Short answer

A cost segregation study can be applied to a building you have owned and depreciated for years. You do not amend the old returns. Instead, your tax adviser files Form 3115, Application for Change in Accounting Method, with the return for the year of change, treating the reclassification as a change from an impermissible to a permissible method of depreciation. The difference between the depreciation you actually claimed and the depreciation you would have claimed under the study's classifications is a section 481(a) adjustment. When that adjustment is negative, meaning you claimed less than you could have, it is generally deducted in full in the year of change. This is the "look-back" or "catch-up" study. It is one of the more technical corners of the practice, it has eligibility rules, and it belongs to your tax adviser. This article explains the mechanism so you can have that conversation. It is general education, not tax advice.

Why a change in accounting method rather than amended returns

Depreciation is a method of accounting. If a building has been depreciated for two or more years with everything in the 27.5- or 39-year class, that treatment is an adopted method. Reclassifying parts of it into 5-, 7- or 15-year classes changes the method, and the tax law's mechanism for that is section 481, which requires adjustments in the year of change so that amounts are neither duplicated nor omitted.

The IRS treats a change from an impermissible method of depreciation to a permissible one, including a change in the recovery period or classification of property already placed in service, as a change eligible for its automatic consent procedures. That is why the Cost Segregation Audit Techniques Guide lists consideration of changes in accounting method among the elements of a quality study: a study on an existing building is not complete unless it can be applied through this mechanism.

Amending prior returns is not the route, and there is a further reason it would not help. Basis is reduced by depreciation allowed or allowable, so depreciation you failed to claim still reduced your basis. The section 481(a) adjustment is how you recover that missed depreciation.

The mechanism, step by step

  1. The study. A practitioner prepares a study of the building as it was when placed in service, using the original closing statement, construction records, drawings and a site visit, and produces a classified asset list that reconciles to the original basis.
  2. The recomputation. Your adviser recomputes depreciation from the placed-in-service date to the beginning of the year of change under the study's classifications, using the recovery periods, methods, conventions and bonus depreciation rules that applied in each of those years.
  3. The section 481(a) adjustment. The difference between the recomputed depreciation and the depreciation actually claimed is the adjustment. If the recomputed figure is larger, the adjustment is negative, which favors the taxpayer.
  4. Form 3115. Your adviser prepares Form 3115 under the automatic change procedures, identifying the designated change for impermissible-to-permissible depreciation, attaches it to the timely filed return for the year of change, and files a copy with the IRS as the instructions require. There is no user fee for an automatic change.
  5. The year of change. A negative adjustment is generally taken into account entirely in the year of change. A positive adjustment, which arises when the study shows you claimed too much, is generally spread over four years.
  6. Going forward. The reclassified assets are depreciated on their new schedules from the year of change.
ElementWhere it comes from
Original basis and land splitClosing statement, appraisal, prior depreciation schedule
Classified asset list as of placed in serviceThe cost segregation study
Depreciation claimed to datePrior returns and the fixed-asset ledger
Recomputed depreciationThe adviser's calculation under each year's rules
Adjustment and its timingSection 481(a); Rev. Proc. 2015-13 section 7
The filingForm 3115 with the year-of-change return, copy to the IRS

Which bonus depreciation rate applies in a look-back

A common misunderstanding is that a look-back study on a 2019 building produces a 100 percent first-year deduction under today's rules. It does not. The recomputation applies the bonus depreciation rules that were in force for the year the property was placed in service and for its acquisition date. The look-back catches up the depreciation you would have had under the correct classifications at the time; it does not import a later, more generous rate. Your adviser will apply the right percentage year by year.

Eligibility rules and limits

The automatic procedures have conditions, and this is where owners who read a marketing page and expect a certain result meet reality.

