Cost segregation – Lookback Studies

A cost segregation study on property placed in service in a prior tax year, also known as a "look-back" study, can offer significant benefits but also comes with some potential drawbacks. Here are the pros and cons:

Pros

Accelerated Depreciation
A cost segregation study allows property owners to reclassify certain building components into shorter depreciation periods (5, 7, or 15 years) instead of the standard 27.5 or 39 years for residential and commercial properties, respectively. This acceleration of depreciation deductions can lead to substantial tax savings and improved cash flow in the early years of property ownership.

Increased Cash Flow
By frontloading depreciation deductions, property owners can significantly reduce their current tax burden, resulting in increased cash flow. This additional cash can be reinvested into the business or used for other purposes, potentially yielding a higher return than if the property had remained in the longer depreciation period.

Tax Planning Advantages
Cost segregation studies offer considerable tax planning advantages, allowing property owners to optimize their tax position and potentially lower their tax bracket.

Cons

Cost of the Study
One of the primary drawbacks is the cost associated with conducting a cost segregation study. Depending on the complexity and size of the property, these studies can cost between $5,000 and $15,000. However, it's important to note that the tax savings often outweigh this initial investment.

Time Investment
The process of conducting a cost segregation study can take several weeks and requires cooperation between property owners, tax professionals, and cost segregation specialists. This time investment needs to be considered when deciding whether to pursue a study.

Potential for Depreciation Recapture
While accelerated depreciation provides immediate benefits, it can lead to depreciation recapture if the property is sold in the future. This could result in higher taxes at the time of sale, especially if the property is not held for a significant period.

Increased Scrutiny
Cost segregation studies may increase the likelihood of IRS scrutiny, as they involve reclassifying assets and accelerating deductions. It's crucial to ensure that the study is performed by qualified professionals and adheres to IRS guidelines.

From 3115

Form 3115 plays a crucial role in applying cost segregation studies to properties, especially those placed in service in prior tax years. Here's how Form 3115 comes into play:

Change in Accounting Method

Form 3115, "Application for Change in Accounting Method," is used to request IRS approval for changing the way a taxpayer accounts for certain items on their tax return. In the context of cost segregation, it allows property owners to:

• Implement cost segregation studies on existing properties without amending prior tax returns.
• Change depreciation methods for assets, including those identified in a cost segregation study.

Catch-up Depreciation

• Section 481(a) of Form 3115 allows building owners to adjust their income to claim deductions as if cost segregation had been applied from the beginning.
• This catch-up depreciation is often referred to as a Section 481(a) adjustment.

Filing Form 3115 Process

• The form is submitted with the federal income tax return for the year of the change.
  A duplicate copy must be filed with the IRS's Ogden, Utah office.
• Supporting documentation, including the cost segregation study and depreciation calculations, should be included.

When filling out Form 3115 for cost segregation, pay special attention to:

• Section A: Identify taxpayer and property details.
• Section B: Describe the change in accounting method.
• Section C: Calculate and report the Section 481(a) adjustment.
• Section D: Indicate automatic consent eligibility and provide the designated automatic accounting method change number (DCN).

Complexity in Future Accounting
Cost segregation can complicate future accounting practices, particularly when it comes to allocating costs for repairs and improvements. This may require more detailed record-keeping and potentially increase the administrative burden. Cost segregation studies on properties placed in service in prior years can offer significant tax benefits and improved cash flow, they also come with associated costs and potential complexities. Property owners should carefully weigh these factors and consult with tax professionals to determine if a look-back cost segregation study is appropriate for their specific situation.