If you own a rental property, do you know if you have taken all of the possible deductions? The number one item that I see most commonly missed for a rental property on self-prepared tax returns is depreciation. You are allowed to depreciate residential rental property over 27.5 years and commercial rental property over 39 years. To calculate the depreciation, you will need the cost basis of the property, which is what you paid for it. Make sure you allocate a portion of the basis to land, another common error on tax returns. The land portion is not depreciable.
Why is it important to depreciate the property? Whenever you sell or dispose of the property, you have to calculate gain or loss on the property. Gain or loss is calculated in the following manner:
Less Cost Basis (including land)
Plus Accumulated Depreciation
If there is a gain, the accumulated depreciation is recaptured and taxed at ordinary income tax rates, up to the amount of the gain. If there is any balance remaining after the depreciation recapture, the remainder is taxed at favorable capital gains tax rates. If the IRS were to calculate the gain on the property, they would treat the property as if it had been depreciated, and you would not get to deduct the missed depreciation as an expense, but would pay ordinary tax rates on the accumulated depreciation calculated up to the amount of gain. Therefore, you want to make sure you are getting that depreciation deduction every year.
You may be very concerned at this point if you have not been taking depreciation, but fear not because we have some solutions for you. The first option is to amend prior year tax returns to deduct the depreciation on the tax returns. There is a drawback to this option: you can only amend tax returns filed in the prior 3 years, so if depreciation was missed prior to those 3 years you would still be missing out on the depreciation.
The second option to catch up missed depreciation is to file a 3115 Application for Change in Accounting Method. Filing this would allow you to capture any missed depreciation as far back as necessary, versus only being able to go back 3 years for amended returns. The form is filed with the current tax return and all of the depreciation is deducted in the current year as a Section 481(a) adjustment. The 3115 is a very in-depth form, so do not try this at home! You will want to use a tax professional to handle the 3115.
If you are reading this and want to take advantage of the 3115 or amending returns to capture missed depreciation, our accountant Wilmington NC will be happy to assist you.