There's be a lot of back and forth on the statute of limtations for depreciation records and after reading some 15 posts and responses I thought I'd take a minute and try to summarize the entire situation and clarify the issue.
The OP asked how long he needed to keep records for depreciable property, specifically a rental house. The answer is "until at least 3 years AFTER the property is disposed of". The reason is because you need to be able to calculate your gain or loss on the sale and you need to be able to support that calculation if asked to do so by the taxing authorities.
The taxing authorities normally have three (3) years to audit a tax return under most normal circumstances. However, if there is a substantial UNDERSTATEMENT of income that statute jumps to six (6) years and if they can effectively assert a fraud argument there is NO statute of limitations UNLESS the fraud is corrected by the original due date of the return WITHOUT REGARD to any extensions.
Two responders reference a pending case where the IRS asserted that an overstatement of basis amounted to an understatement of income which effectively extends the statute of limitations to six years. However, that case (assuming we're talking about the same one, I just read it and do NOT have the cite handy) is very narrow - in a previous post I made I said it did NOT apply to this case. I said that because the issue for the OP was about recordkeeping BUT on reflection it could come into play.
In the case I read the overstatement of basis that resulted in an understatement of income which extended the statute to six years focused on a capital gain. Generally GROSS income is defined (over simplified) as what came in or what you got when you collected money. BUT for capital gain purposes gross income is defined as NET CAPITAL GAIN, not gross sales price. So overstating your basis results in a lower net gain, or larger net loss, which gets treated as an understatement of income sufficient to extend the statute of limitations.
Part of the problem here is that the District Courts are split on how to address this issue. Some have ruled that an overstatement of basis does NOT create an understatement of income and others have ruled exactly the opposite. There is an old Supreme Court case that addressed the issue (I don't recall the year but I'll try to find it next week), but the regulations have been updated since then so some arguments say it doesn't apply - hence the recent Supreme Court Case.
And its important to keep in mind that the U. S. Tax Court is a court of GEOGRAPHICAL jurisdiction tied to the Federal Circuit Court system. This means that the U. S. Tax Court MUST BY LAW rule in a manner consistent with how the Federal Circuit Appelate court has ruled before. If the Federal courts have ruled differently in different jurisdictions then the Tax Court WILL issue different opinions for different taxpayers engaged in exactly similar circumstances but who live in different Federal Circuits where the appelate courts have ruled differently - WHO says taxes ain't fun!
Some responders raised the possibility that this would not matter if the asset were fully depreciated, and I disagree with that position. The underlying issue here is the GAIN from the sale. Without the underlying records supporting the basis you cannot accurately either compute or support any number for basis.
This extends further for a depreciated asset. Gain from the sale of a depreciated asset is split into two parts - gain from appreciate which is taxed currently at long term capital gain rates, and gain from recapture of depreciation which is taxed at a flat 25% (I think that's the rate, though your tax bracket may come into play I am trying to keep this simple). So again, if you don't know, or can't support, your basis, because you don't have the underlying records, how can you calculate any gain or loss?
One other posted commented that if an asset is depreciated to ZERO there can't be any loss on disposition. This isn't entirely accurate because on disposition you get to factor in disposal costs. So it is possible to have a loss on the disposition of totally depreciated asset.
Additionally, I think there was one question about basis when the property was gifted. The basis in the hands of the recipient is determined by the basis in the hands of the donor BUT can fluctuate depending on the sale price and the FMV of the asset at the time of the gift. For example, FMV is $100K but adjusted tax basis is $50K and I gift the property to my daughter. Her basis gets determined by her sale price when she sells it. If she sells it for MORE THAN $100K she can use $100K as her basis and reports a gain, but if she sells it for less than $50K she uses $50K as her basis and reports a loss. If she sells it for anywhere between $50K and $100K she'll report the sale and the basis as the same number - ignoring any depreciation she may have claimed if she kept in service. Gift basis is also adjusted by any gift tax that is paid on the gift when the lifetime exclusion is used up.
On the other hand, for property that is transferred by inheritance depreciation evaporates and the property transfers at full FMV at the time of death, or the alternative valuation date if elected by the executor/personal representative.
Do keep in mind that while I only post what I believe to be accurate it is wise on your part to confirm everything via your own research. Good as I am, I have been known to make the occassional mistake.
Gene E. Utterback, EA, RFC, ABA