Fix missed depreciation before client tax costs add up

Depreciation errors can happen for many reasons, from overlooking an asset to applying the wrong recovery period or not using the right depreciation method. When these mistakes go uncorrected, they can affect taxable income across multiple years and potentially expose clients to additional tax or even penalties.

In some situations, the correction may be made on an amended return, such as for mathematical or posting errors or when no accounting method has yet been adopted. However, once a depreciation method has been adopted, many corrections require Form 3115, Application for Change in Accounting Method, along with a §481(a) adjustment to account for depreciation that should have been claimed in prior years rather than Form 1040-X, Amended U.S. Individual Income Tax Return.

Depreciation and cost segregation

Sometimes, allowable depreciation is not calculated because a client forgets to tell you about new equipment purchased for the business. The correction method depends on whether the taxpayer has adopted an accounting method for the asset.

If clients used the wrong recovery period, depreciation method or convention, the correction is treated as a change in accounting method rather than a simple error correction. Many of these changes are eligible for the automatic change procedures, but eligibility depends on the applicable designated change number and current procedural rules.

A permissible depreciation method is adopted on the first return using that method, while an impermissible method is adopted if it is used on two or more consecutive returns.

If your client bought a new building, you may need to consider additional tax strategies when using depreciation. Cost segregation is a tax strategy that breaks a building into components with shorter depreciation lives, such as five-, seven- or 15-year property, instead of depreciating the entire property over 27.5 or 39 years.

This allows faster depreciation deductions and, depending on the facts, some assets may also qualify for bonus depreciation or §179 expensing, subject to detailed eligibility rules and limitations.

The §481(a) adjustment

A §481(a) adjustment is a required cumulative adjustment to taxable income when a taxpayer changes an accounting method. Its purpose is to prevent income or deductions from being duplicated or omitted during the transition, ensuring that each item is recognized only once. In cost segregation, the adjustment reconciles the difference between depreciation previously claimed and the amount that should have been claimed under the new depreciation method.

Taxpayers must calculate and report the §481(a) adjustment whenever an accounting method change is made, helping maintain accurate depreciation records and compliance with IRS requirements.

Generally, a negative §481(a) adjustment is taken entirely in the year of change, while a positive §481(a) adjustment is spread ratably over four years. A taxpayer may elect a one-year adjustment period for a positive adjustment of less than $50,000, subject to the applicable rules.

When to use Form 3115

Form 3115 is generally filed with the timely filed return, including extensions, for the year of change and does not automatically require Form 1040-X. When a taxpayer is using an impermissible depreciation method, the form is generally attached to the return implementing the change.

For most automatic accounting method changes, the original form is attached to the timely filed return for the year of change, and a signed duplicate copy is filed with the IRS in Ogden, Utah.

Whether multiple issues may be reported on one Form 3115 depends on the applicable designated change numbers and the concurrent change rules under the current automatic change procedures. Changes involving the same type of depreciation method issue and the same designated change number can often be grouped.

The original Form 3115 attached to the return does not need to be signed, but the duplicate copy must be signed by the appropriate taxpayer or authorized individual. The preparer must also sign the duplicate copy when applicable.

More than one issue might require additional steps

If there are two issues to correct, such as depreciating land with the building and improperly amortizing closing costs, separate analysis is required. Depreciating land with a building may fall under the impermissible-to-permissible depreciation change rules, often associated with DCN 7, while improperly amortized closing costs may involve a different method change. Confirm the applicable designated change numbers and concurrent change rules before deciding whether separate forms are required.

Multiple fixed assets can usually be corrected on one Form 3115 if the issues are the same type of depreciation method change and fall under the same designated change number. One Form 3115 and one combined §481(a) adjustment are typically allowed for grouped depreciation issues.

Depreciation is a must

By learning how to identify depreciation errors, calculate and report §481(a) adjustments and determine when Form 3115 is required, tax professionals can confidently resolve missed depreciation issues while improving accuracy and providing greater value to their clients.

Understanding when each option applies can reduce time and help ensure compliance with IRS requirements.

Ready to apply these rules to real client work? Explore the Sept. 3 Correcting Missed Depreciation Webinar for practical guidance on choosing the proper correction method and completing Form 3115. The webinar is also available on demand.