When Cost Segregation Changes Accounting Method

A cost segregation study can be performed years after a commercial property was placed in service. When that study identifies property that should have been depreciated differently, the owner faces two separate questions: Is the new classification supportable, and how can the depreciation treatment already used on filed returns be changed?

The IRS Cost Segregation Audit Technique Guide explains that reclassifying previously placed-in-service property can result in a change in accounting method when the reclassification changes an adopted depreciation method, recovery period, or convention.

The direct answer is that once a depreciation method has been adopted, a later cost segregation study generally cannot be implemented simply by treating the prior depreciation as a mathematical correction. When the reclassification changes the adopted method, recovery period, or convention, the ATG points to the accounting-method-change rules, generally including Form 3115 and an adjustment under IRC § 481(a).

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Key Takeaways

• A prior-year cost segregation study can create an accounting method change when it changes an adopted depreciation method, recovery period, or convention.
• Whether a depreciation method has already been adopted is central to the analysis.
• The ATG generally points taxpayers with an adopted method toward Form 3115 rather than retroactive amended returns.
• IRC § 481(a) addresses the cumulative adjustment associated with changing the accounting method.
• Not every depreciation correction is an accounting method change.
• Peco Foods shows that accounting-method procedures do not override an unsupported underlying reclassification.
• Engineering determines what the property is, while tax procedure determines how a prior-year change is implemented.

When Does Cost Segregation Become an Accounting Method Issue?

A cost segregation study may identify property that was originally depreciated as part of a building but is supportably classified differently under the applicable depreciation framework. If the study is performed after depreciation has already been reported, implementing that conclusion may involve more than changing an asset description.

The ATG states the Service's position that a change in an adopted depreciation method, recovery period, or convention for depreciable property resulting from reclassification is generally a change in method of accounting.

That distinction matters because MACRS depreciation depends on several connected elements. Property classification affects the applicable recovery period, and the recovery period can affect the depreciation method and convention used to calculate deductions.

A later cost segregation study can therefore change the way the same basis is recovered over time.

The ATG addresses this issue directly because taxpayers may perform cost segregation studies on used or previously existing property and then recompute depreciation associated with prior years. From an examination perspective, the IRS is not looking only at whether the assets were reclassified correctly. The examiner is also instructed to consider whether the resulting depreciation changes were implemented through the proper accounting method procedures.

What Does It Mean to Have an Adopted Depreciation Method?

The accounting-method question depends in part on whether a method has already been adopted for the property.

The ATG describes the Service's historical position that a taxpayer adopts a permissible accounting method for depreciation in the taxable year the depreciable asset is placed in service with respect to its depreciation method, recovery period, and convention. For an impermissible depreciation method, the ATG explains that adoption generally occurs when the property is treated consistently on two or more consecutively filed returns.

Once a method has been adopted, changing the depreciation method, recovery period, or convention through a property reclassification generally moves the issue into the accounting-method-change framework.

This is why the timing of a cost segregation study matters.

A study performed around the time the property is placed in service can present different procedural circumstances from a study performed after multiple returns have already reported depreciation under another treatment. The engineering classification question may be similar, but the method used to implement the tax result may not be.

That also explains why describing a later study as merely “correcting class lives” does not resolve the issue. Chapter 6.B explains that reclassifying property placed in service in prior years can still result in changes to the recovery period, depreciation method, or convention.

Why Does the ATG Discuss Form 3115?

IRC § 446(e) and Treas. Reg. § 1.446-1(e) provide the underlying accounting-method framework. The ATG is examination guidance explaining how that framework relates to cost segregation.

In Step 15 of its examination procedures, the ATG states that a change in an adopted depreciation method, recovery period, or convention resulting from reclassification generally requires the consent of the Commissioner. It explains that the taxpayer generally files Form 3115, Application for Change in Accounting Method.

The ATG also tells examiners that claims seeking to change an adopted depreciation method based on a cost segregation study performed after the original return was filed should generally not be handled as retroactive method changes through amended returns. Instead, it points to the applicable voluntary accounting-method-change procedures.

Chapter 6.B similarly explains that a taxpayer generally cannot change an adopted accounting method by filing an amended return unless specific guidance provides an exception.

This is a procedural distinction, not an engineering conclusion.

A cost segregation study can provide the technical analysis supporting how assets should be classified and depreciated. The study itself does not determine which tax form or accounting-method procedure applies to a particular taxpayer.

The ATG identifies Rev. Proc. 2015-13, or successor guidance, for the general voluntary method-change procedures and identifies the applicable list of automatic changes separately. Whether a particular change qualifies for automatic treatment or requires non-automatic procedures depends on the applicable guidance and facts.

