What Happens if You Forget to Take Depreciation on a Rental Property?

Depreciation is a valuable tax benefit for rental property owners, allowing them to recover the cost of wear and tear over time. However, some landlords mistakenly overlook claiming it, either due to lack of knowledge or accounting errors. This can lead to financial consequences when filing taxes or selling the property.

Skipping depreciation might seem harmless in the short term, but it can create complications that affect taxable income, asset value, and future tax liabilities. Understanding these implications is key to avoiding costly mistakes and ensuring compliance with IRS regulations.

Taxable Income Implications

Failing to claim depreciation increases taxable income because the IRS assumes the property is generating revenue without accounting for its gradual decline in value. Depreciation is an expense that reduces rental income subject to taxation. Without it, landlords may pay more in taxes than necessary, forfeiting a deduction that could lower their overall tax burden.

For example, if a property generates $20,000 in rental income annually and has $5,000 in allowable depreciation, taxable income would be reduced to $15,000. Without claiming depreciation, the full $20,000 is taxed, which could push the owner into a higher tax bracket. This is especially problematic for those near the threshold of a higher marginal tax rate.

The impact extends beyond federal taxes. Many states follow federal depreciation rules, meaning state tax liabilities may also be inflated. Additionally, self-employed landlords who report rental income on Schedule E may miss out on indirect benefits, such as reducing their adjusted gross income (AGI), which can affect eligibility for tax credits and deductions tied to income limits.

Impact on Asset Basis

When depreciation is not claimed, the property’s adjusted basis remains higher than it should be, creating complications upon sale. The IRS requires that depreciation be accounted for, whether or not it was deducted. This concept, known as “allowed or allowable” depreciation, ensures the tax consequences of depreciation apply regardless of whether the deduction was used.

A higher adjusted basis might seem beneficial since it suggests a lower taxable gain upon sale, but this is misleading. The IRS reduces the basis by the depreciation that should have been taken, so owners miss out on tax savings during ownership but still owe taxes on the depreciation when selling.

For instance, if a rental property was purchased for $300,000 and should have accumulated $50,000 in depreciation, the adjusted basis for tax purposes would be $250,000. If the owner failed to claim this depreciation, they might assume their basis remains at $300,000, but the IRS will still calculate gain based on the $250,000 figure. If the property is sold for $400,000, the taxable gain is $150,000 ($400,000 – $250,000), not $100,000. This miscalculation can result in a higher-than-expected tax bill, particularly when factoring in capital gains and depreciation recapture taxes.

Possible Recapture Issues

Depreciation recapture requires property owners to pay taxes on the portion of gain attributable to depreciation when selling a rental property. Even if depreciation was never claimed, the IRS assumes it was and applies recapture rules accordingly. This means landlords who overlooked depreciation can still be liable for taxes on it when they sell, despite never benefiting from the deduction.

The tax rate for depreciation recapture is capped at 25% under Section 1250 of the Internal Revenue Code. This is separate from capital gains tax, which applies to the remaining profit from the sale. For example, if a property accumulated $40,000 in depreciation, the IRS will tax that amount at the recapture rate. If the owner falls into a tax bracket lower than 25%, they still owe the full recapture tax. If they are in a higher bracket, they pay no more than 25% on the recaptured amount, but their remaining capital gain may be taxed at standard long-term capital gains rates, which range from 0% to 20% in 2024, depending on income.

Recapture applies even in cases where the property is exchanged rather than sold. In a 1031 exchange, which allows deferral of capital gains taxes on like-kind property swaps, depreciation recapture is also deferred—unless cash or non-like-kind property (boot) is received. If boot is involved, the recaptured depreciation becomes taxable in the year of the exchange.

How to Rectify Missed Depreciation

Correcting missed depreciation requires filing a change in accounting method with the IRS, as depreciation is not something that can simply be adjusted on a single year’s tax return. The IRS mandates the use of Form 3115, Application for Change in Accounting Method, to properly claim unclaimed depreciation retroactively. This form allows property owners to catch up on all previously missed depreciation deductions in a single year without having to amend prior returns.

One advantage of using Form 3115 is the automatic consent procedure under Revenue Procedure 2015-13, which means taxpayers do not need direct IRS approval to make the correction. The form includes a Section 481(a) adjustment, which accounts for the cumulative effect of missed deductions and applies it to the current tax year. This can result in a substantial one-time deduction, potentially offsetting taxable income and reducing tax liability significantly. If the adjustment creates a net operating loss (NOL), the taxpayer may be able to carry it forward to future years, depending on current tax laws governing NOL usage.

Potential IRS Actions

The IRS has specific procedures for handling cases where depreciation was not claimed. While failing to take depreciation is not a violation, it can still trigger scrutiny. If an audit occurs, the IRS will adjust the property’s basis to reflect the depreciation that should have been taken, which can lead to unexpected tax liabilities. If the omission resulted in an underpayment of taxes, penalties and interest may be assessed on the unpaid amounts.

In some cases, the IRS may view the failure to claim depreciation as an improper accounting method, requiring correction through Form 3115. If a taxpayer attempts to amend prior returns instead of using the proper procedure, the IRS may reject the amendments and require the formal accounting method change. This can delay resolution and create additional administrative burdens. If the mistake spans multiple years, the cumulative impact can be significant, making it important to address the issue proactively rather than waiting for an audit or IRS notice.