  • Year of disposition. You generally cannot use the automatic change procedures for property in the year you dispose of it. If you plan to sell soon, the timing has to be planned with the adviser.
  • Prior changes and other eligibility rules. The general procedures restrict repeated changes for the same item within a period and set other conditions. The adviser checks each before filing.
  • Audit protection and its exceptions. Filing under the procedures generally gives audit protection for the treatment of the item in prior years, subject to exceptions set out in the procedures, including for taxpayers under examination in some circumstances.
  • The study must support the earlier years. The evidence has to describe the building as placed in service. Renovations since then are separate assets with their own dates and are not swept into the look-back.
  • Passive activity limits. A large negative adjustment is a large deduction, and the same passive activity rules that limit rental losses apply to it. A deduction you cannot use is a suspended loss.
  • State conformity. States may not follow the federal treatment. Ask.

What the look-back changes about recapture

Catching up depreciation increases the depreciation allowed on section 1245 property. On a later sale, gain is recaptured as ordinary income to the extent of depreciation allowed or allowable. Since the basis was already reduced by allowable depreciation whether or not you claimed it, the look-back does not create recapture that would not have existed; it aligns what you claimed with what reduced your basis. The practical point is the same one that applies to every study: the timing benefit should be weighed against the sale you expect.

Who does what

  • The practitioner prepares the study of the building as placed in service, with the evidence and the reconciliation, and produces an asset list your adviser can recompute from.
  • The tax adviser decides whether a change is available and advisable, performs the recomputation, computes the section 481(a) adjustment, prepares and files Form 3115, and applies the passive activity and state rules.
  • You supply the records: the original closing statement, prior returns and depreciation schedules, construction and renovation records, and the history of use.

A practitioner who offers to "file the 3115 for you" as part of a study package is offering tax return work. Ask who signs, under what professional standards, and how they will coordinate with the adviser who signs your return.

Signs a look-back is being oversold

  • A promised catch-up deduction before anyone has seen the prior depreciation schedules.
  • Today's 100 percent bonus rate applied to a building placed in service years ago.
  • No mention of the passive activity rules, the year-of-disposition rule or state conformity.
  • A study that classifies the building as it is today, including later renovations, as if it were the building placed in service originally.
  • A fee tied to the size of the adjustment.

What people ask on Reddit and other forums

The searches that lead people to these threads are usually phrased "look-back cost segregation study", "catch-up depreciation".

The "form 3115 cost segregation" and "cost segregation reddit" threads on r/tax are full of owners who found out late. From the sources below:

"I've owned the building for six years. Do I amend six returns?" No. The change is made on Form 3115 with the current return, and the difference is a section 481(a) adjustment, generally taken in full in the year of change when it favors you.

"Can I get today's 100 percent bonus on a 2019 building?" No. The recomputation applies the rules in force for the year the property was placed in service and its acquisition date. The look-back catches up what you would have had, not a later rate.

"Is there an IRS fee?" Automatic changes carry no user fee. The adviser's and practitioner's fees are separate.

"Can I do it the year I sell?" Generally not under the automatic procedures. Plan the timing with your adviser.

Questions people also ask

How far back can a look-back study go?

The change is made in the current year and the adjustment catches up depreciation from the placed-in-service date, however long ago that was, provided the eligibility rules are met and the evidence supports the study. Prior returns are not reopened.

Do I have to amend prior returns?

No. The section 481(a) adjustment in the year of change is the mechanism, filed with Form 3115.

Is there a fee to file Form 3115?

Automatic changes carry no user fee. Your adviser's fee for the work is separate.

Can I do this in the year I sell the building?

Generally not under the automatic procedures. Plan the timing with your adviser.

Does the adjustment count as income or a deduction?

A negative adjustment, meaning you under-claimed depreciation, is a deduction generally taken in full in the year of change. A positive adjustment is income spread over four years.

What if my building was placed in service before 2018?

The recomputation uses the rules in force for each earlier year, including whatever bonus depreciation rate applied when the property was acquired and placed in service.

Sources