How to Apply Cost Segregation on a Tax Return Using IRS Form 3115

Cost segregation is a tax strategy that allows property owners to accelerate depreciation deductions, reducing taxable income in the short term. This method reclassifies certain building components from long-term real estate assets to shorter-lived personal property or land improvements, which can be depreciated more quickly. To apply cost segregation on a tax return, IRS Form 3115 (Application for Change in Accounting Method) is used to make the necessary adjustments. Completing this form properly ensures compliance with IRS regulations while maximizing tax benefits.

Qualified Assets for Segregation

Not all building components qualify for cost segregation, so identifying the right assets is key. The IRS allows certain elements of a property to be classified separately from the structure, enabling them to be depreciated over shorter recovery periods. These assets typically fall into categories such as personal property, land improvements, and certain indirect costs associated with construction or acquisition.

Personal property includes items that are not permanently affixed to the building and can be removed without affecting its structural integrity. Examples include specialized lighting, carpeting, cabinetry, and electrical or plumbing systems that serve specific equipment rather than the entire building. These assets often qualify for a five- or seven-year depreciation period under the Modified Accelerated Cost Recovery System (MACRS).

Land improvements, which are distinct from the land itself, also qualify for accelerated depreciation. This category includes parking lots, sidewalks, landscaping, and outdoor lighting. Unlike commercial buildings, which are depreciated over 39 years, land improvements are typically depreciated over 15 years.

Determining Depreciation Categories

Breaking down a building’s components into separate depreciation categories requires understanding how different assets qualify for accelerated deductions under IRS guidelines. The distinction between real property and assets eligible for shorter recovery periods depends on how an item is used, whether it is integral to the building’s operation, and if it serves a separate function from the overall structure.

A key consideration is whether an asset is part of a building system, such as HVAC, plumbing, fire protection, or elevators. These systems are generally classified as 39-year property for commercial buildings or 27.5-year property for residential rental properties. However, when portions of these systems serve a specialized function—such as dedicated cooling units for computer servers or plumbing used exclusively for manufacturing processes—they may qualify for shorter depreciation periods.

Another factor is how an asset is attached to the building. If removing an asset would cause significant damage, it is likely part of the structure and subject to a longer depreciation period. Items that can be detached without altering the building’s integrity may qualify for shorter recovery periods. For example, modular partitions, certain tenant improvements, and equipment-specific electrical wiring often meet the criteria for accelerated depreciation.

Completing IRS Form 3115

Filing IRS Form 3115 is required when applying cost segregation to an existing property, as it formally requests a change in accounting method to reflect the reclassification of assets for depreciation purposes. This process allows taxpayers to claim missed depreciation from prior years without amending past returns, following the automatic consent procedures outlined in Rev. Proc. 2024-9.

The most relevant sections for cost segregation are Part I, Part II, and Schedule E. Part I requires general taxpayer information, including name, tax identification number, and a brief description of the accounting method change. Part II, which applies to automatic changes, includes details about the property, the applicable asset classifications, and whether the change affects multiple tax years. Schedule E is where the Section 481(a) adjustment is calculated, capturing the cumulative depreciation adjustment resulting from the reclassification of assets.

A properly calculated Section 481(a) adjustment reflects the difference between depreciation previously claimed and the amount that would have been deducted had the correct method been used from the beginning. If the adjustment results in additional deductions, the full amount can typically be claimed in the year of change. If the adjustment increases taxable income, it is generally spread over four years.

Reflecting Adjustments on Returns

Once depreciation adjustments are determined, they must be integrated into the tax return correctly to ensure compliance. The primary impact of cost segregation appears on Form 1040 (for individual property owners), Form 1120 (for corporations), or Form 1065 (for partnerships), depending on the taxpayer’s entity type. The recalculated depreciation deductions flow through to the applicable tax form via Schedule C, E, or K-1, affecting taxable income.

The Section 481(a) adjustment is reported on the tax return as an “Other Income” or “Other Deduction” item, depending on whether the change results in additional depreciation deductions or an increase in taxable income. If the adjustment leads to a deduction, it can provide an immediate tax benefit, whereas an increase in taxable income is generally spread over four years.

Recordkeeping Requirements

Maintaining thorough documentation is necessary when applying cost segregation, as the IRS may request supporting evidence to substantiate depreciation adjustments. Proper recordkeeping ensures compliance and helps defend against potential audits by demonstrating how assets were classified and why they qualify for accelerated depreciation. These records should be retained for as long as the property is owned and for several years after its disposal.

One of the most important documents to retain is the cost segregation study itself. This study, typically conducted by a qualified professional, details the methodology used to reclassify assets and provides a breakdown of costs assigned to different depreciation categories. Supporting documentation should include invoices, construction contracts, engineering reports, and appraisals that verify the cost and nature of each asset. Additionally, taxpayers should maintain copies of IRS Form 3115, prior tax returns reflecting depreciation deductions, and any correspondence with tax professionals regarding the accounting method change.