New client, Rentals, No Depreciation, 3115

[BulldogTom]

I picked up a new client a couple weeks ago.  Not complicated, so I thought.   Interest, dividends, cap gains and a couple rental properties.   I ask for the prior year return and I notice there is almost no depreciation on the rentals, just a washer and dryer on the schedule.   She digs up her information on the purchase dates (2008 and 2013).   No depreciation taken for all those years.   I calculate the missed depreciation over the years at approx. $170K.   Client income is in the $20K region.  

It seems to me that this will generate an NOL, but had it gone on the Sch E all those years, some of it would have been suspended passive losses.   

Am I looking at this correctly?

Tom
Longview, CA

[Lee B]

Very tricky situation since post 2020 NOLs cannot be carried back. Will this client ever be able to use this NOL?

If she can't use the NOL carried forward, then it would be preferable to create suspended passive losses.

My strategy if possible, would be to take the position that she was not an active participant in the rentals

Therefore all passive losses would I believe,be suspended and ultimately deducted against the properties when sold.

Don't know whether that can be done, but it certainly is worth exploring.

Good Luck,

 

 

[mcb39]

Wow! the (Little) things that nobody (including the IRS) caught.  I am thinking of possible lost credits such as EIC, etc. , which possibly could have affected this lower income taxpayer.  Makes you want to cry when you get one of these and your hands are literally tied. 

 

[Abby Normal]

Might be better to amend all of those years, to come up with the passive loss carryovers. Since the older refunds will be lost, I probably wouldn't bother filing those. Just file the last 3 years.

[Lee B]

Don't know how old your client is, but the ultimate fix might be the step up in basis when she passes?

[BulldogTom]

1 hour ago, Abby Normal said:

Might be better to amend all of those years, to come up with the passive loss carryovers. Since the older refunds will be lost, I probably wouldn't bother filing those. Just file the last 3 years.

How about putting the 481(a) adjustment on each respective Sch. E which will create the suspended passive losses you are trying to get to?   Actually, this was my first thought, but I believe the IRS is looking for the 481(a) adjustment on the Schedule 2 - Adjustments to Income.   If I put it on the Sch. E, I get the expense where the expense was meant to be.   I like the symmetry of this approach, but I think the IRS prescribes otherwise and I can't nail it down for certain in my research.   

On the other hand, if I put it on 1040 Schedule 2, I can generate an NOL and still use it to offset gains if she sells the rentals.   Something just seems icky about doing it this way....

Tom
Longview, TX

[Lee B]

I thought that NOLs could be used to offset ordinary income but not capital gains since the IRS considers the two to be different classes of income?

[jklcpa]

4 hours ago, BulldogTom said:

How about putting the 481(a) adjustment on each respective Sch. E which will create the suspended passive losses you are trying to get to?   Actually, this was my first thought, but I believe the IRS is looking for the 481(a) adjustment on the Schedule 2 - Adjustments to Income.   If I put it on the Sch. E, I get the expense where the expense was meant to be.   I like the symmetry of this approach, but I think the IRS prescribes otherwise and I can't nail it down for certain in my research.   

On the other hand, if I put it on 1040 Schedule 2, I can generate an NOL and still use it to offset gains if she sells the rentals.   Something just seems icky about doing it this way....

Tom
Longview, TX

Since the accounting change for the error from impermissible to permissble method has gone on for more than the second year, amending would also be incorrect. The proper method is to file form 3115, code 7 if the assets have not yet been disposed of, and the 481 adjustment that will be negative should be shown on Sch E. Doing so will put the prior years' adjustment into the category of a passive activity loss (as if) the depreciation and PALs had been calculated correctly all along, and then take the current year's depreciation on the proper line of Sch E.

If the assets have already been disposed of, use code 107 on the form 3115 that basically eliminates the allowed or allowable "penalty" of never having taken the deduction but having to use the reduced basis at sale.

[jklcpa]

Tom, obviously one goal is that, at the end of all calculations and current year's depreciation, that the accumulated depreciation and NBV of the assets are correct, and . . .

the second is that any PAL carryforward reflects the actual amount as if everything had been reported properly in the first place.  Hope someone will chime in if my reasoning is incorrect on this part, but I believe that it may be necessary to make some adjustment to the PAL for any years where the taxpayer may have been allowed the special $25K allowance if the MAGI was under $150K on a joint return, or half those amounts on MFS returns.  Were there any years where that may have been the case?

