Schedule E: Depreciation for Investment Property; Depreciation Recapture and House Improvements

[Anonymous]

Hi Community - I hope you are doing well. I would appreciate your expert advice for the below:

1) I recently discovered that my depreciation for a rental house for the past several years wrongly included "Land" value. Moving on and for 2023 - can I make the adjustment (i.e. exclude "Land" value) without the need to amend previous returns and does it matter that depreciation is the same (i.e. straight line) over 27.5 years? It will not be if I remove the "Land" value. Also, I could not take passive losses from the rental house for the past several years due to limitations. 

2) In terms of depreciation recapture - will these adjustments to depreciation schedule affect how depreciation recapture will work and one could explain how it will take place - I will highly appreciate it?

3) How do I depreciate house improvements from 2 years ago - do I just add the amount and put 27.5 years for straight-line depreciation and how? 

4) I forgot to include closing costs for this investment property I bought several years ago. Can I add those closing costs now and amortize those and how?

Hope for your advice.

[Anonymous]

Hi, Experts - @Carl , @LeticiaF1, @xmasbaby0  - could you please advise? Thank you.

[Carl]

You say it's been wrong for "several years". If you've been depreciating incorrectly *or* using an incorrect method *or* not depreciating any one or more assets for 2 or more consecutive years, then amending is not an option. You have to file IRS Form 3115 for fix this. Now while the program does include the 3115, very little support in the way of "help" is available for that form. I *HIGHLY* suggest you seek the services of a tax professional in your area; especially if your state also taxes personal income. Doing things wrong "WILL" cost you dearly, and what you pay for professional help will be a pittance in comparison to the fines, penalties, late fees, interest and back taxes you will be assessed if not done correctly.
Typically, folks don't catch their mistake until the tax year they sell the property. That's when all the additional costs really kick in and can significantly reduce (if not eliminate) any gain you may realize on the sale.  Please seek professional help with a tax pro in your locale with this. I do not recommend you attempt the 3115 yourself.
Check out IRS Publication 946 at https://www.irs.gov/pub/irs-pdf/p946.pdf beginning at the bottom of page 13 and on to page 14. Basically it states:
Generally, you must get IRS approval to change your
method of accounting. You must generally file Form 3115,
Publication 946 (2023) Chapter 1 Overview of Depreciation 13
Application for Change in Accounting Method, to request
a change in your method of accounting for depreciation.
The following are examples of a change in method of
accounting for depreciation.
• A change from an impermissible method of determin-
ing depreciation for depreciable property if the imper-
missible method was used in two or more consecu-
tively filed tax returns.
• A change in the treatment of an asset from nondepre-
ciable to depreciable or vice versa.
• A change in the depreciation method, period of recov-
ery, or convention of a depreciable asset.
• A change from not claiming to claiming the special de-
preciation allowance if you did not make the election
to not claim any special allowance

[Anonymous]

@Carl 

Thank you. I have had not right depreciation for past 3 years. It means no option to amend 2020, 2021 and 2022 but only to file IRS Form 3115? 

Could you advise what this IRS Form 3115 will essentially fix and what "fines, penalties, late fees, interest and back taxes" and "additional costs really kick" will be there at the time of house sale if not done properly now? 

@DianeW777  - I would appreciate your advice as well.

[DianeW777]

Yes, the Form 3115 is used as a change in accounting for the depreciation that was not handled or used in previous tax returns.  It can be combined on one tax return for the year you file it with your timely filed tax return (including extensions).

• Attach the original Form 3115 to the filer's timely filed (including extensions) federal income tax return for the year of change. The original Form 3115 attachment does not need to be signed.  
• About Form 3115, Application for Change in Accounting

You do have time to amend if 2020 is the first year of the error in depreciation. The statute of limitations runs out April 15, 2024, or two years after the tax was paid whichever is later. If you miss the deadline, then Form 3115 will be the best option for you.

• For tax years 2022, 2021, or 2020 - How do I file my 2022, 2021 or 2020 Tax Return?
• How do I amend a prior year return?  

Lastly, you can complete your 2023 tax return correctly and you should, then you can file the 3115 with your 2024 tax return next year to include the depreciation you did not use on the earlier returns.  I would suggest using a professional to help with the form if you choose to use it.

Depreciation in tax law is allowed or allowable, this means use it or lose it.  When you have a future sale, you will recapture that expense, meaning you will reduce your cost basis before determining gain even though you didn't use the depreciation. For this reason the amendments or the Form 3115 is very useful to include any depreciation you did not use or expense in the earlier years.  Generally, fines and penalties are assessed on tax balance due, however I will let Carl speak to additional fines that could be assessed and why. 

@Anonymous 

[Carl]

It means no option to amend 2020, 2021 and 2022 but only to file IRS Form 3115?

That is correct.

Could you advise what this IRS Form 3115 will essentially fix and what "fines, penalties, late fees, interest and back taxes" and "additional costs really kick" will be there at the time of house sale if not done properly now?

That form is used to "correct" your past depreciation errors in the current tax year you are filing now, and "make things right" going forward.

Many folks don't realize that depreciation is not a permanent deduction. In the tax year you sell or otherwise dispose of the property, that depreciation has to be accounted for. If you sell it, then all depreciation taken, or depreciation you should have taken (whichever is higher) is recaptured in the year of the sale. Two things happen with depreciation recapture.

1) It increases your AGI for that tax year, and can potentially bump you into the next higher tax bracket. Weather it does that or not, depends on the numbers.
2) Recaptured depreciation is not taxed as ordinary income. It's taxed at the capital gains tax rate which can be anywhere from 0% to a maximum of 25%.

Now, if you end up having to pay back some of your refund from prior years (or additional tax if you didn't get a refund) that overdue unpaid balance will be charged interest for each month late. I think the interest accumulates for a maximum of 1 year, but not sure.
As for fines and penalties, if any are assessed a tax pro "might" be able to  assist you with getting those forgiven. However, any interest that may be due can not be forgiven, as that is a requirement mandated by congress.

I've no clue how things work for state taxes if your state also taxes your personal income. But again, a tax pro in your local area can educate and help you with that.

[tagteam]

Best advice here is to get a tax professional, @Anonymous 

Any foregone depreciation (depreciation deductions you were entitled to take) would be a negative Section 481(a) adjustment on Form 3115 while any deductions that exceeded that which were allowed would be a positive adjustment. Y

You really do need guidance from a local tax professional for this scenario.