If you are a home-owning child care provider, you are allowed to calculate home depreciation and deduct it as a business expense on Form 8829 (the business use of home form). You should always deduct home depreciation, because even if you don't, the IRS will assume that you did. When you sell your home, you may be taxed on the amount of your “allowed or allowable” home depreciation. This is called “depreciation recapture.” Even if you never deducted home depreciation on your tax return, you may still have to pay the depreciation recapture tax when you sell. The only exception is if you sell your home for less than its "tax basis," which is generally the original purchase price, plus the cost of improvements, minus allowable depreciation...whether you actually deducted the depreciation or not.
I frequently meet with new clients who have been in business for several years and never deducted any home depreciation. Or sometimes they deducted the wrong amount of depreciation, either because of using the wrong building value for their home or figuring their time/space percentage incorrectly in Part I of Form 8829. If you find yourself in either situation, you can do one of two things.
You can go back to the first year of operation in the home and file amended tax returns for that year and all succeeding years. Or you can include Form 3115 with your current year tax return and deduct depreciation for all of the prior years at once. You can generally only go back about three years when amending a tax return, but you can go back any number of years with Form 3115, so long as your business is still in operation in the same home.
Sometimes child care providers don't realize they were required to deduct home depreciation until they sell the home and find out that they owe a "recapture tax" on the depreciation they never actually deducted. Such providers can attach Form 3115 to their tax return for the year of the sale and catch up all the prior year depreciation to offset the recapture tax.
The title of Form 3115 is Application for Change in Accounting Method. This is a mouth full and the form is quite complex, so you will almost certainly want to get professional help. Depreciation must be calculated for all of the previous years involved. I find that the tax savings generated by filing Form 3115 usually more than covers the preparation fee, especially if there are multiple years to correct. One copy of the completed Form 3115 is attached to your current year income tax return and another copy is sent to a special IRS office in Washington, D.C.
Besides catching up on home depreciation, you can also catch up on prior year deprecation for other business-use assets at the same time, such as appliances, play structures, furniture, computers, etc. You may want to do a home inventory to discover furnishings and other items you owned before your business started that are now used regularly for business purposes. Such items are depreciated based on their resale value on your business start date. You can include any item not previously deducted as a business expense, so long as it was still in business use at the beginning of the tax year for the tax return with the Form 3115 attached.
When new clients come to me, I require that they correct any prior year home depreciation using Form 3115 or by filing amended tax returns.
For further information, check out Tom Copeland's article How To Claim Previously Unclaimed Depreciation, which covers home inventories and gives an example of the tax savings that are possible when filing Form 3115.
Last updated: 14 December 2011