May 13, 2020
Missed Depreciation — Can It Be Fixed?
Missed Depreciation — Can It Be Fixed?
Missed depreciation errors can be corrected by either filing an amended return or filing a change in accounting method Form 3115 with a current year return. Depreciation errors that are NOT subject to the accounting method change filing requirements should be amended returns and include:
Amended Returns:
- You claimed the incorrect amount because of a mathematical error made in any year.
- You claimed the incorrect amount because of a posting error made in any year.
- You claimed the incorrect amount on property placed in service by you in tax years ending before the statute of limitations has expired.
- You are changing the amount of Section 179 claimed or not claimed.
- Election to apply the $2,500/$5,000 de minimis safe harbor rules (within its own time period requirements of return due date plus extension).
- Election not to claim bonus depreciation under 168k (within its own time period requirements of return due date plus extension).
Amending returns will only correct depreciation errors that have occurred in the last three years (refund statute). Errors that have occurred before that cannot be “caught up” on current or amended returns and will only be “caught up” when the asset is sold using a Form 3115 and Code 107 as discussed below.
Change in Accounting Method Form 3115:, Change in Accounting Method, is used to correct most other depreciation errors, including the omission of depreciation. If you forget to take depreciation on an asset, the IRS treats this as the adoption of an incorrect method of accounting, which may only be corrected by filing Form 3115. When changing methods of accounting from not taking depreciation (incorrect method) to taking depreciation (correct method) use Code 7 on Form 3115 if the asset is still in use, code 107 if disposed.
The IRS’s automatic consent procedures for taxpayers who have adopted an impermissible method of accounting for depreciation (or amortization) and have either claimed no allowable depreciation, less depreciation than allowable, or more depreciation than allowable is provided in the guidance at Rev. Proc. 2015-13 and Rev. Proc. 2018-31.
Generally, Form 3115 must be attached to the taxpayer’s tax return for the year of change by the original due date (including extensions). A copy must also be filed with the IRS no later than when the original is filed with the taxpayer’s return.
Taxpayers who qualify under the automatic procedure are permitted to change to a method of accounting under which the allowable amount of depreciation is claimed. The unclaimed depreciation from years prior to the year of change is taken into account as a net negative (taxpayer favorable) adjustment in the year of change, generally effective for tax years ending on or after December 31, 2001 and are deducted in full on the return for the year of change.
Changes that are considered to be a change in accounting method are:
- Changing from not taking depreciation to taking depreciation. (Because this is a change from an impermissible method to a permissible method use Code 7 on Form 3115)
- Changes in methods or conventions, (Because this is a change from 1 permitted method to another, use Code 8 or 200 if MACRS on Form 3115)
- Changes to or from a required life, (Because this is a change from 1 permitted method to another, use Code 8 on Form 3115)
- Correcting depreciation on leasehold improvements from using the incorrect life of the lease term to the correct life of the asset (generally 39 years). (Use Code 199 on Form 3115)
Rev. Proc. 2015-13 is also to be used to correct depreciation after an asset has been sold and the 12/30/03 regulation changes correct other depreciation errors. The Procedure’s additional primary value is to recover depreciation deductions mistakenly overlooked, for which, under the “allowed or allowable” rule the taxpayer had to reduce basis in the asset. This Revenue Procedure effectively makes the “allowed or allowable” penalty disappear! Code 107 on Form 3115 is to be used to “catch up” omitted depreciation on an asset when it is sold.
Changes that do not require Form 3115 because they are not considered changes in a method include, and which may only be made on an amended return:
- A change in computing depreciation because of a change in the use by the same taxpayer,
- Changes in placed-in-service dates.
- A change in useful lives,
Note: Making a late depreciation election or revoking a timely valid depreciation election (including the election not to deduct bonus depreciation). If you elected not to claim any bonus, a change from not claiming to claim bonus is a revocation of the election and is not an accounting method change. Generally, you must get IRS approval to make a late depreciation election or revoke a depreciation election. You must submit a request for a letter ruling to make a late election or revoke an election.
Other depreciation corrections still qualify for the automatic change provisions of Rev. Proc. 2015-13.
