Misconception About Cost Segregation: It is Never Too Late

A common misconception among property owners is that if they did not perform a cost segregation study in the year they acquired their property, they have missed their chance to benefit from accelerated depreciation. In reality, the IRS allows taxpayers to conduct a cost segregation study in later years and implement the results using IRS Form 3115, Application for Change in Accounting Method.

Cost segregation is a tax strategy that identifies and reclassifies parts of a building into shorter-lived asset categories, such as 5-, 7-, or 15-year property, rather than depreciating the entire property over 27.5 or 39 years. Although it is ideal to perform a cost segregation study in the year the property is placed in service, the IRS does not require this timing. Taxpayers can conduct a study in a subsequent year and use Form 3115 to change their depreciation method.

Filing Form 3115 allows a taxpayer to change from their previous depreciation method (typically treating all costs as long-lived real property) to a new, permissible method (allocating costs based on a cost segregation study). The IRS provides an automatic consent procedure for most depreciation changes, meaning taxpayers do not need to wait for IRS approval before implementing the change, provided they follow the required steps.

When a taxpayer files Form 3115 to implement a cost segregation study after the year of acquisition, they calculate a Section 481(a) adjustment. This adjustment represents the difference between the depreciation actually claimed in prior years and the depreciation that would have been claimed had the correct method been used from the start. If the adjustment is negative (i.e., the taxpayer is entitled to more depreciation), the entire amount can generally be deducted in the year of change. This process allows taxpayers to "catch up" on missed depreciation without amending prior tax returns.

However, all taxpayers must be aware that if they later sell the depreciated asset, the IRS requires that any gain from previous depreciation deductions be taxed as ordinary income, a process called depreciation recapture. When calculating recapture, Section 1245 applies to personal property, and Section 1250 applies to real property.

To maximize and accurately claim the missed depreciation, taxpayers should consult a tax professional. A tax professional can oversee and evaluate the cost segregation study, prepare all required forms, ensure the recapture is correctly calculated if the property is sold, and maintain all records for IRS review.

In conclusion, taxpayers are not restricted to the year of acquisition to benefit from cost segregation. By adhering to IRS procedures and submitting Form 3115, property owners can retroactively accelerate depreciation, claim missed deductions, and enhance cash flow—all without needing to amend prior returns. This opportunity remains available as long as the taxpayer complies with the applicable IRS rules and procedures. Reach out to our team if you have any questions about cost segregation, at (202) 455-6010 or schedule a confidential consultation.