Incorrect depreciable basis

There are two ways do this:

• File an amended return: This only works if you didn’t deduct depreciation on your rental assets for one year. Go back and amend the return to reflect the missed depreciation. Note: You can only go back one year to claim a possible refund for missed depreciation.

• Adopt a change in accounting method: This option allows you to go back as far as you need. Make the adjustment on your current year tax return to expense the missing depreciation.

  • Why am I adopting a change in accounting method? Not claiming depreciation in two or more years indicates that you've chosen an accounting method without depreciation. In this case, you must now elect to change your accounting method to include depreciation.

To get IRS approval to change an accounting method, you'll need to file Form 3115, Application for Change in Accounting Method.

In general, you can only change the accounting method to catch up on missed depreciation or change depreciation that was calculated incorrectly.

The method used to fix incorrect depreciation depends on the length of time the deductions were taken.  

• If the error occurred for only 1 year: If only one tax return has been filed with the incorrect basis, the error would be corrected by filing an amended tax return for that year.
• If the error occurred for 2 or more years: An accounting method has been established, and in order to fix the issue, you would not amend the prior tax returns, rather you would file a Form 3115 with the current year tax return.

When a taxpayer depreciates land—which is a non-depreciable asset - for two or more years,  they have legally established an impermissible method of accounting.

Because an accounting method has been established, the IRS strictly prohibits correcting this error by filing amended tax returns. Instead, the correction must be made on the current year tax return by filing Form 3115 (Application for Change in Accounting Method).

Since land was included in depreciable basis, your client claimed more depreciation than was legally allowed. To correct this, use Form 3115 and calculate a positive Section 481(a) adjustment to repay the omitted taxable income.

1. Calculate "Actual Depreciation Claimed": Calculate the depreciation actually deducted on tax returns since the property was placed in service.
2. Calculate "Legally Allowable Depreciation": Recalculate the depreciation from the original start date using the correct basis .
3. The Adjustment: Subtract the allowable amount from the claimed amount.

Because the adjustment means owing tax on the excess depreciation taken in previous years, the IRS allows the following two treatments:

• The 4-Year Spread: Under standard rules, a positive Section 481(a) adjustment is recognized as additional income ratably over four consecutive tax years (25% per year), starting with the current tax year. It is reported on Schedule E as "Other Income."

• The De Minimis Election: If the total Section 481(a) adjustment is less than $50,000, you can elect to recognize the entire amount on the current year tax return.

There are very specific rules on how to complete Form 3115 and how to file Form 3115, so review the instructions at the IRS website for this form.