- Rev. Proc. 2015-13 allows the use of one Form 3115 to correct mistakes on more than one asset.
Explanation of the 2-year rule:
The use of an incorrect method of depreciation, which would include taking no depreciation, is considered the use of an incorrect accounting method. Once an incorrect accounting method has been used for two years, a Form 3115 is required to change accounting methods back to a correct method, or in this case, since not taking depreciation is incorrect, to begin taking depreciation a Change in Method Form 3115 must be filed. To change to the correct method, meaning to take the overlooked or correct depreciation requires the filing of the change in accounting method under Rev. Proc. 2015-13 in most cases. (Instructions to Form 3115)
If no depreciation had been taken and only one year has passed the return may be corrected via amendment because the incorrect method had only been used for one year.
Examples of depreciation change in accounting methods:
- Using an incorrect method (or no method, which is also impermissible!),
- Changing a method or convention, (like 200DB to S/L)
- Change to or from a recovery period assigned by the Code,
- Changing to or from bonus depreciation,
- Changing from non-depreciable to depreciable, or vice-versa.
Form 3115 will have to be filed, with the entire amount of incorrect or overlooked depreciation deducted in full in the year of correction via this Form 3115. The total depreciation adjustment is called a Section 481(a) adjustment, which, if negative may be deducted in full in the year of change.
If positive, it may be added in ratably over 4 years, or if positive but less than $50,000 in total the taxpayer may elect to add it in to income in full in the year of change.
The form may be filed at any time for any year, and if for a prior year sale, is accompanied by an amended tax return, effective for a Form 3115 filed for taxable years ending on or after 12/30/2003.
- Use Code 7 as the Code number of change on Page 1 of Form 3115 if correcting an error while the asset is still owned by the taxpayer.
- Form 3115 will use Code 107 as the Code number of change on Page 1 of Form 3115 if the asset has been sold and Rev. Proc. 2007-16 applies.
Rev. Proc. 2015-13 requires that a signed copy of Form 3115 be filed to the IRS office. No advance approval is required to correct the error, as this is an automatic approval change in most cases. There is no user fee.
An original of the Form 3115 should be included with the tax return filed for the year of change. The original must be filed by the due date of the return, plus extension. There is a 6-month automatic extension of this due date providing the return was timely filed, and an amended return (with this change) is filed within 6 months.
When filing Form 3115, the additional statements listed below must be attached:
- A detailed description of the former and new methods of accounting,
- A statement describing the taxpayer’s business or income-producing activities,
- A statement of the facts and law supporting the new method of accounting, new classification of the item of property, and new asset class,
- A statement identifying the year in which the item of property was placed in service.
On Form 3115 at the top of the page make sure to include this notation:
Filed Under Rev. Proc. 2015-13
Depreciable Basis was Not the Correct Amount
Using an incorrect basis is not a changing in accounting method, it is a "mathematical or posting error", so Form 3115 cannot be used (some people say it can be used in the year of the sale, but I'm still not convinced of that).
Basis for Depreciation was Too High.
If the Basis for depreciation was too high (and therefore too much depreciation), it is probably not a big deal. The taxpayer has been benefiting from the 'extra' depreciation all of these years, and when the property is eventually sold, will need to pay the Unrecaptured Section 1250 Gain on that. Hypothetically if they have always been in the same tax bracket, they will 'break even' (or even end up better off due to being limited to 25% for the Unrecaptured Section 1250 Gain). If the taxpayer still owns the property when she dies and it gets a step-up in Basis, then he/she really did good by taking too much depreciation.
Basis for Depreciation was Too Low.
If the basis was too small (and therefore not enough depreciation), you cannot fix it using Form 3115. In this case the ‘open’ years should be amended to correct the error to receive the immediate tax benefit available in the open years. When the property is sold, less depreciation will have been taken, than would have been taken had the correct basis been used. Therefore, in theory, there will be less Unrecaptured Section 1250 Gain. This is an OK solution unless you are in a lower tax bracket when the property is sold.
Some people say your can catch up the depreciation using the Form 3115 when the property is sold. The problem with that, it is still not a change in accounting method for depreciation NOT taken. It is still a “mathematical or posting error” for the INCORRECT basis used.
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