How to Catch Up Depreciation on Rental Property

A few weeks ago, a husband-and-wife team of real estate investors came to my company stating that they self-prepared their own taxes — including their rental properties on Schedule E — but neglected to deduct depreciation on their rental properties for all those years.

Thankfully, they had just started investing in real estate in 2017, so the number of years of missed depreciation were not too great.

Should You Catch Up Missed Rental Property Depreciation?

Yes, you should catch up missed rental property depreciation, for two main reasons:

1. Tax Savings
2. Depreciation Recapture Rules

Tax Savings

The first reason why you should catch up missed rental property depreciation is because doing so will result in additional depreciation expense that will reduce your tax liability.  This results in real cash back in your pocket that you can use to invest in more real estate.

Of course, you may be subject to the passive activity loss rules on Form 8582, meaning that you may not get an immediate benefit for the caught-up depreciation expense.  However, these losses would simply be suspended and used up in a year when you have sufficient passive income to absorb them or when you sell the rental property.

Depreciation Recapture Rules

The second reason why you should catch up missed rental property depreciation is because even if you didn’t take any actual depreciation expense on a rental property, you will still have to pay the depreciation recapture tax when you sell the property as though you had taken depreciation.

So it’s certainly in your best interest to catch up your missed rental property depreciation.

If you’re going to have to take the depreciation recapture tax hit anyway when you sell the property — whether you actually took depreciation expense or not — you may as well have enjoyed some previous tax benefit for that depreciation.

And if the passive losses generated by your additional depreciation expense are limited, meaning that they rolled forward as suspended passive activity losses from year to year and you didn’t actually enjoy tax savings immediately upon catching up your missed depreciation, your suspended losses — including the caught-up depreciation — would reduce your taxable gain on sale.

Note: If you’re selling rental property, be sure to consider the tax benefits of a 1031 exchange!

Two Methods to Catch Up Depreciation on Rental Property

I explained to them that when it comes to catching up depreciation on rental property, they have two options:

1. Amend all the returns on which they neglected to take depreciation, or
2. Catch up all the missed depreciation in the current tax year with a 481(a) adjustment using Form 3115

While there could be some instances in which the first option is advisable, in this particular case, the second option — catching up all the missed rental property depreciation in the current year using Form 3115 — was advisable.

This is because the taxpayers did not have a balance due for any of these years, so any amendment to their previous years’ returns to take depreciation expense that they missed would generate a refund for those years.

However, the taxpayers would not be eligible to receive a refund for the tax years before 2019 since the three-year refund statute expiration date for those years had already expired — this means that they would not get an actual tax benefit for the caught-up depreciation!

In light of this, the taxpayers agreed with my recommendation for me to catch up their rental property depreciation via a 481(a) adjustment using Form 3115.

Here’s how I did it.

How to Catch Up Rental Property Depreciation Using Form 3115

Here’s how to catch up rental property depreciation (and amortization) using Form 3115.

Step #1: Obtain the closing statement for the rental property or properties in question.

Hopefully, you saved this document for every property you’ve invested in.  If not, consider reaching out to your escrow company to see if they’ve retained a copy they could send you.

Step #2: Determine your original basis in your rental property.

To do this, add up all the items from the closing statement that are included in your basis.  Examples of these costs are:

• Selling Price
• Escrow / Title Charges
• Recording Fees

You would also include costs that you paid outside of escrow, such as inspection fees.

Note that property taxes, prepaid interest, and costs incurred in obtaining financing for your property are not included in your property’s basis.

Step #3: Divide your basis between land and building.

Next, you’ll take that basic figure you determined above in Step 2 and allocate it between building and land.

The typical way to do this is to allocate it based on the county assessor’s split between land and building.

For a deeper dive into how to do this, check out our article on how to calculate rental property depreciation.

Step #4: Determine your original amortizable loan costs in your rental property.

To do this, add up all the items from the closing statement that you incurred in order to obtaining financing for your rental property.  Examples of these costs are:

• Processing Fees
• Underwriting Fees

You would also include costs you incurred outside of escrow to obtain financing, such as appraisal fees.

Step #5: Determine your additional basis in your rental property.

If you incurred costs post-purchase to improve your property, determine what you paid for these costs as well and on what date you incurred them.

Step #6: Determine any additional loan costs post-purchase.

If you refinanced your property post-purchase, these are amortizable loan costs as well; note that if your previous loan was paid off in your refinance, all of your loan costs from your original loan would be written off in your 481(a) adjustment.

Step #7: Calculate your depreciation for each year you “missed,” all the way up to the year before the return you’re filing.

You’ll probably need a tax software to do this, but the depreciation for the building portion of your basis will be over 27.5 years with the property considered being placed in service in the middle of the month you placed it in service (this is called the “mid-month convention”).

Step #8: Report the adjustment correctly on Form 3115.

You will report your adjustment on Schedule E of Form 3115.

Step #9: Report on Your Form 1040, Schedule E.

Finally, report your adjustment on your Form 1040, Schedule E, as a “481(a) adjustment.”