Let’s talk fun and games – and significant tax savings – with IRS Form 3115.
To apply cost segregation to an existing property, you must file IRS Form 3115, Application for Change in Accounting Method. To apply cost segregation to a newly acquired property, Form 3115 is unnecessary because there is no change in accounting.
But we’ve gotten ahead of ourselves. Let’s first talk about cost segregation.
Cost segregation is a tax reduction strategy that separates out the various elements of a property for accelerated depreciation and tax savings in the short term. A commercial building itself may be depreciated over 39 years (27.5 years for residential property), but many of its constituent parts, like flooring, plumbing, furniture and fixtures, may be depreciated over as little as five years. That’s tax savings – cash back in the business rather than paid to the government.
Let’s consider a $1 million commercial building. Without cost segregation, the property may be depreciated by $25,641.
After cost segregation, the scenario might look more like this:
Value of building = $650,000. Depreciation = $19,231
Value of assets with 15-year depreciation schedule = $75,000. Depreciation = $5,000
Value of assets with 5-year depreciation schedule = $275,000. Depreciation = $55,000
Total depreciation = $79,231. That more than triples depreciation and reduces tax liability substantially in the short term.
To establish cost segregation, a commercial property owner (or owner of a multi-unit residential property) must perform an IRS-compliant cost segregation study. These studies should be conducted by professional engineers knowledgeable in IRS regulations governing cost segregation.
Once the cost segregation study on a newly acquired property is complete, the Cost Detail and Cost Summary pages are appended to the tax return. Together, they identify the segregated assets and their depreciation adjustments.
On existing property, IRS Form 3115 must be filed. It requests a change in accounting method to reflect the reclassification of assets for depreciation purposes. It also allows for look-back claims from prior years without amending past returns.
It is important for Form 3115 to be filled out correctly, usually by a CPA. The key sections are Part I, Part II, and Schedule E, which detail the accounting method changes, apply them, document adjustments to prior years and calculate the amount of accelerated depreciation. The catch-up depreciation for prior years is added to the depreciation for the current year and claimed on the tax return. This adjustment is called a Section 481(a) adjustment, and it goes on line 26 of Form 3115.
Once depreciation adjustments are determined, they must be integrated into the tax return correctly to ensure compliance and reduce the possibility of an audit. Form 3115 is filed along with the tax return and the Section 481(a) adjustment is reported on the tax return as “Other Deduction.”
Many CPAs who lack specialized expertise in real estate and cost segregation partner with firms like National Tax Group, whose engineers and CPAs have extensive experience conducting IRS-compliant cost segregation studies and can ensure it is applied to the tax return in accordance with IRS guidelines and regulations.
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