Dear Tax Talk:
The house that I previously owned and lived in is now a rental unit. It went into service in August 2000. I have not been claiming any depreciation on that property on my taxes, as I had (erroneously) planned on using the unadjusted basis of that property when I sold it. Now I find out that the IRS is depreciating that property whether I claim it or not. So ... what are my options now? Can I go back and amend my taxes back to 2000, or am I just out of luck?
-- Keith

Dear Keith,
As you're finding out a little late, depreciation on a rental property is not an optional deduction. Some people think that because the property does not decline in value, there is no sense in claiming a deduction now and paying tax on it later.

As you now realize that is erroneous. When you sell a property on which depreciation could be claimed, the basis of the property is adjusted for the depreciation that was allowed or allowable. In your situation, the depreciation was allowable, so you're stuck reducing your basis by that amount and paying tax on depreciation recapture at 25 percent.

You can only go back and amend your returns for three years and claim the depreciation that would have been allowed. If you file every year by April 15, you can amend 2004 through 2006 by April 15, 2008.

When computing depreciation, you're only allowed to depreciate the structure portion of the real property, not the land. Hence, you can minimize the recapture by properly allocating the basis of the property between depreciable building and nondepreciable land. Usually this is done based on the relative fair market value of the two components. Some property tax bills provide a breakdown between land and building, which is good to use as a basis for allocation.

If you have passive loss carryovers from prior years relating to this rental, you can increase these losses by the understated depreciation in prior years. For example, if your adjusted gross income, or AGI, in all the years since you commenced renting these properties exceeded $150,000, any losses from the rental activity would have been suspended and carried forward. Because these losses are still carrying forward, it is OK to adjust for the depreciation that wouldn't have otherwise been deductible in those years.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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