounting for depreciation to the permissible method, Code 7.)  The effect of the Form 3115 would be to add the entire amount of overlooked depreciation (in full) in the year of correction.  The total depreciation adjustment is called a Section 481(a) adjustment.  When sold, you are reducing your (corrected) basis by the depreciation you take on Schedule E (when you file Form 3115) in the year of the sale.

See this article for a more in depth explanation of when to amend and when to adopt a change in accounting method: What if I didn't take depreciation on my rental property?   

See this article for getting your rental property's basis correct:  Major improvements before rental property put into service and basis There is also information in the article about short term rentals.  

[DianeW777]

Form 3115 is used to take a deduction in the current year for all years you missed by not including the capital improvements as an asset when you began renting the property three years ago.  The form 3115 is only available in the TurboTax desktop version (CD version).  You can't link to the desktop version, you need to download it, install it, and open it. 

• How do I switch from TurboTax Online to TurboTax CD/Download?

As indicated by Mike9241, you will recapture that depreciation whether or not you decide to use Form 3115 to deduct the expense.  

• In your case, if the first year you began to rent is still within the allowable amendment time frame you can amend all three years and eliminate the use of Form 3115.  The first return you would be allowed to amend that would be an advantage to you is 2019 if completed by April 15, 2023.  If the rental activity began before 2019, then Form 3115 is your only option.

Regardless of how you proceed you will do the following this year when reporting the sale.

1. You are allowed to use the full cost of the rental when you sell.
2. You must calculate all depreciation that would have been allowed whether you used it or not. This will be taxed at a special rate of 25% if the gain equals or exceeds this amount.
3. The remainder of the gain after accounting for the depreciation will be capital gain or possibly a portion, may be allowed under the home sale exclusion rules if you meet the requirements within the immediate five years preceding the sale.
   1. IRS Publication 523  (Home sale rules)
   2. If the home is currently set up as a rental on your return at the time of sale, then you need to complete the sale in the rental asset or assets.
   3. You will need to answer "No" to Special Handling to answer the questions about using it as a home. On the next screen you will be asked 'Was this asset included in the sale of your main home?'. Select Yes and then follow the screens to finish the reporting of your sale.
      • TurboTax will allocate the proper taxable amount due to the depreciation from the gain on the sale, only gain that exceeds this will be eligible for the exclusion.  You will not see 100% of the gain excluded, even if the total gain is below $500,000 for married taxpayers.

As indicated by other comments a professional may be your best option for 2022.

@Vick  

[Carl]

Although the 3115 may look simple, its not by any stretch. Unless you are a tax professional you are highly advised to seek professional help. Doing the 3115 wrong can (and usually will) make things worse and more costly. When that happens, it's when one usually realizes that the cost of professional help would have been a pittance in comparison.

[Anonymous_]

In your case, if the first year you began to rent is still within the allowable amendment time frame you can amend all three years and eliminate the use of Form 3115. 

See https://www.irs.gov/publications/p946#en_US_2022_publink1000107383

Unfortunately, since the same impermissible method of determining depreciation in two or more consecutively filed tax returns, the taxpayer needs to file Form 3115.

Adoption of accounting method defined.

Generally, you adopt a method of accounting for depreciation by using a permissible method of determining depreciation when you file your first tax return, or by using the same impermissible method of determining depreciation in two or more consecutively filed tax returns.