IRS Offers Easy Way to Correct Depreciation Errors

Depreciation can be one of the most beneficial deductions that a business or real estate investor utilizes, yet it is also one of the easiest to get wrong. A building improvement gets expensed when it should have been capitalized, something never got added to the depreciation schedule and is noticed years later, or assets are depreciated using an incorrect life. The list goes on and on. The good news? When depreciation has been incorrectly calculated in prior years, the IRS has a process for taxpayers to correct certain errors and avoid amending tax returns. IRS Form 3115, Application for Change in Accounting Method comes to the rescue.

What is Form 3115?

Taxable income must generally be computed by using an acceptable tax reporting method applied on a consistent basis. To change this “method of accounting”, taxpayers need the consent of the IRS. Form 3115 is used to request that consent and many changes qualify for automatic consent. The way an asset is initially set up to be depreciated (including choice of depreciation method and life) is considered a method of accounting. The same goes for whether the asset was capitalized and depreciated or expensed in the year of purchase. These are all considered accounting methods, and to fix an incorrect accounting method, Form 3115 is required. It is not acceptable to simply start using a correct method after discovering the error.

Depreciation Correction or Accounting Method Change?

One important question is how long the incorrect depreciation treatment has been in place. Typically, a method of accounting is established through consistent treatment over time. A single year of incorrect depreciation is usually treated as an error, not an accounting method change, and is corrected by amending that year’s return rather than filing Form 3115.

If the same incorrect treatment has been used on tax returns for two or more years in a row, it is then considered a method of accounting and can be corrected with Form 3115. Using Form 3115, the IRS will automatically grant a request to change an incorrect depreciation treatment to a correct method.

A Real-World Example

An individual taxpayer owns a rental house where the income and expenses are reported on Schedule E of their individual tax return. When gathering documents for the current year tax return, they realize that they forgot to tell their CPA about the new roof on the rental house that was paid for several years ago. The taxpayer still owns/rents out the property, but the roof was never included in the depreciation schedule, so no depreciation was ever claimed. Since this incorrect treatment has been running for more than two years, it is now a method of accounting.

Rather than having to amend prior returns that would have been affected, they can file Form 3115 to change to the correct method of accounting. In the year Form 3115 is filed, depreciation is recomputed assuming the asset was placed in service and depreciation began on the correct date. Any depreciation that was missed between the original placed in-service date and the year prior to filing Form 3115 is claimed as a “catch-up” adjustment, often referred to as a Section 481(a) adjustment. Going forward, the asset is then depreciated correctly.

The Internal Revenue Code (IRC) Section 481(a) Adjustment or “Catch-Up” Adjustment

The mechanism behind the “catch-up” deduction is the IRC §481(a) adjustment. When changing accounting methods, the law requires an adjustment that captures the amounts necessary to prevent income or deductions from being duplicated or omitted because of the change.

In the case of depreciation, this means looking at the depreciation that was taken under the old (incorrect) method and comparing it to the amount that was allowable under the correct method for all prior years. The net difference is the 481(a) adjustment amount. These catch-up adjustments can be negative or positive.

A negative §481(a) adjustment results in a decrease in taxable income when assets are under-depreciated in prior years and are catching up on missed deductions in the current year. The full negative §481(a) adjustment is generally taken into account in the reporting year. A positive §481(a) adjustment results in an increase in taxable income when an asset is over-depreciated in prior years. A positive §481(a) adjustment is generally spread ratably over four tax years, the reporting year and the following three years.

What Form 3115 Does Not Do

Form 3115 can streamline correcting past depreciation errors, but it is not a one-size-fits-all approach and has some limitations:

• It cannot be used to make or revoke elections. Depreciation method elections (such as revoking bonus depreciation or safe harbor elections) are not covered by the standard change from an incorrect method to a correct method.
• It does not bypass the §481(a) adjustment rule. No cherry-picking of individual prior year returns to be corrected is allowed. It rolls the cumulative net difference into a single §481(a) catch-up adjustment.
• It does not automatically fix your state returns. States do not uniformly follow federal depreciation rules, meaning a federal Form 3115 will not resolve state differences. It is important to check the state’s specific filing requirements and comply as necessary.

Cost Segregation Studies and Form 3115

Cost segregation studies are a beneficial tool for accelerating depreciation deductions. They work by reclassifying portions of a building’s components from 27.5 year or 39 year depreciable lives into shorter recovery periods of 5, 7, or 15 years. If the building for which a cost segregation study is being performed was placed in service two or more years ago, it will likely require filing Form 3115 to claim the amount of missed depreciation the study reports.

The cost segregation study is what determines the updated depreciation deductions, while Form 3115 provides the mechanism to adopt that treatment and claim the accumulated catch-up depreciation deductions. See related article to learn more about cost segregation studies: Cost Segregation Studies – Potential Tax Savings for Property Owners

Final Thoughts

Depreciation mistakes happen, and for businesses and real estate investors, they can quietly lead to missed deductions that cost real money. If you have questions about potential past missed depreciation or have recently received a cost segregation study and are not sure where to start on the reporting end of things, please contact us for assistance.

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