If you own a rental property and you have not been claiming depreciation, you may believe you have kept things simple and avoided a complication at sale. The opposite is true. When you sell, the recapture is calculated on the depreciation that was allowed or allowable, and allowable means the amount you could have claimed whether or not you actually did.
So the deduction you never took is charged back to you anyway. You paid more tax every year you held the property, and you pay the recapture at the end as though you had taken it. That is tax paid twice on the same amount.
Allowed or allowable
Those three words are the whole of it, and they are the statutory standard rather than an interpretation.
The rule exists to stop people avoiding ordinary income treatment at sale by simply omitting depreciation deductions along the way. It does that effectively. What it also does, entirely as a side effect, is punish the person who omitted them out of caution, inattention, or a belief that it was simpler.
There is no version of this where not claiming it leaves you better off. Depreciation on a rental is not optional in any sense that helps you.
What it costs at the sale
Gain attributable to depreciation on real property is unrecaptured section 1250 gain, and it is taxed at a maximum rate of 25 percent.
Set that against the ordinary long term capital gain rates of 0, 15, or 20 percent and the shape becomes clear. The depreciation portion of your gain is taxed at a higher maximum rate than the rest of it. That is the price of having had the deduction.
Which is fine when you had the deduction. It is simply a loss when you did not.
The mechanics, briefly
Residential rental property is depreciated over 27.5 years, straight line, with a mid month convention, under the general depreciation system.
Land is not depreciable. The purchase price has to be split between land and building, and only the building is depreciated. That allocation governs every year’s deduction and is needed again at the sale, so it should be documented at purchase from the contract or the property tax assessment rather than estimated years later.
The annual figures run through Form 4562 and onto Schedule E, alongside the repair and improvement questions covered in rental property on Schedule E, line by line.
If you have not been claiming it
This is fixable, and it is much better to fix it before a sale than after one.
There are two routes, and which applies depends on the situation rather than on preference.
An amended return, where an incorrect amount of depreciation was deducted in a year. This is the straightforward correction for an isolated error.
Form 3115, an application for change in accounting method, where an amended return is not available. This is the route where a method has been adopted and persisted with, which is what consistently omitting depreciation amounts to.
The Form 3115 route has a feature that makes it worth knowing about. It carries a section 481(a) adjustment, which captures any unclaimed or excess amount of allowable depreciation, being the difference between what was actually deducted and what was allowable before the year of change. In other words, the depreciation you missed across earlier years is picked up rather than lost.
A negative adjustment, which is the direction that favours you, is generally taken in a single year, the year of change. A positive one is generally spread across four, the year of change and the three following.
The threshold that decides between the two routes is a technical question and is not stated here, because it is the kind of detail that should come from the instructions for the year in question rather than from an article.
Why this is worth raising before a sale rather than after
Because the sale fixes the numbers.
Once the property is sold, the recapture is computed on what was allowable across the whole holding period, and the years you did not claim are gone as deductions while remaining fully present as recapture. Correcting the method while you still own the property lets the missed deductions come back. Correcting it afterwards does not.
If you are contemplating selling a rental you have held for years, this is the question to ask first, ahead of anything about the sale price.
What to have in place
Keep the depreciation schedule itself, year by year, for as long as you own the property and beyond. Keep the land and building allocation with the document it came from. Know your adjusted basis rather than assuming you can rebuild it from a purchase contract and a memory.
These are the records that decide both what you deduct each year and what you owe at the end, and they are the ones that are hardest to reconstruct once they are needed.
Checking whether depreciation has been claimed correctly, and correcting it while there is still time for the correction to be worth something, is part of preparing a return with property in it.