Correcting excess depreciation (7 years) and a (stupid) Form 4562 cost-basis
This is a humbling experience for me. I've tried to manage my source documents and my taxes carefully all my life. But when I retired in 2002, I became a space-cadet for about a year -- almost with a "dropout" mentality or "second childhood."
I'd used TurboTax since 1993, and of course, it can give you a sense of false security. If you don't consult a tax-guide like Ernst/Young -- something I'd always done for changes in my tax situation -- you can make mistakes -- especially when you're temporarily a space-cadet.
I try to work out problems like this on my own, but I always seek second opinions. At this point, I haven't fully completed my own research.
THE PROBLEM: I had a condominium property in the state where I retired -- call it "state A." I moved back to my home state -- state B -- at end of 2002, starting my residence there at beginning 2003. I chose to convert the property in A to rental use.
The relationship between A and B requires paying income tax on the rental income in state B, and claiming a credit in state A. [This is an exception to other state-to-state relationships in which a credit can be claimed for taxes paid to another state.]
As I said, I wasn't thinking when I did my taxes for the first year after I relocated to state B. My belongings -- books, like Ernst/Young -- were still packed. So were all my source documents except for those of that tax-year*. I wanted to get my taxes done as soon as possible. So when I set up the basis for depreciation to be expensed on Schedule E, I simply punched in the purchase price of the home.
Even worse -- I didn't use my annual county (state A) tax-assessment to compute a ratio and allocate between depreciable property and land. Instead, I used the original purchase price of the home as the depreciable basis.
In fact, the property -- purchased for $50,000 -- actually fell in value (as well as assessment) during that period.
On the plus side, I have discovered a formal, notarized property appraisal* in my files, dated just over one year before I moved from state A to state B and began renting the property to a tenant. The appraisal pegs the property's FMV fair-market-value at $47,000.
This FMV should be the proper starting point for computing the basis. Assume that the value of land in assessment documents before and after this appraisal would allocate $9,000 to land on a corrected Form 4562. [or whatever the initial tax-filing included as a cost-basis -- I think that's the form, though.]
So far, by my estimate, I have expensed approximately $3,060 in excess depreciation over what should have been written off over the seven-year period.
HOW TO PROCEED:
First, I'm guessing that I have to submit an amended Form 4562 to show the proper cost-basis. This, by itself, complicates the problem. This, and the second item below are -- if I'm not mistaken -- in need of particular focus.
Second, I'm guessing that I might have to submit a Form 3115 if I need to modify the cost-basis and show the amount allocated to non-depreciable land.
Third, if it is only the extra work of completing the three previous years' 1040X forms to amend those returns still allowed for amendment, I can do that.
Fourth, I assume that the unamendable portion of depreciation already expensed should be added back as "other income" on my 2010 tax return Schedule E.
The amendments for the prior years, plus the 2010 filing, would put me back on the proper depreciation schedule for the duration.
Especially, my main concern involves my decision to hold the property, finish paying off the mortgage in a couple years, and wait until I can get a decent price for it. In 2006 (in the middle of the bubble), it would've gone for almost $200,000. Now, I'll be lucky to get what I paid for it net of capital gains taxes and other costs, and I don't want to wait and compute an "adjusted basis" for capital gains that results in a higher tax upon sale later on.
Of course, I would have to amend my state returns in state B. I don't think it makes sense to amend returns for state A, since "taxes owed" would still be $0.00. The annual State A filing is perfunctory, since I'm above a no-file threshold and must still file a non-resident return showing my AGI, my "A"AGI, and the split between my state B income and the state A income/loss.
My main concerns here: The accumulated shortfall in taxes paid works out to somewhere between $35 and $90 per year. Mostly, my IRS overall tax-rate has bounced around between 8% and 11%, depending on some annual rental income losses (greater and more frequent in the last four years) arising from periodic vacancy of the property lasting longer than I'd expected.
I wouldn't have to pay interest on this if I can just slip between the raindrops and fix it, and I certainly would like to avoid penalties. As I see it, the depreciation error is an error in deductions, so there would be a three-year period beyond which this would no longer be a bother.
But if I have to change the basis originally defined on the Form 4562, or I need to actually "request" this change on a Form 3115, what are the implications?
If there are any details missing, or you recommend a change in approach, please say so. If you strongly recommend avoiding the filing of extra forms and amendments, you can tell me that, but please consider this in a nexus of probability or risk, and implications for the future sale of the property and capital gains taxation.
Please be candid and specific. If you think it would help to give me a bulleted list of steps to follow, be my guest. I need to correct this error in a way acceptable to IRS -- and especially, to avoid any further hassle.