Retroactive Look-Back Cost Segregation Study

By Jason Watson, CPA
Posted Sunday, October 6, 2024

Is there more to a cost segregation study? Yes, there is! So, we have two look-back cost segregation situations-

• You do a cost segregation study in 2024 and would like to “catch up” depreciation that was not taken on previous tax returns.

• You do a cost segregation study in 2024 for a prior year (let’s say 2021) and would like to apply accelerated depreciation to that year with a tax return amendment.

What’s the difference between a look-back cost segregation study and retroactive cost segregation study? Probably not much, but we’ll split some hairs. Let’s consider a retroactive study to be one where you are wanting to restate depreciation on a prior year tax return. Next, a look-back study is where you are wanting to catch-up depreciation in the current year. The IRS references look-back in their IRS Publication 5653 Cost Segregation Audit Techniques Guide (ATG).

Cost Segregation Examples

Why would you want to pick the second option above (the amendment or retroactive option)? Perhaps your income was sky high in 2021 and that big marginal tax bracket could use a little dent. Perhaps that was the only year you qualified as a real estate professional or could use the short-term rental loophole, and you just discovered this thing called cost segregation and accelerated depreciation, but your rental property is now long-term.

What if it is 2024, and you purchased a rental property in 2018. Assuming you could deduct the depreciation expense to create a reduction in taxable income, you would be unable to claim the refund because of the 3-year claim for refund statute of limitations. 2018 tax returns were due in 2019. 2019 plus 3 years is 2022. So, this would be silly, right? You are likely forced to use look-back.

Same situation as above, but you perform a retroactive cost segregation study for the 2021 tax year including the tax return amendment. Now we are cooking with gas (maybe). 2021’s tax returns were due April 15, 2022, so you have until April 15, 2025, to claim a refund, or October 15, 2025, if you extended your tax returns. You also have some housekeeping concerns in 2022 and 2023 since the depreciation taken would now be incorrect based on the new depreciable basis going forward from the 2021 amended tax return. Housekeeping is a nice way of saying tax return amendments are probable.

What if you don’t feel like amending your 2021 tax returns? Perhaps you believe amendments increase audit risk (spoiler alert, they don’t)? Perhaps you don’t like the 2022 and 2023 housekeeping problems with depreciation. Better yet, perhaps 2024 is a much higher income year, and a big old depreciation deduction sounds tasty. What can be done? By using Form 3115 Application for Change in Accounting Method with an IRC Section 481(a) adjustment, you can take advantage of 2021’s bonus depreciation in 2024.

Read that again! You are allowed to take advantage of 2021’s 100% bonus depreciation in 2024 where bonus depreciation is a lowly 60%. There are more mathematical gymnastics since the property eligible for bonus depreciation has been partially depreciated. Also, if you opted out of bonus depreciation in the past, this becomes problematic.

Another option is to not take bonus depreciation. Rather, you take the accumulated accelerated depreciation for 2021, 2022 and 2023 plus 2024 on your 2024 tax returns. This is an acceleration in a sense since you are carving out 5-year property (for example), but taking most (80%, 4 out of 5 years) from the back end of the depreciation schedule on today’s tax return.

Keep in mind that you can elect out of bonus depreciation for certain classes of property. In the example above, you could opt-out for 5-year property since you mostly don’t need it, and retain bonus depreciation for 7-year and 15-year property.

Look-Back Cost Segregation Mechanics

Ok, we’ve tossed around some terms like Form 3115 and IRC Section 481(a). What’s the difference, and how are they used together?

Form 3115 Application for Change in Accounting Method is used to request permission from the IRS for a change in an accounting method (such as cash to accrual) including changes to your depreciation accounting method. Specifically, if you’ve been historically depreciating a 5-year asset over 39.0 years, and you now want to accelerate depreciation, you need permission from the IRS.

Since this request is mostly rubber-stamped by the IRS, you then use IRC Section 481(a) to adjust depreciation to the correct number on your tax returns. In other words, this adjustment is more of a do-over or mulligan where you say, “had we depreciated correctly from the beginning, it would be this new number here that we conveniently want to deduct today.”

Quick summary- Form 3115 asks for permission to change and IRC Section 481(a) states that proper taxable income computation requires omitted or duplicate depreciation amounts to be accounted for. What is the IRC Section 481(a) adjustment thing? Here is the code-

A few options to summarize-

• Amend the prior year tax return since income was significantly higher that year, or you can only support real estate professional status or short-term rental loophole that year.

• Use Form 3115 plus the IRC Section 481(a) catch-up on today’s tax return which conveniently has two options- use bonus depreciation or elect out of bonus depreciation.

