Scenario: A Landlord Who Never Claimed Depreciation

This page describes a composite hypothetical. It is not a real client or a real result. Amounts are assumptions, and IRS procedures for accounting method changes are updated periodically, so confirm the current rules.

The Scenario in Brief

An investor bought a small rental house five years ago and has reported the rent and expenses each year but never claimed depreciation. The investor's previous preparer never mentioned it. A new advisor reviewing the returns notices the omission and explains that the situation should be handled carefully. The investor asks what can be done.

Assumptions Used

• Purchase price and eligible costs: 250,000 dollars, with 50,000 dollars allocated to land and 200,000 dollars to the building.
• The property is residential rental property with a 27.5-year recovery period.
• The building was placed in service five years ago, and no depreciation was claimed on any return since.
• The investor still owns the property.
• The property produces modest taxable income, and the investor's income is moderate.

Allowed or Allowable

The advisor would first explain a key rule. When property is sold, the basis is reduced by the depreciation that was allowed or allowable, whichever is greater. Even though the investor did not claim depreciation, the basis is treated as if it had been. That means the investor lost the deduction in prior years but would still face the basis reduction and recapture on a later sale, unless the omission is corrected. This is why correcting the error matters.

The Method Question

The advisor would explain that failing to claim depreciation for two or more consecutive years is generally treated as adopting an impermissible accounting method. The usual correction is not to amend each prior return, but to file Form 3115, Application for Change in Accounting Method, under the applicable automatic change procedure, and to claim the missed depreciation as a Section 481(a) adjustment on the current return. For a taxpayer who missed only one year, the situation may be handled by an amended return instead. The advisor would check the facts, the years involved, and the current procedures.

Worked Arithmetic

At an assumed 22 percent marginal rate, a 36,000 dollar deduction would reduce federal tax in the year of change by about 7,900 dollars, if the deduction can be used in full. The rental loss limitation rules could restrict the use of the deduction if it produces a loss. The advisor would also confirm that ongoing annual depreciation of about 7,273 dollars would begin to be claimed on the current and future returns.

Why Not Amend Each Year

The advisor might mention that amending each prior year could seem intuitive, but it is not the approved method for correcting an impermissible accounting method used for two or more years. Amending could also be limited by the statute of limitations for refunds, and older years may be closed. The method change, when available, allows the entire catch-up in a single year without reopening the earlier years.

Reporting and Procedure

Form 3115 would generally be filed with the tax return for the year of change, with a copy sent to the IRS under the current procedures. It requires a description of the change and the computation of the adjustment. The advisor would confirm that the taxpayer is not under examination for the item and that the change is eligible for the automatic procedure. State treatment of the adjustment might differ.

Recapture Consideration

The advisor would also explain that when the investor eventually sells, the depreciation taken would be subject to the unrecaptured gain rules. The investor is not better off by leaving the depreciation unclaimed, since the basis reduction applies anyway. Claiming it as allowed preserves the benefit now.

Scenario Variations Worth Considering

If the investor had sold the property last year, the opportunity to correct through a method change would generally be gone, and the sale would have been reported with incorrect basis. If the investor had claimed a partial amount of depreciation, a different correction might apply. If the property had been used as a residence part of the time, the depreciation base would differ.

Risks and Limits

• Procedures and eligibility conditions can change.
• The deduction may be limited by loss rules.
• State conformity varies.
• The calculation here is simplified.

What This Scenario Teaches

Missed depreciation is a common and fixable issue, but the correct method matters. A formal accounting method change can capture the whole catch-up without amending each year.

Questions to Bring to Your Advisor

1. Was depreciation missed on any of my properties?
2. Is a method change or an amended return the right correction?
3. How large is the catch-up adjustment and can I use it?
4. What are the state effects?

Educational purposes only. This page is an illustrative educational scenario, not tax, legal, or accounting advice, and it does not describe a real client or a real result. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.