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How to Use Form 3115
to Deduct
Previously Unclaimed Depreciation

by Tom Copeland

 

The issuing of IRS Revenue Procedure 2004-11 should make a significant, positive impact on the thousands of taxpayers who have not claimed all of the business depreciation deductions they were entitled to in earlier years. Many taxpayers and tax preparers often fail to take depreciation deductions because of various reasons, and then later came to the realization that these deductions were allowed or allowable. But this Revenue Procedure makes using depreciation rules more practical and profitable.

The revenue procedure allows taxpayers to deduct previously unclaimed depreciation by filing Form 3115 Application for Change in Accounting Method. The property must be depreciable under section 167, 168 (ACRS), 168 (MACRS) or 197. The taxpayer must not have previously taken any allowable depreciation or have taken less than the amount allowable. To deduct previously unclaimed depreciation, there are five major guidelines. The taxpayer must:  

  • Be in business in the year Form 3115 is filed (even if for only part of the year)
  • Own the property they wish to depreciate in the year Form 3115 is filed. The taxpayer can sell the property later without adversely affecting their Form 3115 deductions.
  • Be using the property for their business in the year Form 3115 is filed.
  • File Form 3115 before filing the current year tax return.
  • Claim the depreciation deductions by filing a timely Form 1040 (including extensions).

The most likely taxpayers who will be able to take advantage of this revenue procedure are those who own rental property, those who claim the home office deduction, and the self employed, particularly family child care providers. There are a large number of items that may not have been previously depreciated by a taxpayer that are prime candidates for including on Form 3115. These include:

  • The house, home improvements (new furnaces, roof, remodeling projects, room additions, fixtures, etc.), and land improvements (fences, driveways, landscaping, etc.) 
  • Personal property such as: computers, printers, desks, tables, chairs, file cabinets, furniture and appliances
  • Property that was owned by the taxpayer before the business began and then used in the business
  • Property such as pole barns, water pump houses, etc. for farmers

Obviously, a particular item must be a legitimate business expense for it to be entitled to a depreciation deduction. In the field of family child care, there are scores of items that meet this test (washer, dryer, freezer, refrigerator, beds, sofas, outdoor play equipment, etc.). What should be done if the taxpayer has no receipts for the undepreciated property? Have the taxpayer search for other records: credit card statements, canceled checks, repair service contracts, etc. Take pictures of the property. Copy recent ads that describe the property and list its price. The most important point for property owned before the business began is to have some proof that the taxpayer owned the property at the time the business did begin. Use the lower of the fair market value or the adjusted bases of the property to claim the depreciation deduction. At a recent audit, one of the authors of the article presented photos of previously undepreciated property, along with an estimate of its fair market value. The auditor accepted the estimates without requiring the original receipts.

Using Form 3115 

Tax preparers must follow specific depreciation rules when claiming expenses using Form 3115. Normally a taxpayer must make an election to use straight line depreciation rules in the first year the property was used in the business. If this is the case, then MACRS accelerated depreciation rules must be used to claim deductions on Form 3115. If the taxpayer didn't have the choice to elect to use straight line rules in the first year the property was used for business, then the taxpayer must use the rules that were originally required. Here is a breakdown of the rules that must be used when claiming depreciation using Form 3115:

  • Home: nonresidential real property, 39 (or 31.5) straight line
  • Home improvement: nonresidential real property, 39 (or 31.5) year straight line
  • Land Improvement: asset class 00.3 land improvement, 15 year 150% declining balance
  • Computer: asset class 00.12 information systems. If used 50% or less in business, 5 year straight line. If used more than 50% in business, 5 year MACRS 200% declining balance.
  • Other personal property: asset class 00.11 office furniture, fixtures, and equipment, 7 year MACRS 200% declining balance
  • Car: asset class 00.22 automobiles, 5 year MACRS 200% declining balance

Note: MACRS depreciation rules did not exist before 1987. Consult IRS publication 534, Depreciating Property Places in Service Before 1987, for the rules on how to depreciate property used in your business before 1987.

Tax preparers should think of unclaimed depreciation for their self employed clients as one of two types: Schedule C depreciation (furniture, computer, appliances, and other personal property) and Form 8829 depreciation (home and home improvements). Calculate how much of each type of depreciation your client was entitled to deduct for each unclaimed year. Higher Schedule C or Form 8829 depreciation deductions from Form 3115 may affect the ability to claim some deductions in the current year. Also note that Form 8829 was first introduced in 1991. The rules before then, however, were the same regarding the limitation of claiming home office expenses that create a business loss.

Showing a Loss

Can deducting previously unclaimed depreciation create a loss on Schedule C? Yes and no. Depreciation of personal property can always be used to claim a loss for a business. Depreciation of a home or home improvements cannot. Tax preparers must follow the regular rules regarding carrying forward disallowed depreciation expenses.

When filing Form 3115 with the taxpayer's tax forms, enter all Schedule C depreciation from Form 3115 onto the Schedule C, line 27 "Other Expenses." Write "Section 481(a) Adjustment" next to the amount on one of the blank lines under Part V of Schedule C. Note that this may cause some of the original Form 8829 expenses to be disallowed. Enter all Form 8829 depreciation from Form 3115 onto the "Carryover of excess casualty losses and depreciation." Enter "Section 481(a) Adjustment" on this line. Follow the regular instructions to Form 8829 regarding the deduction limitation rules. Some expenses may have to be carried forward to the next year's Form 8829.

Let's look at an example: Suppose the original Schedule C showed a $1000 profit and the original Form 8829 showed a total of $500 in deductions. If Form 3115 (filed in the current year) had $2,000 in Schedule C depreciation and $1,500 in Form 8829 depreciation (home and home improvements), how much of this depreciation could be claimed in in the current year? First, claim all $2,000 in Schedule C depreciation on the Schedule C, line 27. This creates a tentative loss of $1,000 on the Schedule C. But the original $500 Form 8829 expenses shown on Schedule C cannot create a loss, so this amount must be put back on Form 8829 and carried over to the next year's Form 8829. The new total for the Schedule C shows a $500 loss. Next, put the $1,500 in Form 3115 on line 30 of the Form 8829. Since this amount also cannot create or add to a loss, add it to the $500 that will be carried forward to the next year's Form 8829. Thus, a total of $2,000 will be carried forward to the next year's Form 8829, line 30 "Carryover of excess casualty losses and depreciation."

Special note for owners of rental property: Tax preparers should ask their clients with rental property if they have been deducting all allowable depreciation for their rental property, including any furnishings. Previously unclaimed depreciation should be reported on line 18 "other" on Schedule E.  Write "Section 481(a) Adjustment" next to one of the blank lines.

In the above examples, we have used line numbers as they appear on the 2006 IRS forms. They may differ on forms in later years.

Final Notes 

There is no filing fee to file Form 3115.

Tax preparers should take into account that showing a lower business profit after filing Form 3115 may impact the eligibility of the taxpayer for the earned income credit. Some taxpayers may be able to get a higher credit and some may receive less.

Tax preparers should be assertive in asking their client whether all allowable depreciation deductions were claimed in earlier years. Using this new revenue procedure presents a major opportunity to reduce the tax burden of your clients.


from the Tax Practitioners Journal, Spring 1997.
Posted with permission.


This handout was produced by Think Small (www.thinksmall.org).

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