Entering depreciable improvements to a rental that were not depreciated to calculate gain on sale of rental property

[kuesters]

Client made several improvements over the past 35 years to their rental property.  $63k in improvements were never depreciated or expensed.  Now they are selling the rental property.  How do I record the undepreciated improvements in order to 1) increase taxpayer's basis in the property, and 2) ensure depreciation allowed or allowable is calculated in ProSeries to determine the depreciation recapture amount?

[BobKamman]

Have you been preparing their returns for the last 35 years?

(No, of course not, you would have been doing it correctly.)

How do the taxpayers know these were never expensed?  They have enough receipts and records now to tell you the cost, but they didn't tell their preparer back then?  

Maybe they have gone from ignorance to informed.  Good luck.  

[IRonMaN]

Bob - your opening sentence was my first thought ——— which is a little scary.  The next thing you know I’ll be telling stories of my old days with the IRS, even though I never worked there.  😳

[ljr]

so, client thinks they have a $63K expense to lower their gain and these expenses were only remembered because they are selling. I would check any depreciation schedules they might have from prior years. You might be surprised and see them on there already.

Can they tell you the year of the improvement - it might already be "fully depreciated" or close to it. You would try to take the expense but have depreciation recapture (and of course you would complete form 3115 change of accounting method to request/tell IRS about the depreciation.) so you would net back to zero and have the same capital gain. Unless it was done in the last year or two - tell them it makes no change to the net sale. 

[IRonMaN]

"I would check any depreciation schedules they might have from prior years."

But not all improvements make it to depreciation schedules.  Check 35 years of repairs and maintenance expenses and you might find them there.  Without actual proof that those improvements were never accounted for, I'm not going to use them.

[Terry53029]

@kuesters  You need to file form 3115 if there were improvements never depreciated, but clients should show their records, and not just pull a number out of thin air. If they have no records then I would not account for them, and if client not ok with that I would ask him to go elsewhere.

[BobKamman]

How reliable is Google?  Well, I just moved to a new office and the Maps app on my clients' phones direct them to the dead-end alley in back of the building, which is separated from it by a wall.  So don't rely too much on what Google tells you.  But, 

The IRS provides three main safe harbor rules that may allow rental property owners to immediately expense certain improvements and repairs, rather than capitalizing and depreciating them over several years.

 

The primary safe harbors are the Safe Harbor for Small Taxpayers (SHST), the De Minimis Safe Harbor, and the Routine Maintenance Safe Harbor. 

 

1. Safe Harbor for Small Taxpayers (SHST)

 

This safe harbor allows qualifying landlords to expense all annual costs for repairs, maintenance, and even improvements in the year they are incurred. 

• Property Value Limit: The unadjusted basis (original cost of the building, excluding land) of the rental property must be $1 million or less.
• Annual Expense Limit: Total expenses for repairs, maintenance, and improvements during the tax year cannot exceed the lesser of $10,000 or 2% of the building's unadjusted basis.
• Income Limit: The taxpayer's average annual gross receipts for the three preceding tax years must be $10 million or less.
• Election: This safe harbor must be elected annually by attaching a statement to your tax return.
   

  2. De Minimis Safe Harbor

  This rule is an administrative convenience that allows immediate expensing of low-cost items, regardless of whether they might technically be considered repairs or improvements under normal rules. 

  • Dollar Limit: The cost must be $2,500 or less per item or per invoice line item for taxpayers without applicable financial statements (audited financial statements). The limit is $5,000 for those with applicable financial statements.
  • Consistency: You must have a consistent accounting policy in place at the beginning of the year for expensing items below this threshold.
  • Election: Like the SHST, this is an annual election made with your tax return.
     

    3. Routine Maintenance Safe Harbor

     

    This safe harbor allows the immediate deduction of recurring maintenance costs, even if they might otherwise be considered improvements, as long as they meet specific criteria. 

    • Definition: Routine maintenance is work you reasonably expect to perform more than once every ten years to keep the property in ordinarily efficient operating condition. Examples include scheduled HVAC servicing, inspection, cleaning, or replacing worn-out parts with comparable components.
    • Limitations: It cannot be used for betterments (fixes a material defect or increases capacity), restorations (rebuilds to a like-new condition), or adaptations to a new use.
    • Election: This safe harbor is an accounting method adoption, not an annual election, and typically requires filing Form 3115 to change methods if you haven't used it consistently. 

[Terry53029]

I agree with Bob about google, although not sure what it has to do with this post

[IRonMaN]

I don't think it is the anvils talking, but I'm thinking he is confirming that some of those improvements over the last 35 years could have been expensed.

[Terry53029]

Yes, some of the improvements may have been expensed. I only replyed what to do if some or all of the improvments have not been depreciated. Also I would need to see some records

[kuesters]

Thanks for all the info.  I am actually asking how to enter these assets into the Pro Series program to ensure they are included in the basis, allowable depreciation, and gain calculations.  There is a depreciation code (I think "X") designated as non-depreciable assets, but it doesn't calculate/add the allowable depreciation amount when calculating depreciation recapture.

To answer some of the other responses: No, this is not a prior client of mine and they are not a current client of mine, they are a friend who has shown me the supporting documentation for the improvements.  He is also clueless about taxes and relied on some individual tax preparer who just retired and left the area.

