Can You Fix a Rental Property Depreciation Mistake Years Later?

You get a call from your new accountant who just reviewed your residential rental property as reported on your most recently filed tax return. He calls your attention to an error which, though you were not aware at the time, was costing you a lot of money.

You purchased your apartment building 15 years ago for $6,000,000. Of that amount, $1,200,000 was allocated to land, and $4,800,000 was allocated to the structure. Truth be told, you didn’t think much about depreciation. You knew you would get a deduction for it, but that’s something the accountant takes care of, right?

The government has mandated depreciation methods and useful lives that must be used when depreciating specific assets1. While the taxpayer may often choose between various methods available, your building should have been depreciated over 27.5 years2, as a residential rental, but was put into service as 39-year property. Your prior accountant never caught his mistake, and 15 years later, you are not able to go back and amend your prior tax returns.

But you think, “Not a big problem. I lost some depreciation deductions over the years, but as I am now contemplating selling my building, at least I won’t get beat up as much on depreciation recapture, and I’m in a higher bracket now than I was then. I think my accountant unwittingly did me a favor”.

However, there is a major problem with this. When your rental is sold, you will have to recognize depreciation recapture not on the actual amount of depreciation you deducted, but on the amount of depreciation you were allowed under the law3. How is this going to work out for you when you sell your property sometime in year 16?

In addition to the depreciation you took, the depreciation your accountant missed, totaling $772,028 still reduced your property’s basis, resulting in a much larger taxable gain in Year 16 when you sell the property. Assuming a 32% tax bracket, your year 16 tax could increase by as much as $247,049, for which you never received the corresponding depreciation deductions over the years you owned the property.

Let’s see what this error has actually cost. You purchased your property in November, made some repairs, and put it into service on January 1, 2011. With $4,800,000 allocated to the residential dwelling, you have recognized depreciation in the amount of $123,077 per year. Your new accountant tells you that your deduction ought to have been $174,546 per year, a difference of $51,469, which, with a marginal rate of 32%, has cost you $16,470 per year. You haven’t always been in the 32% bracket, but have been for the last several years. You have been paying an extra $16,470 a year in tax.

Had you been in the 32% bracket for all years of property ownership, your total missed depreciation deductions amounting to $772,028 would have resulted in you overpaying your taxes by $247,050 across all years.

As previously mentioned, you cannot go back and amend 15 years of tax returns. The law allows you to amend a tax return for three years from the later of the return’s due date, or the date it was filed4. Once the statute, or limit, has passed for amending the return, you are now dealing with a change in accounting method. Amendment is now off the table, even for the most recent three years. Though your depreciation method is wrong, you’ve had it in place for a long time now, and are forced to stick with it.

Fortunately, tax law provides a way to correct this problem through a change in accounting method. A method change is filed on Form 3115, and it allows a Section 481(a) adjustment5. This catch-up adjustment allows you to claim, in one year, the depreciation that was missed in prior years.

A change in accounting method will allow you, on your Year 16 tax return, to change the life from 39 years to 27.5 years, have regular and correct depreciation for that part of Year 16 before selling the property, and deduct everything you have missed.

Ironically, the mistake may produce an unexpected benefit. If the property is about to be sold, claiming fifteen years of missed depreciation through a method change in the year of sale may generate a substantial ordinary deduction at precisely the moment it is needed most. What began as a costly error may end up softening the tax impact of the sale.

Perhaps your prior accountant did you a favor after all!

If you find yourself in this, or a similar situation, do not worry that repair is beyond hope because the statute of limitations has expired. A review by an experienced tax professional may be well worth the time.

1. Revenue Procedure 87-56
2. IRC Section 168(c)
3. Treasury Reg Section 1.1016-3
4. IRC Section 6511(a)
5. IRC Section 481(a)