What Role Does IRC § 481(a) Play?

When an accounting method changes, the tax system has to account for differences created by the old method without simply ignoring depreciation already claimed or allowable in prior periods.

The ATG explains that the adjustment to taxable income associated with the change is made under IRC § 481(a).

Conceptually, the § 481(a) adjustment connects the prior accounting method with the new method so that items are not omitted or duplicated merely because the method changes.

In a cost segregation context, this is important because a study performed after several years of ownership may identify depreciation that would have been computed differently if the newly supported classifications had been used from the beginning.

The ATG repeatedly emphasizes examination of the accuracy of the § 481(a) adjustment. Its list of common compliance issues includes inadequate records supporting the adjustment and insufficient detail for determining basis and recovery periods.

That is an important investor lesson. A prior-year cost segregation study is not complete simply because individual assets have been reclassified. The implementation also depends on accurate historical depreciation information, supported basis, placed-in-service information, and the calculations necessary to connect the prior treatment with the revised treatment.

Is Every Depreciation Correction a Change in Accounting Method?

No.

The ATG specifically discusses exceptions contained in Treas. Reg. § 1.446-1(e). Not every change involving depreciation is treated as a change in accounting method.

For example, the ATG explains that changes in depreciation resulting from a posting or mathematical error or a change in underlying facts are not accounting method changes under the regulatory rules it discusses.

The ATG also identifies additional circumstances that can fall outside the definition, including certain changes involving useful life, certain late or revoked depreciation or amortization elections, and changes in an asset's placed-in-service date.

These exceptions are one reason it would be inaccurate to say that every cost segregation study performed after the year of acquisition or construction automatically requires Form 3115.

The correct question is more specific:

What depreciation treatment has already been adopted, and what exactly is the taxpayer now changing?

If the cost segregation study changes an adopted depreciation method, recovery period, or convention, the ATG generally treats the resulting reclassification as an accounting method change. If the adjustment instead falls within a regulatory exception or other applicable published procedure, the result may differ.

The procedural analysis therefore has to follow the facts rather than a blanket rule based solely on when the study was performed.

What Does Peco Foods Add to the Accounting Method Discussion?

The ATG's discussion of Peco Foods, Inc. v. Commissioner illustrates an important boundary between accounting procedure and the underlying substantive tax treatment.

Peco Foods acquired two poultry processing plants in applicable asset acquisitions under IRC § 1060. The buyer and sellers had entered into written agreements allocating the purchase prices among the acquired assets.

Peco Foods later obtained a cost segregation study and filed Form 3115 to change its accounting method and reclassify certain property from nonresidential real property to tangible property.

The Tax Court held that Peco Foods was bound by the clear and unambiguous allocation schedules in its acquisition agreements and could not use the later cost segregation study to subdivide and characterize those assets inconsistently with the agreed allocations.

The lesson for this Breakdown is narrow but important:

Filing Form 3115 does not independently make the underlying reclassification correct.

Accounting-method procedure answers how a permissible change is implemented. It does not replace the need for supportable property classification, basis, transaction treatment, and applicable authority.

The ATG also notes that it is unclear whether the Peco Foods holding applies to acquisitions other than applicable asset acquisitions under § 1060. The case should therefore not be expanded into a universal rule governing every cost segregation study.

Where Does Engineering End and Accounting Procedure Begin?

Engineering identifies the property. Tax procedure determines how a prior-year reclassification is implemented.

CostSegRx engineers analyze the physical property, its assets, functions, systems, installation, documentation, cost basis, and applicable classification framework. That work can establish why a component should be treated differently from the depreciation treatment originally used.

But an engineering conclusion does not erase the depreciation history already reflected on filed tax returns.

If the revised classification changes an adopted depreciation method, recovery period, or convention, the ATG treats the procedural question separately. The taxpayer and tax professional must then determine how the applicable accounting-method rules, Form 3115 procedures, and § 481(a) adjustment apply.

This separation is important because it prevents two different analytical jobs from being confused.

The engineering analysis asks:

• What property actually exists?
• What does it do?
• What does it serve?
• How is it installed?
• What documentation and costs support it?
• What depreciation classification is supported by the applicable framework?

The accounting-method analysis asks a different question:

Given the treatment already adopted on prior returns, how is the supported change properly implemented?

Commercial real estate investors should understand both sides of that equation. A technically strong cost segregation study can identify supported reclassifications, but a prior-year study also needs to fit into the taxpayer's existing depreciation history and the applicable tax procedures.

That is why the ATG addresses accounting methods as part of cost segregation examination. The classification may begin with the physical property, but when the property has already been depreciated under an adopted treatment, implementation becomes a separate and equally important step.