Incorrect basis on rental property, property disposed of this year

[Melissa]

I have a client who had been depreciating a residential rental since 2008. The basis in the property was incorrect as of the first year the property was added to his return. I am working on preparing the filing for 2014, but with the incorrect basis he is showing a loss instead of a gain (had the correct basis been applied). For this type of depreciation error an amended return must be filed. Is it correct then to amended all prior years, correcting the depreciation before preparing 2014? That's a lot of amended returns, is there another course of action that I'm unaware of?

Thanks for any and all help.

[kathyc2]

Just thinking out loud, but unless the TP marginal rate has changed over the years, I don't think the tax net of all the years would make any difference.

If it was me, I would calculate it out first as to what the year to year changes would be on a spreadsheet b4 spending time amending.

[Melissa]

Big difference

The basis is wrong by almost 60,000. I'm pretty sure there's going to be a significant impact.

[kathyc2]

60K too low? Is it possible that was the amount originally allocated to land?

For 60K on residential RE you're looking at just over 2K a year in missed depr. Assuming sale in 2014 was more than original purchase price it would all be recapture anyway. If marginal rate was steady (and less than 28%) the net effect of depreciating and recapturing is going to be a wash.

[Lion]

Form 3115.

[Melissa]

60K too high

None of the amount was allocated to land. Nothing was allocated to land. The property was converted from personal use. At the time of conversion 148,800 FMV vs. 90,000 cost.

Property was sold for 90k in 2014, about 32k depreciation already recognized; about 27k loss.

Thanks for your help.

[Melissa]

It's a mathematical error

Not a method of accounting error. Or am I missing something?

[oceanlovin'ea]

What did they use as a basis for depreciation?

Linda, EA

[Melissa]

They used FMV. Kathyc2 are you suggesting that I adjust the basis this year since the net effect would be similar? Is this permissible? Do I need to use form 3115? If the return is questioned will the IRS consider this treatment acceptable? I don't want to suggest a course of action that won't be defensible.

To all who have chimed in thank you. Your feedback is invaluable as I continue learning how to navigate the convoluted system that is our tax code.

[Kram BergGold]

Your Options as I see Them

Practically, you can't amend as the error starts in 2008. So either you use Form 3115 to correct the error and then show the sale with a small gain due to the correct amount of depreciation or you leave it alone and show the sale with a larger gain due to the $32,000 of depreciation. OR, you tell client to go elsewhere.

[oceanlovin'ea]

similar issue last year

I had a similar situation last year. New clients came in and the wrong depreciation had been used for several years and they had sold the property. I refigured what it should have been and what was actually taken. I made an adjustment in the depreciation taken in the final year. Then showed the sale of property. This property had always been rental property but prior preparer had taken some liberties with depreciation. So far we have not had any letters from IRS.
I would figure out what it should have been and what was taken...(rules do say allowed or allowable). Keep your documentation. Adjust during final year and then sell the property. You might want to put that adjustment in other expenses rather than in the depreciation.
One way or another they are going to pay for taking excess depreciation while it was rented.

When changing personal property to rental, that rule of the "lesser of FMV or cost basis" is really important. I did it wrong one time, but the house was only rented for a short time and the amounts were not that significant. So it was easy to fix. That was when I learned this valuable piece of IRS rules.

Linda, EA

[kathyc2]

They used FMV. Kathyc2 are you suggesting that I adjust the basis this year since the net effect would be similar? Is this permissible? Do I need to use form 3115? If the return is questioned will the IRS consider this treatment acceptable? I don't want to suggest a course of action that won't be defensible.

Actually I was just saying that I personally think it's beneficial to map out on Excel the net effect of the error before spending a lot of time on forms. If I'm following your posts correctly they both originally purchased and then in 2014 sold the house for 90K. So, they don't have any LTCG and need to recapture all the deprecation taken. They need to recapture more now than they would have if depr would have been correct over they years, because they received more benefit than they should have in those years. If marginal rate was constant over the years, then it becomes not a difference in tax, but only a difference in timing.

Another thing you may want to consider is if the client made any capital improvements to the property in the time frame of between the original purchase date and conversion. If they did, that will increase basis and a portion of the depr will not need to be recaptured.

[Roland Slugg]

The basis in the house is $58k ... its cost basis less depreciation ($90k less $32). The $148k FMV is irrelevant and should never have been used. All that did was improperly increase each intervening year's depreciation by about $2k, and that extra depreciation will result in a higher taxable gain in 2014, the year of sale.

FMV is never used to increase an asset's basis upon conversion from personal to business or rental use. It can only serve to lower its basis for depreciation and for calculating loss (but not gain) on its eventual sale or exchange.

[TAX4US]

Depreciation catch up

Asset sold 2015. Dep missed do to oversight. Using 3115 to catch up and then sale of property. What for codes or sections would you use. 481 adjustment is -10k. thanks