Hypothetical: Catch-Up on a Property Owned for Years

Many owners wonder how a catch-up might look in numbers. This example gives a simplified picture.

The facts assumed

A hypothetical owner bought a small apartment building six years ago for $900,000 with $180,000 of land. The depreciable basis of $720,000 has been depreciated over 27.5 years, and the owner has claimed roughly $26,000 a year. Six years of depreciation is about $150,000, adjusting for partial years. The owner is now considering a study and a method change. The owner is assumed to have passive income from other properties.

The study result, assumed

A hypothetical study finds that, as of the placed-in-service date, $110,000 of the cost belonged in 5 and 7 year classes and $70,000 in 15 year classes, with $540,000 remaining in the building at 27.5 years.

What depreciation would have been

Under the study's classification, the depreciation that would have been allowable through the year before the change might look like this in this simplified hypothetical: the short-lived assets would have been largely depreciated, with 5 and 7 year property mostly recovered by year six, and 15 year property partially recovered. The building portion would have produced about $19,600 a year. Total allowable might be around $220,000 in this illustration, assuming no bonus for the older year. If bonus had been available in the placed-in-service year at some percentage, the figure could be higher. Verify.

The adjustment

Depreciation claimed: about $150,000. Depreciation that would have been allowable: about $220,000 in this hypothetical. The difference is about $70,000. That is the assumed adjustment, generally a deduction in the year of change. See The Section 481(a) Adjustment Explained Simply.

What changes going forward

After the change, depreciation follows the new schedule. Because the short-lived assets have been largely recovered, later deductions on them are small. The building portion continues on the 27.5 year schedule at a lower annual amount than before.

Costs

Study fee, added preparation for the method change, and time. Assume the total is a few thousand dollars. The adjustment of roughly $70,000 at an assumed 30 percent rate could reduce tax by around $21,000 in the year of change, if fully usable. See Cost Versus Benefit Without Guarantees.

Compare with a first-year study

A study in the acquisition year with bonus could have produced a larger deduction in the first year if a high bonus percentage applied. A catch-up follows the rules from the earlier year, so it might produce less. This is why the rule in effect for the placed-in-service year matters. See Bonus Depreciation History and Why to Stay Cautious and Used Property and Bonus Depreciation Eligibility.

Risks in the example

• The owner must be eligible to make the change. See Catch-Up Depreciation With Form 3115.
• The adjustment could exceed what can be used in one year.
• A sale soon after would create recapture.
• Records for the older acquisition may be thin.

Lessons

Variations to try

Change the years owned to three and see how the adjustment shrinks. Change it to fifteen and see the effect of a long-held building. Assume the placed-in-service year had no bonus and see how the shift matters. Assume the deduction is only partly usable. Assume the owner sells within two years. Assume the study finds a smaller shift. Each variation clarifies which factor matters most.

Questions the example raises

Was a method previously adopted? Are there other properties to include in the same filing? What does the state require? Can the owner absorb a large deduction in one year? Should the change be made this year or next? These questions are for the preparer.

What the example leaves out

It leaves out the details of the forms, the treatment of assets disposed of before the change, and interactions with other items on the return.

Step-by-step recomputation with a different assumption

Try it again with a younger property. Suppose the same building had been owned for two years. Depreciation claimed might be about $52,000, and the depreciation allowable under the study's classification might be around $95,000, giving an adjustment near $43,000. The adjustment is smaller because there is less accumulated difference. Conversely, if the property had been owned for twelve years, more of the short-lived assets would be fully recovered, and the adjustment could be larger, subject to the rules that applied in the placed-in-service year. The relationship is not linear, and rules from earlier years matter. This is why an owner should ask the preparer to compute the adjustment under a few different placed-in-service assumptions when the date is uncertain.

Reading the numbers with the right expectations

The figures here are inventions, and actual computations depend on the schedule, conventions, and elections. Use them only to understand the structure.

Next steps

Read Method Change Versus Amended Return for Missed Depreciation and use the Cost Segregation Decision Checklist.