Allowed or Allowable Depreciation

The source is section 1016, and the IRS applies it to every depreciable property.

Section 1016(a)(2) adjusts basis for depreciation "to the extent of the amount" allowed as deductions, "but not less than the amount allowable." Where no method has been adopted, the allowable amount is determined under the straight-line method, and Reg. section 1.1016-3 adds that a taxpayer may not take advantage in a later year of a prior failure to claim the allowance.

Publication 946 states it plainly: if you do not claim depreciation you are entitled to deduct, you must still reduce basis by the full allowable amount. If you deduct more than you should, basis drops by the amount from which you received a tax benefit.

Publication 946 also explains when skipped depreciation becomes a method of accounting. You generally adopt a method by using a permissible method on your first return, or by using the same impermissible method on two or more consecutively filed returns. Once a method is adopted, the publication says you generally must file Form 3115 to change it; an amended return is limited to cases such as mathematical or posting errors or property for which no method was ever adopted.

Worked example: ten years of skipped depreciation doubles the gain.

Hypothetical: you bought a rental house for $350,000, $275,000 of it building, and never claimed depreciation. Residential rental property is recovered over 27.5 years, so allowable depreciation is roughly $10,000 a year, about $100,000 after ten years. You sell for $450,000.

Your adjusted basis is not $350,000 but about $250,000, so the gain is about $200,000 instead of $100,000. You never received the $100,000 of deductions. Filing Form 3115 for the year of change can claim the missed amount as a single section 481(a) adjustment; see catch-up depreciation before a sale. Run your own numbers with your CPA.

Where it bites: recapture, exchanges and old records.

For ordinary-income recapture there is a narrow escape. Section 1245(a)(2)(B) and section 1250(b)(3) say that if you establish by adequate records that the amount allowed was less than the amount allowable, the lower amount is used. Publication 544 repeats the rule. The basis reduction itself still uses the greater figure, so the overall gain is unchanged.

In a section 1031 exchange, the reduced basis carries into the replacement property, so the unclaimed depreciation follows you; see basis in replacement property after a 1031 and recapture of depreciation you never claimed. Publication 544 adds that recapture counts depreciation allowed or allowable to any prior holder whose depreciation is reflected in your basis, such as a donor of property you received by gift. If you are short of records, start by rebuilding the depreciation schedule from closing statements and old returns before the sale closes.