[Terry53029]

@kuesters You would open a schedule E, go down to deprecation, and when you click on that line the worksheet will open for you to enter assets

[kuesters]

This answer does not address my question. 

I know how to enter assets for a rental property, but there is nowhere in the asset entry form that specifically discusses assets that were not depreciated.  This matters because tax code requires when you sell a rental property the taxpayer must separate gain into two buckets: (1) the portion equal to depreciation you claimed or should have claimed, which is taxed as “depreciation recapture,” and (2) the remaining gain, which is taxed as long‑term capital gain. This rule applies whether or not you actually took the depreciation.

Type of Asset Code = "X - Non-Depreciated Asset" will not automatically include the depreciation not previously claimed in the gain taxed under the depreciation recapture rules.  How do I enter the undepreciated assets in the asset entry form to properly include the undepreciated amounts in the depreciation recapture compoent of the capital gain.

[ljr]

if you are positive they were not expensed then try just inputting the asset using the "original" date of purchased or placed in service with the amount and the correct asset type. It should calculate the depreciation report and there is a line on the input worksheet where you can manually input prior depreciation. See what that does. But. . . . 

I would lean to they were expensed somewhere in the last 35 years and not try to do this now. 

[TaxGuyBill]

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@kuesters wrote:

I know how to enter assets for a rental property, but there is nowhere in the asset entry form that specifically discusses assets that were not depreciated. 

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Back up.  Why are you not filing Form 3115 to 'catch up' with the missed depreciation?  If you are not doing that, you are likely causing your client to pay thousands more in tax than they really need to.

[Terry53029]

@kuesters As I said before you have to file a 3115 for any assets that either were not expensed or depreciated. You can't just add them for current year.

[BobKamman]

Back up even further.  What happens if you don't file Form 3115?  The Internal Revenue Manual anticipates that may happen, and no one goes to jail.  Sometimes the adjustments are allowed anyway. But what would be reported on the return for year of sale, anyway?  Add in the improvements, then deduct the accumulated depreciation not claimed for all years, then add that back in as capital gain, perhaps taxed at a higher rate?  How many of these improvements would be fully depreciated by now, anyway? (Remember that 35 years ago, when the problem started, depreciation on residential real estate was much faster than it is today.)  

Still sounds like the taxpayer is grasping for straws, now that he has been told how much capital gains tax he must pay (not to mention higher Medicare premiums).  Still, it's unlikely that he'll be audited, and these are the instructions the examiner will follow if no 3115 is filed. (By the way, the form wasn't even available until about 25 years ago.) 

4.11.6.7.4 (02-09-2021)

IRC 446(e) - Taxpayer Changed Method Without Obtaining Prior Consent

1. IRC 446(e) provides that, except as otherwise provided, a taxpayer must secure the consent of the Commissioner before changing a method of accounting for federal income tax purposes. The Commissioner may require a taxpayer that has changed a method of accounting without the Commissioner's consent to change back to its former method. The Commissioner may do so even when the taxpayer changed from an impermissible to a permissible method. The Service may change the taxpayer back to its former method in the taxable year the taxpayer changed without consent, or if the statute of limitations is closed for that year, in the earliest open year. For example, the Service may change a taxpayer back to its former impermissible method of accounting if the taxpayer changed to a permissible method of accounting without the Commissioner's consent, even where the statute of limitations has expired for the year of change. See Rev. Proc. 2002-18, § 2.06.

2. While the examiner may allow an unauthorized method change, such action should only be an exception. The examiner, using professional judgment, should consider the following factors when applying the exception: . . .

[sjrcpa]

By filing the 3115 you can deduct the "unclaimed" depreciation as ordinary income.

The 1231 gain/capital gain/unrecaptured 1250 gain are most likely taxed at lower rates than the ordinary income.

Doing it correctly with the 3115 will likely save tax.

[sjrcpa]

P.S. I think this may be an automatic change (permission not required) on the 3115. @TaxGuyBill  ?

[BobKamman]

You can do the same thing without filing Form 3115 also -- just be aware that it may increase the likelihood of an audit from 0.5% to 1.0%.  The results in either case depend on any given auditor on any given day.  Probably disallowance in either case, based on lack of records, not lack of 3115.  

[TaxGuyBill]

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@sjrcpa wrote:

P.S. I think this may be an automatic change (permission not required) on the 3115. @TaxGuyBill  ?

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Yes, it is an "automatic" change.

Form 3115 is still required to do it, but "automatic" means the IRS will just accept the change on Form 3115 without questioning it or having to specifically "approve" of the change.

[sjrcpa]

Thanks for confirming Bill.

[BobKamman]

I think it might not be an automatic change, but all I know is what the Form 3115 instructions tell me. 

Ordinarily, the IRS will not consent to a request for an accounting method change when an applicant ceases to engage in the trade or business or terminates its existence. Generally, an applicant is considered to cease to engage in a trade or business if the applicant terminates its existence for federal income tax purposes, ceases operation of the trade or business, or transfers substantially all the assets of the trade to another taxpayer.

[sjrcpa]

@BobKamman IRS has issued specific guidance about this situation. You can do a change of accounting method 3115 in the year of sale and claim the "missed" depreciation.

I don't have the cite or the time and inclination to look it up now.