MAY 24, 2024

5 Biggest Depreciation Mistakes Landlords Make on Their Tax Return

Here at Choice Tax Relief, landlords have increasingly become some of our most popular clients.

Whether they haven’t filed their taxes in several years or have made some major calculation errors on their tax return, they usually have some big mess that we get to untangle.

But of all the tax mistakes that we see landlords make, not calculating depreciation on their rental properties correctly is by far the most common.

Here are the five biggest depreciation mistakes that landlords tend to make on their tax returns

Mistake #1: Not Taking Depreciation at All

We see landlords who own multiple rental properties, or even just one, have filing their tax returns without reporting any depreciation expense.

This often costs them thousands of dollars in missed depreciation deductions.

If the properties were acquired relatively recently, this error could potentially be fixed by amending the erroneous returns.

Often, however, fixing this mistake requires filing an IRS Form 3115, Application for Change in Accounting Method.

This is because at a certain point, a landlord has established an accounting method of not
taking depreciation expense, and the fix for that is by requesting a change of accounting method – that is, a change to take depreciation – using Form 3115.

Completing and filing Form 3115 can be a lot of work. We have to recalculate what their depreciation would have been every year, get the original closing statements on their properties, and look at any additional capital improvements they’ve made over the years.

Landlords should keep in mind that even if they don’t take depreciation, they’re still on the hook for depreciation recapture. You have to pay depreciation recapture on either the amount of depreciation you actually took or the amount that you could have taken.

It is in your best interest to calculate depreciation on your rental properties or you could be stuck with not only a bigger tax bill than you should have over the years you were operating your rental properties, but also a bigger tax year than you should when you sell them.

Mistake #2: Calculating Basis Incorrectly

When you buy an asset like a rental property, before you take depreciation on that asset, you have to know what your basis is in the property. Your basis is what you paid for the rental property.

Some landlords do not have on hand their settlement statement or closing statement, so they just look at the county assessor’s office and see what their valuation of the property was. This can get you close to the actual amount of your basis in your rental property, but sometimes it will be way off.

What you should be doing is getting your closing statement from the transaction to calculate your basis.

You start with that purchase price figure and make adjustments for various things that might be found on the closing statement, such as title insurance, recording costs, and any other costs that you incurred in order to purchase the property.

If you took out a mortgage to purchase your rental property, there are likely costs on the closing statement that you would allocate to loan costs and amortize over the length of your mortgage.

Sometimes, items includable in your property’s basis or as part of your loan costs may not appear on your closing statement..

For example, if you paid for an appraisal right of the property as a condition of obtaining your loan and you paid for that appraisal outside of escrow, you would include this cost as an amortizable loan cost even though it may not have appeared on your closing statement.

Mistake #3: Depreciating Land

Let’s say you’ve correctly calculated your basis in your rental property, and it ends up being $500,000.

Do you get to depreciate that entire $500,000? Generally, no; it is only that building portion of your property’s basis – as opposed to the land portion – that you’re allowed to take a depreciation deduction on.

But how can you know how much of your property’s basis should be allocated to building and how much should be allocated to land?

The most common way that landlords, as well as tax accountants, allocate a property’s basis between land and building is by taking the percentages the county assessor allocated to land and building, respectively, on the property’s property tax bill and multiplying those percentages to the landlord’s total basis in the property..

The building basis is the amount that you can take a depreciation deduction on. You still have that basis in the land that still helps you out when you go and sell the property, but you can’t depreciate the land.

And once you’ve determined your basis in the building portion of your property, you have to depreciate it over the correct period.

Mistake #4: Depreciating Over the Wrong Period

Most rental property is going to be categorized as either residential rental property or non-residential rental property.

Residential rental property generally means people live in it. Non-residential rental property means people don’t live in it.

Residential rental property is generally depreciated over 27-and-a-half years, and non-residential rental property is generally depreciated over 39 years. These periods are 30 and 40 years, respectively, for non-U.S. property.

Mistake #5: Taking Bonus Depreciation on Their Rental Property

Landlords can not take bonus depreciation on their entire rental property.

If you separate out some of your basis into bonus-eligible components – such as through a cost segregation study – then you can take bonus on those components, but you can’t take bonus on the whole thing.