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Old 02-07-2011, 12:23 PM
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Join Date: Feb 2011
Posts: 2
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.


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.

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Old 02-10-2011, 12:05 PM
Junior Member
Join Date: Feb 2011
Posts: 2
Answering my own question -- "Simple is best" said the Swiss chef

I see 80 hits to my question but no posts. Perhaps the problem statement was too long.

This seems to be a not so uncommon problem among those holding rental property. You have three ways to go: Don't correct it, cross your fingers, and roll your eyes if you ever sell the property; correct it going forward -- cross your fingers for three years; be scrupulous and correct the entire enchilada.

First, try to avoid filing amendments to three prior federal and three prior state returns. I chose that as an option, because it spread out the extra tax payments across three years, and I thought I would avoid a penalty. Instead, you would pay interest on the correcting tax-payments sent with the amendments. And -- it turns out -- you wouldn't even owe a penalty (for taxes owed in excess of $1,000 above withholding and estimated taxes), if you owed $0.00 or were due a refund in the year preceding.

Second, recompute the property cost-basis correctly. Build a spreadsheet with the actual depreciation expenses of all prior years in one column, and the corrected amounts for prior years in a second column. Add a third column to compute the difference between each row of the other two columns. Check the total original expenses against what had been shown on your Turbo-Tax depreciation worksheets for the most recent year plus the annual amount you will claim this year -- it should add up to the dollar. Enter a "SUM" formula to total the differences for all prior years (the third column) -- this should give you the amount you will correct as "Other income" on this year's return. You may need to tweak the depreciation-reclaimed so far in forms-view of Turbo-tax by a few dollars, so that the annual amount in the "corrected" column of the spreadsheet just matches the amount shown on the form 4562 worksheet of Turbo-Tax (or whatever software you're using).

Note: supposedly you only had to file the form 4562 in the year the depreciation began. Your tax-software generates a new 4562 each subsequent year, even though it doesn't print it for filing. So you should have a complete paper-trail for at least three or four years that includes that form if you ever need it. Further, since you aren't changing the depreciation method but only the cost-basis, you shouldn't need to file a form 3115 request form. That simplifies things considerably.

Third, enter the excess depreciation (total from the third spreadsheet column) in line 21, form 1040 as "Other income" -- perhaps using Turbo-Taxes feature to create a note for printing explaining the error.

Fourth, move some money from your savings account to your checking to cover the unplanned tax payment -- which you will mail out on April 18.

Fifth, recompute your 2011 estimated taxes based on only the new annual depreciation expense and excluding the "Other income" claimed on your 2010 1040.

Sixth, sleep easy, knowing that you won't have to cross your fingers for three years, or pay additional capital gains tax should you sell the property.

MORAL: Do it right the first time, and if you're going to be a landlord -- learn to be a landlord.

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