1) Search for allowed ir allowable regarding the depreciation.  Yes it's possible that there's a gain on sale instead of a loss.  The depreciation is considered whether taken or not.  That amount sounds a bit high...but I'm not at my desk.  WAS land factored in?  Eleven years x 2.56% x $ 350,000 =  ?

2) Research Form 3115

3) Cash payments are not, per se, disallowed. Proving them is a bit more difficult tho & it sounds like this auditor has a burr under his saddle. You'll need to look for court cases showing how to document cash payments