Wrong cost basis used for 10+ years--now a sale

[origun]

Taxpayer has a rental home purchased in 1999. It has been a rental since purchase. (She inherited some money and used it to pay cash for a rental house.) I inherited the client in 2005 and at that time used the previous preparer's cost basis and depreciation schedule to continue depreciation. Now, in 2011, she has sold the home and is working with me to find out the upcoming tax consequences. Here is a simplified version of the situation:
Original purchase price $80,000 according to verifiable records which I just saw for the first time.
Previous preparer used $55,000 as cost basis and depreciated $34,000, assigning the rest to land. I just took those numbers and continued depreciating. So we have over 10 years of under depreciation.
She just sold the property for $65,000.
I know I could amend for open years now. I also know I have to use depreciation "allowed or allowable" when selling--so could/should I refigure depreciation that would have been allowable and use that on the 4797 when I file her return next year?

Thanks for any help you can give.

[taxea]

Either I missed something or you didn't say why the depreciation basis was not correct. If, in fact, the basis for depreciation that was being used was too low then a one-time adjustment can be made on the return to correct it. You would then haved to show the calculation used to determine the correct deprection amount and make the adjustment for the difference between what was taken and what should have been taken. If you do it this way she doesn't lose the amount that was "depreciable" over the years. After this adjustment is made you can then do the sale.

[origun]

Thanks taxea

I don't know why the cost basis was too low--I didn't do the original return which set up the depreciation schedule. I'm assuming the previous preparer just made an error, assuming she purchased for $55k instead of $80k. My guess is that the $55k should have been the depreciable part (the building) and he/she took out the percentage allotted to land twice.

So, can I do the correct calculations for 1999 through 2010 and take the additional depreciation for all prior years on a 2011 return (with explanation and showing all calculations, of course)--which will result in a significant Schedule E loss for the half year she rented it in 2011? And then use the correct purchase price and depreciation on a 4797 for sale of property?

Or perhaps I should amend 2010 and take all the depreciation for 1999 through 2010 and then the 2011 return with the sale will be a "cleaner" return?

[JAinNC]

If client paid 80,000 for property, - was the land included in that total price?
55,000 house + 2500 for land = 80,000.

Since the land is not depreciable - I always split out the land so it shows on dep sheets --
many others do not. I would think the count property records go back to 1999 or prior.

Just my 2 cents worth

Jeannie

[origun]

land vs improvements

JAinNC: Thanks for your input. The information that I received when I started doing the return several years ago (from prior return, not original purchase documents) had approximately $55k as purchase price, which was broken down as $21k for land and $34k for improvements (i.e., depreciable). This breakdown is a similar percentage to our county assessor's records which I have looked at--so is reasonable. However, taxpayer says she paid c. $80k and has records to support it.

[Uncle Sam]

Wrong Cost

Until you see documentation - you can't assume the taxpayer is right.

She could be talking about improvements or renovations to the property after purchase.

Based on your last post - you've been overdepreciating.

[origun]

Underdepreciating, not overdepreciating!?

Uncle Sam, Today I saw a printout from the realtor who handled the original purchase (and also the sale this month) which says the original purchase price in 1999 was the $80,000. I have requested the taxpayer to bring me a document from the title company and/or a deed to authenticate the realtor's statement. Yeah, I know...you can't accept everything a realtor says at face value! (But I am not relying just on the taxpayer's word; the $80k was printed in a document--valid or not, I need to ascertain!).

It seems to me that since 1999 we (previous preparer and myself) have been underdepreciating--that the "Improvements" (i.e., building) as opposed to "Land" should be more than the $34k, probably closer $45-$50k, judging from local assessor's breakdowns of land vs improvements on similar property.

[JohnH]

Seems to me you have a client with a property which cost $80k and which had a rather high land value of $46k. A little unusual, but not unheard of. Certainly better than any of the alternatives. I haven't triied to run the numbers, but what would be the net tax difference if you handle this the simple way vs the complicated way?

[origun]

Interesting point, John

Thanks for your comment, John. If I assume the $80k purchase price included $34k for building and $46k for land, life is certainly simpler. No amendments, no re-calculating depreciation, no explanatory notes for IRS. By doing so, taxpayer will have a capital loss of < $3k and she will be happy. However, I am somewhat familiar with the housing involved and would have a hard time, in good conscience, assigning over 50% of the purchase price to the postage-stamp size lot with no significant landscaping!

If I do re-calculate the depreciation for the years involved, taxpayer would end up with reduced Sch E income and a lower tax bill of < $5000. [I haven't quite figured out how to do this but taxea says I can do a one-time adjustment; must research this.] And for the sale, basis is reduced by the additional depreciation so taxpayer has a capital gain of about $2k. And taxpayer will probably be in the 15% tax bracket so will have a 0% capital gain. So this would be advantageous to taxpayer.

[JohnH]

Wow, looks like it would be worth doing the complicated way.. Also looks like it should also justify a preparation fee well in excess of $1k.

[appelman]

If you really want to do it by the book...

This might call for a 3115, which isn't quite as scary as it looks. Just be sure to follow the directions. I believe this would fall into the category of automatically approved change in accounting method. It is fairly common to do this in the year of sale -- for example, in cases where there was no depreciation at all taken along the way. I wouldn't amend anything.

[erchess]

John and Origun

John, if I'm reading right Origun took over the return from another preparer in his firm whose error created most of the problem on this return. I hope the firm has a mechanism for rewarding Origun for fixing a mess not of his making but it can't involve billing the client for more than if all prior work for this client had been done correctly.

Origun if I remember right you work for Block. You probably know better than I do who else on this board works for them but I'm aware of and have immense respect for you, Travis Bickle, WhiteOleander, and Snowshine. If I'm wrong about you working for Block say so and post what software you use so that others who use the same can chime in on the nuts and bolts of how this statement and adjustment are done in your software. If I'm right and you do work for Block the other Block employees may want to discuss that in PM or Email for contractual reasons. I don't know how to make this adjustment and write the statement but it would shock me if TTB does not have all you need beyond what is specific to your software.

[joanmcq]

I'm not quite sure I'm getting this; the Sec 481 adjustment on the Sch E will reduce ordinary income, but then you will reduce the loss by additional depreciation taken? Doesn't it just come out in the wash; ordinary loss against depreciation recapture?

In my neck of the woods, especially during the boom, it was not unusual to have a property with 3/4 of a city lot assigned to land. One house I bought as a foreclosure had previously been assigned that much to land vs. improvements. When I bought it, I couldn't use the previous assessment to determine how much to depreciate since it was so out of whack compared to what I paid for the whole thing. I had to make a decision before the property was reassessed; it took about a year to reassess, so I just made an educated guess to the value of the improvements.

Oh, and depreciation corrections are done on the 3115. Charge a bunch for it.

[Kram BergGold]

Effect of 3115

If you fix the depreciation using Form 3115, then the 2011 return will show increased deductions on Schedule E and a higher gain or less of a loss on Form 4797. This may be a wash or it may reduce the taxpayer's tax depending upon her other income.

[Uncle Sam]

Wrong Basis

It's hard to tell bldg/land allocations based on real estate valuations sometimes.
I had an audit just two weeks ago where for a 3-story residential home where the two top floors are rented out. The real estate tax receipt card shows a building/land ratio of 53/47 ratio - but after the auditor took a look at a picture of the place - gave my client 80% for building.