We spend a lot of time talking to real estate investors and property owners, many of whom are not familiar with cost segregation and have not performed studies for their previously acquired properties. We are frequently asked some version of this question:
“I have several existing rental properties. Can I still do a cost segregation study?”
YES! You can still do a cost segregation study for a property acquired in a prior year. These retroactive cost seg studies are performed much the same way they would be for a newly acquired property, but with a few additional steps required.
The process for completing a retroactive cost segregation study typically involves making a change in accounting method by filing a Form 3115 (Application for Change in Accounting Method). Taxpayers are required to file this form whenever they intend to change their method of accounting for a particular item (depreciation is just one of many “accounting methods” a taxpayer can have). As part of the filing, you are allowed to recognize what is known as a Section 481(a) adjustment. This is the “catch up” adjustment that allows you to recoup the depreciation you missed by not performing the cost segregation study in the first year.
The process for completing a change in accounting method is relatively straight forward, but there are a few important rules that must be followed to properly complete the change:
- The Form 3115 must be filed in multiple places. The original gets attached to your federal income tax return and a copy gets sent (via fax or snail mail) to the IRS National Office. If you are under exam, you must also provide a copy to the examining agent.
- The Form 3115 must be completed and filed before the due date (including extensions) for the tax year of change. This is not a form that you can file late.
- The Section 481(a) adjustment is recognized as of the first day of the year of change (typically January 1st for calendar year taxpayers) and is recorded as an “other” deduction (separate from the depreciation expense) on the tax return. In addition to the Section 481(a) adjustment, taxpayers should also adjust their current year depreciation expense to reflect the change.
Case Study
Below is a quick example of how a retroactive cost segregation study would work for an asset that is a few years old:
Property Type: Office building
Depreciable Basis: $1,000,000
Placed in Service (PIS) Date: 7/1/2021
Method Change Year: 2023
In the above example, the total adjustment resulting from the retroactive cost segregation study would be $234,241 of additional tax depreciation recognized in 2023. This amount is the difference between the total depreciation taken through 2023 before the cost segregation study ($63,034) and the total depreciation taken through 2023 after the cost segregation study ($297,276).
Am I still able to claim bonus depreciation?
Yes, as long as you did not make an election out of bonus for the tax year the property was placed in service, you can claim bonus depreciation as part of an accounting method change for any assets that are reclassified from a non-bonus eligible property type (e.g., 39-year nonresidential real property, 27.5-year residential rental property, etc.) to a bonus eligible property type (e.g., 5-year personal property, 15-year land improvement property, etc.).
Will this increase my chances of being audited?
In our experience, filing an accounting method change does not increase your chances of being audited. The process of making an accounting method change is well established and there are currently over 200 different types of accounting method changes available to taxpayers, so it is a frequently used process. An accounting method change for depreciation is an “automatic” change, meaning consent for the change is automatically granted just by properly filing the Form 3115. There is no formal IRS review or approval process like there is for “non-automatic” or “advance consent” accounting method changes. However, it is an additional touch point with the IRS and it is important to complete the process correctly (which means employing an experienced and qualified tax professional to assist you with preparing and filing the required information).
Do I need to do it for all of my properties at the same time?
No, there is no requirement that you do a cost segregation study or file an accounting method change for every property in your portfolio. Depreciation methods are on an asset-by-asset basis, so you can pick and choose which assets you include as part of the accounting method change. You can also file Forms 3115 in multiple years, as long as they do not include the same assets (i.e., file a Form 3115 for Property A in 2023 and then file a Form 3115 for Property B in 2024).
I acquired the property in a year that bonus depreciation was 100%, but I am doing the cost seg study for 2023. Can I still claim 100% bonus or can I only claim 80% for 2023?
100%. The bonus depreciation % is determined based on when the property was acquired and placed into service, not when the cost segregation study is performed or when the accounting method change is filed.
Summary
A retroactive cost segregation study can be a powerful tool for real estate investors who missed out on the benefits of accelerated depreciation when they first acquired the property. However, there are several considerations to take into account before performing a retroactive cost segregation study and many requirements that must be met to complete one successfully. It is important to work with an experienced cost segregation provider. If you have any questions please reach out to Andrew Kohrs at [email protected] or another member of the MVO team.
