Have You Claimed All Your Depreciation?

A rule that’s been in the tax code since 1954 may let you claim depreciation you never knew was missed — long after those returns were filed.

If you own investment real estate, this is worth a few minutes. We’ll cover only what matters and why. And when you finish, you’ll have one very important question to ask your accountant.

First, a 20-second depreciation refresher

Depreciation generally allows you to deduct the cost of an investment property’s building and certain improvements over time. Land isn’t depreciated. Those deductions can reduce taxable income while you own the property.

Now here’s the interesting question. What if there is depreciation you were entitled to that never made it onto your tax returns?

Why it’s worth taking another look

Investment properties can be owned for decades. Accountants change. Properties are inherited. Improvements are made. Records change hands. And over time, investors may accumulate multiple properties and real estate investments. There are plenty of ordinary reasons depreciation can get overlooked.

So think about every investment property and DST you’ve owned and ask yourself:

Do I know that all of the depreciation I was entitled to has actually been taken?

If you’re not certain, keep reading.

Meet Section 481(a)

The name isn’t very exciting. What it can potentially do is.

Federal tax rules provide a way to account for depreciation that should have been taken in prior years. It’s called a Section 481(a) adjustment.

When the requirements are met, a Section 481(a) adjustment can account for depreciation that was allowable in prior years — including years in which no depreciation was deducted at all. Where the adjustment reduces taxable income, it is generally taken into account in the year the change is made.

In plain English: depreciation that went unclaimed in prior years may still be claimed today.

Let’s put some numbers on it

Suppose an investor should have taken $50,000 of depreciation each year on a rental property, and for some reason it wasn’t taken for three years.

$50,000 × 3 years = $150,000 of depreciation.

Prior unclaimed allowable depreciation may be taken into account through a Section 481(a) adjustment. This generally applies when the issue spans two or more consecutive years; a single year is usually addressed by amending that year’s return instead. Whether and how an adjustment applies depends on the investor’s individual circumstances and the applicable tax rules.

Now for the part that may really surprise you

The IRS distinguishes between depreciation that was allowed and depreciation that was allowable. “Allowed” generally means depreciation you actually deducted. “Allowable” means depreciation you were entitled to deduct.

Why does that distinction matter?

Because the IRS says the basis of your property generally must be reduced by the depreciation allowed or allowable, whichever is greater. If you were entitled to depreciation but didn’t claim it, the IRS says you must still reduce your basis by the full amount of depreciation allowable.

Think about that for a moment. You could miss the benefit of a depreciation deduction while your property’s basis is still reduced as though you had taken it.

That’s the part of this rule every investment property owner should know.

Own 1031 DSTs? Check those too.

If you own 1031 Delaware Statutory Trust investments, there’s one more place worth reviewing.

Under IRS guidance, an investor in a qualifying DST is treated for federal tax purposes as owning an undivided fractional interest in the underlying real estate attributable to the investor’s interest. That means depreciation on that real estate is generally accounted for at the investor level, just as it would be on a property you held directly.

DST sponsors generally furnish investors with annual tax reporting showing their share. That reporting can look different from the partnership K-1 reporting many investors and tax preparers are accustomed to seeing, which is where the detail can be missed when the return is prepared. And if you’ve completed multiple 1031 exchanges over the years, you may now have several DST investments appearing in your tax records.

That makes this a particularly worthwhile question: is the depreciation associated with every one of my DST investments being accounted for on my tax returns?

Where to look before you call

You don’t have to work this out yourself. Your own returns will usually show it.

On Schedule E, line 18 is “Depreciation expense or depletion.” If that line is blank or zero for a property you owned all year, it’s worth asking about.

Your return may also include depreciation schedules showing the assets being depreciated. If you own an investment property that’s producing income, but you can’t find any corresponding depreciation, that’s worth asking about. For a DST, that same annual reporting from the sponsor is what to compare against your return.

If something’s missing, you don’t need to diagnose it. You just need to raise it.

So how can prior-year depreciation be addressed?

This is where your accountant takes over. Certain depreciation issues may be addressed through an accounting-method change using Form 3115 — Application for Change in Accounting Method — rather than by amending years of previous tax returns.

The IRS specifically recognizes changes from certain impermissible to permissible depreciation methods and provides for a Section 481(a) adjustment for unclaimed allowable depreciation when the applicable requirements are satisfied. The IRS’s accounting-method procedures also contain audit-protection provisions for qualifying changes, subject to requirements and exceptions.

Not every depreciation issue is handled this way, which is precisely why a tax professional should review the individual circumstances. And that’s as far into Form 3115 as we’re going.

Here’s the question we promised you

You now know enough to have the conversation. Ask your accountant:

“Can you review whether I’ve taken all of the depreciation I was entitled to on every investment property and DST I own — and whether any prior-year depreciation should be accounted for now?”

The answer may be that everything has already been handled correctly. And if the review identifies something worth addressing, you’ll be glad you asked.

Important Tax and Accounting Disclosure: NexTrend Securities, Inc. is not an accounting firm and does not provide tax, accounting or legal advice. This article is provided solely for general educational purposes and should not be relied upon to determine whether any taxpayer has unclaimed depreciation, is eligible for a Section 481(a) adjustment or accounting-method change, should file Form 3115, or qualifies for any particular tax treatment. Depreciation, basis, inheritance, ownership changes, DST taxation and accounting-method changes involve rules, limitations and exceptions that depend on individual facts and circumstances. Investors should consult with their own CPA or other qualified tax professional regarding their specific situation before taking any action.

DST investments involve risk, including illiquidity and potential loss of principal, and are suitable only for accredited investors.