Correcting Past Returns

[ezorn33]

Didn't want to hijack the other thread...

So, I'm pretty sure I screwed up on calculating the basis for depreciation of my rental property in past years. I bought a condo in May 2007 and lived in it until November 2010. For much of that time, I rented out the second bedroom. When reporting that extra income on my taxes (using H&R Block's software), it never occurred to me that any portion of my purchase price was for land, so the basis I've been using for depreciation thus far has been the entire purchase price.

Of course, now that I think about it, that was a pretty dumb oversight, and one I'd like to correct, especially now that I have moved out of the condo and turned it into 100% rental property.

How do I go about correcting past returns? I assume I can't just use the correct number this year and in the future and hope no one notices...

[taxref]

I would probably like to hear more details about the condo in relation to the entire building. I'd especially like to know how many condos are in the building.

Depending on the building situation itself, the land value may be so small as to be immaterial. I have had some clients own rental condos in buildings with dozens of units, so in those cases the land value would be very low on a per-unit basis.

[ezorn33]

I'm sure it is very low. There are 6 buildings in the development, each of which has 32 units -- so 192 total units in the complex. What other info would be helpful?

[taxref]

Based on the information provided, I don't think I would bother to amend the previous year returns. While that answer is technically incorrect, the amount of actual tax dollars involved is probably tiny. That difference in tax was made even smaller because the entire condo was not rental property prior to late in 2010.

Even if the land value for the complex was $500K, on a per-unit basis that would divide out to only $2,600. With condos, you also have a situation in which you don't have the option of tearing down your building and selling the land. That serves to further reduce the land value in relation to the condo itself.

I would assign a minimal value to the land, probably about $1K. I would change the depreciable basis by that amount for 2010, and apply the appropriate percentage to the new amount.

Again, what I am recommending is not the technically correct way to do this. However, the actual amounts involved are most likely immaterial.

[ezorn33]

So you wouldn't be concerned about the change in basis from year to year on the same property triggering IRS interest?

Given that I intend to rent it out for the foreseeable future, I assume you are suggesting that the basis should be the new value (purchase price - $1K) every year from now on?

[cpadvisor]

In a word: No.

But, if you want to have some fun, check out Form 3115 and consider correcting your depreciation error, or amend your prior year return...

[commentator]

Rented out the 2nd bedroom? Are you sure? Are you sure you didn't simply have an expense sharing arrangement with the person in that bedroom?

Technically (and that's all tax law is, a bunch of technicalities), you should amend your 2007, 2008 and 2009 returns to claim the depreciation you failed to take. Technically, again, your basis was reduced by that unclaimed depreciation even though you got no tax benefit.

[ezorn33]

OK, so I think we're 2-1 in favor of just doing it right this year and letting the last couple of years go. Let's see where we end up.

[TheOtherMe]

I go with the leave it alone and start doing it correctly this year.

[commentator]

Feb 8, 2011 23:03:01 GMT -5 TheOtherMe said:

I go with the leave it alone and start doing it correctly this year.

"Correctly this year" means using the correct basis (that is reduced for depreciation allowed or allowable in 2007-2010) to compute depreciation starting in 2011.

[ezorn33]

To add a little bit of detail...

I purchased for $237,500. It's now worth ~$210,000 (maybe).

And on my 2010 property tax assessment, the split is $25K for land and $94K for improvements. This seems depressing and strange.

Thoughts? Does this change anyone's advice? If not, what does "doing it correctly" mean?

[taxref]

It doesn't change my opinion. While I often use the property tax assessed land/building amounts to prorate the values, yours seems way off. I can't picture that kind of breakout being accurate in your circumstances, unless the buildings themselves are on the verge of being condemned.

Doing it correctly would involve a number of steps. You would need to file amended tax returns for all years involved. Cpadvisor also mentioned Form 3115, which is the proper way to request a change of accounting method (which again is technically needed in your case). I have only filled out a few of them over the decades, but its a monster of form.

Edited to add: I wouldn't be concerned about the small change in depreciable basis being a red flag. While anything is possible, such a small change would probably be well under the radar.

[ShoreEA]

taxref, I'm sorry, but I think you are way off base here. Are you really advising a taxpayer NOT to correct prior year tax returns that overstate deductions? Of course ezorn33 should file Form 3115 and amend all returns back to the beginning of the incorrect depreciation. The amount of tax over the years will be relatively small, but it will "uncomplicate" things going forward.
Regarding "red flags": Turning yourself in (rather than waiting for IRS to figure it out themselves) usually causes IRS to abate penalties that they may charge. Interest must be charged by statute.

[taxref]

In a case similar to this, I would advise not to do the 3115 and amended returns. I would simply adjust the basis and take the correct depreciation in future years. Of course, that is not the technically correct course of action. However, I think at some point in these decisions materiality should play a factor.

Per one of my messages above, I would recommend a land value of about $1K in this particular case. 27.5 MACRS results in an annual depreciation rate of about 3.636%. Consequently, his depreciation deduction was overstated by $36 per year. If his marginal rate is 15% through 28%, he had a tax underpayment of between $5 and $10 per year.

Assuming his total underpayment for the 3 year period is $30, even if the error was spotted he would probably owe no more than $60 after interest and penalties were added.

I have done a number of 1040Xs to fix both overpayments and underpayments in the past. But when the dollar amounts are tiny, as in this instance, I give the client both sides and let him decide.

[cpadvisor]

Feb 10, 2011 0:19:38 GMT -5 taxref said:

In a case similar to this, I would advise not to do the 3115 and amended returns. I would simply adjust the basis and take the correct depreciation in future years. Of course, that is not the technically correct course of action. However, I think at some point in these decisions materiality should play a factor.

Per one of my messages above, I would recommend a land value of about $1K in this particular case. 27.5 MACRS results in an annual depreciation rate of about 3.636%. Consequently, his depreciation deduction was overstated by $36 per year. If his marginal rate is 15% through 28%, he had a tax underpayment of between $5 and $10 per year.

Assuming his total underpayment for the 3 year period is $30, even if the error was spotted he would probably owe no more than $60 after interest and penalties were added.

I have done a number of 1040Xs to fix both overpayments and underpayments in the past. But when the dollar amounts are tiny, as in this instance, I give the client both sides and let him decide.

I'll second that.