Excess Depreciation Claimed – Now What?

Excess Depreciation Claimed – Now What?

Justin Fundalinski of Jim Saulnier & Associates, who I met while volunteering time for the betterment of the Financial Planning Association, asked me a procedural question about a fascinating situation he encountered regarding depreciation and disposition of residential rental real estate, causing pause. Tax questions that cause ME to pause are the spice of life.

So down the rabbit hole I went, copiously reviewing the Code, the Manual and IRS Publication 527. Uncertain of conviction I also asked questions of other National Tax Practice Institute Fellows, even going so far as to obtain a covered opinion. In the end, the range of options worthy of consideration is astonishing.

If you are still with me this is a synopsis of the fact pattern:

In 1976 a US Taxpayer, who for this post we’ll call Ms. Independent-Widow, bought a home in the elite Washington Park neighborhood of Denver, Colorado. In 1977 Mr. Middle-Age-Man swooned onto the scene and to the surprise of many swept Independent-Widow off her feet. She was quickly smitten, and with astonishing velocity (from the progeny’s perspective) off to the mountains together they moved to share common quarters, never marrying.

Intelligently Ms. Independent-Widow rented out her house in Washington Park starting in 1977. She ALWAYS prepared, signed and filed her own income tax forms, always. Even though she claimed depreciation expense on the residential rental real estate every year since acquisition, she failed to keep a sufficient record of her basis in the property. Not only that, but:

• At a certain point when Independent-Widow started using TurboTax her depreciation method switched from ACRS to MACRS.
• Depreciation claims were wildly inaccurate year-over-year as a result
• The property should have been fully depreciated by 2005 as the life expectancy for depreciation purposes of residential rental real estate is 27.5 years.

How this happened only tried and true DIY-ers can really answer.

TurboTax IMHO is WOEFULLY INADEQUATE if you own ANY real estate for investment purposes.

So what happened next?

In 2015 the taxpayer sold the property on an installment sale and hired Justin to prepare her tax returns.

In an effort to report the installment sale in accordance with US Treasury Circular 230, where the gross profit ratio should factor in the amount of depreciation that Independent-Widow should have claimed, Justin suspected the claimed depreciation expenses year-over-year were in violation of 26 U.S. Code § 167, for tax years 2006 through 2014.

After questioning Independent-Widow it became easy to speculate that quite a bit more depreciation expense was claimed over the depreciable life of the investment (27.5 years) than should have been claimed.

Now it appears Independent-Widow has a negative basis in her Washington Park Real Estate investment.

The exact accumulated depreciation is both unknown and indeterminable due to the expunging of records.

If you’ve made it this far, thank you, Justin’s questions are:

1. What does someone do when they mistakenly claimed too much depreciation on a rental property after the property has been sold?
2. How is an installment sale disposition transaction reported for income tax purposes in the tax year 2015?

Excess depreciation in real estate.

In that there appears to be little precedent for this fact pattern, my initial guess was that IRS Form 3115 – Accounting Method Change may be in order relevant to residential rental real estate reported on Schedule E attached to the owner’s 1040 and an adjustment made as per IRC 481(a).

Uncertain, I polled other Fellows of the National Tax Practice Institute in the hopes of arriving at a consensus opinion and got a range of opinions deemed #BuzzWorthy. The most aggressive opinion came from NATP where their team asserted as follows:

“Although this topic is not explicitly stated in IRC, nor are there any court cases one way or the other, generally when an asset is over-depreciated it is due to error in calculation. Therefore, upon disposition of the property, the taxpayer should report the gain (or loss) on sale of building as they have it calculated. There isn’t a need to go back and amend returns or report a 481(a) adjustment in year of sale because this generally stems from a miscalculation or error.”

A majority of the other respondents interested in the question generally agreed that:

• Adjustments to depreciation should ‘in theory’ occur with Form 3115 and filed with the 2015 tax return.
• As a tax practitioner Justin really cannot address the years he doesn’t “know” about.
• All Tax Records prior to 2005 are nonexistent ANYWHERE, including purged from the IRS

So how is Justin to report on the 2015 1040 form?

IMHO Justin should consider:

1. Disclosing to Independent-Widow in written detail that the Washington Park property was over depreciated.
2. Relying on the ‘allowed or allowable’ depreciation claim in the year of sale and adjust basis to $0.
3. Reporting the installment sale in 2015 asserting all the proceeds are taxable as either ordinary income, capital gain, and/or interest.
4. Disclosing an uncertain tax position regarding depreciation with the tax return and let the chips fall where they may with the IRS.

In that the gain is all basically un-recaptured gain, gross profit percentage on the installment sale is 100%.

*HOWEVER – TAKE THIS AT FACE VALUE*

1. When I laid out the fact pattern to one of my many friends inside the IRS, it became abundantly clear that from their perspective a Form 3115 filing requirement with a positive 481(a) adjustment is in order and that the positive adjustment may be added to income for reporting purposes proportionally over the next 4 years.
2. The problem with this position that the IRS concedes is that you have to KNOW the total amount of depreciation taken over the life of the property to correctly make the calculations and there is literally NO WAY of accurately determining total depreciation claimed as NO TAX RECORDS EXIST ANYWHERE PRIOR TO 2005, INCLUDING INSIDE THE IRS.
3. Conservative Enrolled Agents were of the opinion that an obligation exists to help the taxpayer essentially ‘guess’ at what depreciation was claimed between 1977 and 2004, prepare the 3115 Form accordingly and claim the 481(a) positive adjustment over the next 4 tax years to lighten the income tax burden.
4. Less conservative Enrolled Agents basically shrugged their shoulders, hung their heads and said it appears Independent-Widow gets away with over depreciating her property.

Enrolled Agent in Denver

In conclusion how you report this real estate transaction for income tax purposes seems to be between you and your GOD. Call me for my confidential opinion as you see fit.

For more information on this contact me anytime at your convenience.

Photo by Ronnie George on Unsplash (4/15/2021)