As you can see, there is a nice tax planning opportunity here and perhaps even some tax arbitrage given income fluctuations. Keep in mind that generally you will be going back to the service date of the rental property (ready and available for rent) to calculate the amount of depreciation that should have been taken (accumulated) between then and now.

Could you file Form 3115 but not use IRC Section 481(a) to adjust depreciation? Yes. Maybe. Kinda rare. Sure, there is a world where you want (need) to change depreciation today for the future, and do not need or perhaps you are not eligible for a look-back catch-up adjustment.

Sidebar: Changing from 27.5 to 39.0 years for depreciation, or vise-versa, does not require filing Form 3115. A change in computing the depreciation allowance in the year of change for property is not a change in method of accounting according to Treasury Regulations Section 1.168(i)-4(f). Who knew? See our section on switching depreciation for more information.

Look-Back Cost Segregation Study For 1 Year

What about going back just one year? You purchase a rental property in 2023 and naturally start depreciating it using conventional methods. You learn about cost segregation in 2024 after filed your 2023 tax returns. Now what? Are you hosed because you technically have not established an accounting method yet (spoiler alert, you need two years)? Nope.

The short answer is the one above- File Form 3115 Application for Change in Accounting Method and apply an IRC Section 481(a) adjustment. But there is a technical difference that most tax professionals are unaware of. To request a change in accounting method (in this case, for depreciation) you normally need to have at least two years of using an accounting method to have an established method. If you have only depreciated the rental property on one tax return, you do not have the requisite two years necessary to apply for a change in accounting method. As such, your only recourse is (was) to amend your tax returns to deduct the unclaimed depreciation. Yuck.

However, according to the 447 pages found in IRS Revenue Procedure 2024-23 (pages 38-39 to be exact),

(b) Taxpayer has not adopted a method of accounting for the item of property. If a taxpayer does not satisfy section 6.01(1)(a)(i) of this revenue procedure … because this item of property is placed in service by the taxpayer in the taxable year immediately preceding the year of change the taxpayer may change from the impermissible method of determining depreciation to the permissible method of determining depreciation for the 1-year depreciable property by filing a Form 3115 for this change, … Alternatively, the taxpayer may change from the impermissible method of determining depreciation to the permissible method of determining depreciation for a 1-year depreciable property by filing an amended federal income tax return.

Tilt! To put into simple terms- there is an exception for year 2 where you can apply for a change in accounting method without technically establishing a chosen method to change.

Opted Out of Bonus Depreciation Revisited

As we mentioned in a previous section, bonus depreciation election is assumed. If you elect to opt-out of bonus depreciation for some reason (and there are some narrow ones), you can revoke the election to opt out which is like a triple negative. How about this? You can amend your tax returns to claim and deduct bonus depreciation under IRS Revenue Procedure 2020-50.

This is generally good news but here is the bad news- a taxpayer who opted out may revoke that election by filing an amended return only if-

• the initial election to opt out was made on a timely filed tax return, and

• the amended tax return is filed within six months (excluding extensions) of the original tax return’s due date.

Yuck! However, there might be relief by making a request using Form 3115 Application for Change in Accounting Method. More discussion is likely required with your cost segregation buddies at WCG CPAs & Advisors.

Retroactive Cost Segregation Summary

Here is another summary in table format-

Service Year	Cost Seg	Amend	3115	481(a)	Bonus
2021	Look Back	No	Yes	Yes	Maybe
2021	Look Back	Yes	NA	NA	Optional
2021	Retroactive	Yes	NA	NA	Optional
2023	Look Back	No	Yes	Yes	Maybe
2023	Look Back	Yes	NA	NA	Optional
2024	Current	NA	NA	NA	Optional

Generally, filing Form 3115 is preferred to amending tax returns for a handful of reasons-

• More economical in terms of professional fees.

• No housekeeping troubles with “sandwiched” tax returns where multiple years might need to be amended.

• Less hassles with state tax returns.

• Amending tax returns is usually limited to the prior 3 or 4 years, or what is sometimes referred to as “open” tax returns. Theoretically, there is no limit to how far back you can go using a look-back cost segregation study with Form 3115.

However, as mentioned previously, there might be reasons specific to that tax year which necessitates the amendment.

The big takeaway with all this is- The bonus depreciation percentage is based on when the rental property was acquired and placed into service, and not when the cost segregation study is performed or when Form 3115 is filed!

Keep in mind the theory- Form 3115 combined with IRC Section 481(a) allows you to look-back and claim the depreciation that was rightfully yours all along. So, to expand on the paragraph above, if your rental property was placed in service (ready and available for rent) in 2023, you are limited to 80% bonus depreciation. If you fired up the rental in 2024, then 60%. But, if you had it placed in service in 2022, then you get to use that year’s bonus depreciation which was 100%.