Cost Segregation for Older Buildings

A late cost segregation study is performed on a property that has been owned and depreciated for one or more years. The study reclassifies building components retroactively, identifying personal property and land improvements that should have been depreciated over shorter lives.

The reclassification is treated as an accounting method change, and the catch-up depreciation is claimed in the current year using Form 3115. You do not need to amend prior tax returns. The IRS allows this method change under automatic consent procedures.

For cost segregation purposes, the late study is performed the same way as an initial study. The engineer identifies and values the components, and the tax advisor calculates the catch-up adjustment and going-forward depreciation.

Catch-up depreciation is the additional depreciation you would have claimed in prior years if you had performed cost segregation at the time the property was placed in service. It is calculated as the difference between what you actually claimed and what you should have claimed under the reclassified method.

The catch-up adjustment is taken in the current year as a Section 481(a) adjustment. This adjustment can be substantial, especially for properties that have been owned for many years and have significant personal property and land improvement components.

Understanding how entity structure affects tax planning is critical when evaluating whether a late cost segregation study is beneficial for your real estate portfolio and whether you can use the catch-up deduction in the current year.

Form 3115 is the Application for Change in Accounting Method. It is filed with your tax return to request IRS consent to change your depreciation method. For late cost segregation, the form is filed under automatic consent procedures, which means you do not need to request advance approval from the IRS.

The form includes a calculation of the Section 481(a) adjustment, which is the catch-up depreciation. This adjustment is taken in the current year and does not require amending prior returns.

Your tax advisor will prepare Form 3115 as part of the late cost segregation study. The form is attached to your tax return, and the catch-up adjustment is reported on your depreciation schedule.

Cost segregation old property strategies are particularly valuable for properties that have been owned for many years because the catch-up adjustment can be substantial. The longer you have owned the property, the more depreciation you have missed, and the larger the catch-up deduction.

For example, if you purchased a commercial building 15 years ago and have been depreciating it over 39 years, a late cost segregation study can reclassify components and claim the additional depreciation you should have claimed in years 1 through 15.

Even if the building has been owned for decades, cost segregation can still be beneficial as long as there is remaining basis to reclassify and remaining years of depreciation to accelerate.

The retroactive reclassification treats the cost segregation as if it had been performed at the time the property was placed in service. The components are reclassified, and depreciation is recalculated for all prior years.

The difference between what was claimed and what should have been claimed is the Section 481(a) adjustment. This adjustment is taken in the current year and can create a large depreciation deduction, which reduces taxable income and can generate significant tax savings.

The Section 481(a) adjustment is a one-time catch-up in the year of the change. Going forward, depreciation is based on the reclassified components and the remaining recovery periods.

After the late cost segregation study and the catch-up adjustment, going-forward depreciation is based on the reclassified components. Personal property continues to be depreciated over 5 or 7 years, and land improvements over 15 years, based on the remaining recovery periods.

The going-forward depreciation is typically higher than the depreciation under the 39-year method because the reclassified components have shorter lives. This provides continued tax benefits in future years, even after the catch-up adjustment.

For properties with significant remaining life, the going-forward benefit can be substantial and should be considered when evaluating whether a late study is worthwhile.

A late cost segregation study requires historical records to determine the placed-in-service date, the original basis, and any prior depreciation claimed. The engineer also needs access to the property to inspect and document the components.

If historical records are not available, the engineer can reconstruct the property using available information, such as building plans, permits, and physical inspection. Most late studies can be completed even if original records are missing.

Property owners should gather as much documentation as possible, including purchase agreements, closing statements, prior depreciation schedules, and any renovation or improvement records. This helps ensure the study is accurate and defensible.

The benefit of a late cost segregation study depends on the remaining basis, the remaining recovery period, and the ability to use the catch-up deduction in the current year. For properties with significant personal property and land improvement components, the benefit can be substantial.

A benefit analysis should compare the tax savings from the catch-up adjustment and going-forward depreciation against the cost of the study. In most cases, the benefit exceeds the cost by a multiple of 5 to 10 times or more.

For more on how estate planning strategies integrate with cost segregation, review the dedicated page, which discusses timing considerations for late studies.

If you plan to sell the property within a few years, a late cost segregation study can still be beneficial because the catch-up adjustment provides immediate tax savings. However, you should model the depreciation recapture on sale to ensure the net benefit is positive.

Accelerated depreciation increases the amount of recapture on sale, but the immediate tax savings from the catch-up adjustment and the time value of money typically outweigh the recapture tax. If you plan to use a 1031 exchange, the recapture can be deferred indefinitely.

Coordinate with your CPA to model the net tax outcome over the expected holding period and disposition strategy to determine whether a late study is beneficial for your investment.