Primary Residence with Improvements turned Turned Rental, Depreciation Mess

[G2R]

New client looking to sell their rental.  Over 20 years ago, the property was their primary residence for a short time.  They put in over $100k in improvements during that time, then converted it to rental.  So basis, $100k purchase price, $100k improvements. They only used their purchase price as the basis for depreciation and failed to include any of the capital improvements (Land value wasn't a blip on the radar). The depreciation taken over the years is a disaster of mistakes.  

Regardless of the depreciation they took, I still calculate the depreciation as it should have been calculated and report the gain and depreciation recapture off the correct calculations despite the fact they didn't get the benefit of the depreciation deductions. Here's my dilemma.  As crazy as this sounds, it make more sense for her to ignore the improvements all together so the bulk of the gain gets the favorable capital gains rate rather than the depreciation recapture rate? 

Selling price is north of $600k so were looking at big gains here and their in a very large tax bracket already.  Is there another tax strategy out there maybe that might help and do I/can I ignore all the improvements they made?

[Abby Normal]

I think you're missing that they get to take all of that missed depreciation this year. See form 3115.

[G2R]

I've never used that form, but read about it multiple times on this forum.  Ugh, @Abby Normal every time you answer one of my posts I have to actually LEARN a whole new section of the code.   

Skeleton in the Closet: Would filing this form make the IRS go back and review what depreciation they actually took?  Because if so, the Pandora's box that might open could be a disaster.  

[Lee B]

Since the 3115 fixes the skeletons in the closet, I don't think there is anything to worry about.

You have some fixed asset allocation issues and depreciation errors to fix.

You're aware of the problems, it's your responsibility to bring them to your client's attention and to fix them.

Not to do so, would be a huge problem!

I have never had any problems as a result of filing a 3115.

[Possi]

The 3115 isn't as bad as it looks. Use the line by line instructions. 

Also, if they are in a high tax bracket, they might have some suspended losses that can be used to their benefit. 

You can do this. It's not hard, honestly. I'm not the sharpest tool in the shed, but I can do the 3115. You got this. 

[Gail in Virginia]

Possi is smarter than she gives herself credit for, but this really is not as complicated as it looks at first glance.  Like most IRS forms, take it one step at a time and read the directions (slowly, in my case, and sometimes two or three times!)

[Lion EA]

Lisa Ihm of Brass Tax Presentations has a self-study course on Form 3115 for only $20:

https://brasstax.com/other-on-demand-webinars#548450be-8c9e-4353-83e8-2cfe301cce8f

Also, download her free spreadsheets for attachments to Form 3115:

https://brasstax.com/practice-aids

The form is about eight pages, but you're not filling them all out, just the appropriate pages to correct depreciation.

[G2R]

Thank you everyone for the advice and encouragement! I really, really appreciate it. 

[Catherine]

What everyone else said.  The 3115 will NOT cause problems with prior years - its purpose is to correct all those prior year problems in one swell foop, without making any changes in the deep dark past.

Lisa Ihm's book/booklet is terrific and well worth the price.  Once you actually sit down with it, you'll be surprised how relatively straightforward it is.  What you will need to do is to manually correct depreciation on that property, because the 3115 corrections do not automatically flow anywhere; there are too many possibilities.

The hardest part is to remember to MAIL in a copy to ...wherever it goes; Ogden maybe, in addition to attaching the form as a pdf to the return.

[Abby Normal]

1 hour ago, Catherine said:

in one swell foop

[Catherine]

21 hours ago, Abby Normal said:

Glad you liked that.  Been using it for years.

[G2R]

Hi everyone!  I can't thank you enough for all the help with this.  I was able to get through the 3115 (insert proud smile) and now I'm working on the tax implications of their state taxes. 

Any NY preparers ever dealt with NY or RI regarding this form?  I read that California requires approval before a change in accounting method but I haven't found any rules regarding NY or RI.  
 

btw, @Lion EA thank you for recommending that self study course.  It was well worth the price.  

[Lion EA]

You're very welcome. I have Lisa's 3115 stuff, but haven't had to use it. I did use her inexpensive Cancellation of Debt text to walk me through a rental house foreclosure situation one time, and was pleased with her step-by-step explanation.