Tax Mechanics
Never Took Depreciation on Your Rental? Here's What That's Costing You, and How to Fix It
If you have never claimed depreciation on a rental property, you have been overpaying income taxes every year you've owned it, and you will still owe depreciation recapture tax when you sell, even though you received no benefit from the deduction. The IRS allows you to correct this using Form 3115, recovering all missed depreciation in a single tax year.
By Rich Arzaga, CFP®, CCIM
The Real Estate Whisperer® Financial Planning
| 4 min read
One of the most consistent surprises I encounter working with real estate owners heading into retirement: they never took depreciation. They either didn't know they could, or they'd heard somewhere that taking it makes things complicated at sale. So they skipped it. Year after year.
The problem is, skipping it doesn't protect you from anything. It just means you gave up the benefit while keeping the liability.
How Depreciation Works, and Why You're Owed It
The IRS treats a residential rental property's building structure as having a useful life of 27.5 years. Each year, you're entitled to deduct 1/27.5th of the building's cost as depreciation, compensation for the property's gradual wear and deterioration. For commercial (non-residential) property, cost recovery is 39 years.
On a property with a $275,000 depreciable basis, that's $10,000 per year in deductions. Over 10 years of ownership, that's $100,000 in deductions you may have never claimed.
On a typical rental property, not claiming depreciation can mean forfeiting $8,000, $12,000 in annual deductions, or more.
The Double Penalty of Not Claiming
Here's where it gets particularly frustrating. The IRS operates under what's called the "allowed or allowable" rule: when you sell the property, they reduce your cost basis by the amount of depreciation you were entitled to take, regardless of whether you actually took it.
Translation: you'll pay depreciation recapture tax on deductions you never received. You pay the tax. You never got the benefit. That's the double penalty.
The Fix: Form 3115
The IRS provides a clean remedy for this: Form 3115, Application for Change in Accounting Method. It allows you to claim all missed depreciation as a catch-up deduction, a Section 481(a) adjustment, in a single current year. You don't have to file amended returns for every prior year.
Depending on how many years you've owned the property and the size of your depreciable basis, this catch-up deduction can be substantial, sometimes large enough to offset an entire year's income from other sources.
Form 3115 lets you recover years of missed deductions in a single filing. One return, all the benefit.
What to Do Next
Pull your last few years of Schedule E and look at the depreciation line. If it's blank or zero, that's your signal. Take those returns to a CPA who works with real estate investors, ideally one who has filed Form 3115 before, and ask them to calculate your cumulative missed depreciation.
You've been paying taxes you didn't have to pay. Let's stop that.
Frequently Asked Questions
- What happens if you never claimed depreciation on rental property?
- You overpaid income tax every year you should have claimed it, and you will still owe depreciation recapture tax at sale, even though you never received the deduction. The IRS reduces your cost basis regardless of whether you claimed the deduction.
- Can I go back and claim depreciation I missed?
- Yes. Using Form 3115, you can claim all missed depreciation as a single catch-up deduction in your current tax year. This is the IRS-approved method for correcting this error without filing amended returns for each prior year.
- How much depreciation should I be claiming each year?
- For a residential rental property, the annual depreciation deduction is the building's cost basis (purchase price minus land value, plus certain improvements) divided by 27.5. On a $275,000 depreciable basis, that's approximately $10,000 per year.
- Does taking depreciation create a tax problem when I sell?
- Taking depreciation does trigger depreciation recapture tax at sale, taxed at a maximum of 25%. But the key point is: that recapture applies whether you took the deduction or not. So you're better off taking the deductions and getting the cash flow benefit now.
About Rich Arzaga, CFP®, CCIM
Rich Arzaga is the founder of The Real Estate Whisperer® Financial Planning and creator of The Real Estate Income Lab® and The 5% Real Estate Performance Gap®. He provides comprehensive, flat-fee financial advice that brings investment real estate together with retirement, investments, taxes, insurance, estate planning and the rest of a client's financial life.
About RichKeep Exploring
Tax Mechanics
The Rental Property Tax Mistake That Can Derail Your Retirement Income
Rental property owners heading into retirement often discover costly tax errors too late to fully correct. Here's what to watch for and how to protect your income in retirement.
Tax Mechanics
Sell Before You Fix It: The Counterintuitive Tax Strategy for Distressed Rental Properties
Sometimes the smartest move with a distressed rental property is selling it as-is rather than renovating first. Here's the tax math that makes the case.
Tax Mechanics
Missed Depreciation on Your Rental Property? Here's How Form 3115 Fixes It
If you've been skipping depreciation on your rental property, Form 3115 lets you recover all of it in one year, no amended returns required. Here's exactly how it works.
Have a financial question of your own?
Financial planning often starts with a question. Let's talk about what's on your mind and what you're trying to accomplish.
Talk to Rich