Another 2 thoughts - AMT calculations, and I hope you are getting a healthy retainer for this work.

[BulldogTom]

24 minutes ago, jklcpa said:

Tom, obviously one goal is that, at the end of all calculations and current year's depreciation, that the accumulated depreciation and NBV of the assets are correct, and . . .

the second is that any PAL carryforward reflects the actual amount as if everything had been reported properly in the first place.  Hope someone will chime in if my reasoning is incorrect on this part, but I believe that it may be necessary to make some adjustment to the PAL for any years where the taxpayer may have been allowed the special $25K allowance if the MAGI was under $150K on a joint return, or half those amounts on MFS returns.  Were there any years where that may have been the case?

Another 2 thoughts - AMT calculations, and I hope you are getting a healthy retainer for this work.

Yeah, I keep getting this nagging feeling that I need to see the detail for every return from 2008....

Tom 
Longview, TX

[BulldogTom]

@jklcpa  No, I don't think I have to make an adjustment for what did not happen just because it could have.   If I did, I would have to recompute every return between 2008 and 2021 to determine the tax effect and bring every one of those adjustments into 2022.   I don't think the Rev Procedures and Regulations prescribe that intense of an analysis.   I think the intent is to take the adjustment for the item in a vacuum in the year you file the 3115.

Anyone disagree?   I am not sure, but I hope I am right because I don't have enough summer left to complete this return if I have to re-do every return.

Tom 
Longview, TX

[jklcpa]

Thinking that through, that does make sense because any loss that could have been used wasn't used for any tax benefit and would still be c/f, so yes, in a vacuum in the current year of correction.

[Lee B]

In the back of my mind I am wondering, "whether no depreciation was ever deducted or

whether at some point the depreciation detail just didn't get rolled over and depreciation ceased?"

[Catherine]

4 hours ago, cbslee said:

In the back of my mind I am wondering,

Sometimes the best you can do is the best you can do. Question the client, see whatever older returns exist, and go from there. If the client had self-prepared returns, the possibility of depreciation being taken diminishes substantially; they don't understand it so they ignore it. 

[Sara EA]

Oh yeah?  I had a client who had self-prepared for years and had depreciation correct down to the penny!  I was impressed.  Look at the prior year returns to see if depreciation was ever taken, but you don't have to amend or do anything with them.  The 3115 will handle all the missed depreciation.  Since the adjustment will increase current income, I believe there is an automatic election to spread the income over four years. 

You do have to calculate the missed depreciation.  Every time I do that, I wonder if newer preparers even know how.  I think we've all become a bit stupider by having software do so much math for us.

[mcb39]

30 minutes ago, Sara EA said:

 

You do have to calculate the missed depreciation.  Every time I do that, I wonder if newer preparers even know how.  I think we've all become a bit stupider by having software do so much math for us.

I don't think we are stupider, nor should we be.  We have to keep an eye on computer calculations to make sure they are correct.  That's why we have research books and boards like this one to keep us up to date.

If my assistant makes a serious mistake, I can usually tell that her results are wrong even before I go through it. Nothing leaves my office without my scrutiny.  That does not mean that I never make a mistake.  It means that I am vigilant and cautious.

[jklcpa]

2 hours ago, Sara EA said:

The 3115 will handle all the missed depreciation.  Since the adjustment will increase current income, I believe there is an automatic election to spread the income over four years. 

No, a correction for cumulative missed depreciation expense will be an additional reduction to Sch E and create an overall passive activity loss from the 2 properties.

Reread the original post where Tom estimates the total of missed deductions to be in the 170K range and current income is only about 20K.

[Catherine]

15 hours ago, Sara EA said:

I had a client who

If you read what I wrote, it was that "the possibility of depreciation being taken diminishes substantially." I also had a client who did it correctly on their own. Exactly ONCE in over 25 years. But the ones who stare at you blankly, ask "what's that?" and have no recollection of it.... it's a fair bet to say it was never calculated or deducted.