Form 3115: Applying a Cost Segregation Study on a Tax Return

• In this article we will discuss how to apply a cost segregation study on a tax return.
• We will show the step-by-step process of applying a cost segregation study in the year a property is purchased. 
• We will show the detail on applying a cost segregation study on property owned and placed in service prior to the current tax year.
• Example filled-in Form 3115 and other tax return forms provided for reference. 
• Depreciation adjustments and catch-up calculations discussed with examples provided.

This blog post is designed as an example on how to apply a cost segregation study on a tax return. It is recommended you bookmark this page for future reference if you prepare tax returns with a cost segregation study. Filled-in forms with examples are used as a reference to help you prepare an accurate return when a cost segregation study is involved.

All images enlarge in a second window by clicking on them. You may print out the images as a helpful tool in preparing your tax return. You can make calculations right on the printouts. This post will be updated when the rules change for cost segregation studies; refer back to this page anytime you deal with cost segregation. 2020 tax forms and the latest release of Form 3115 were used in the examples in this post. The tax forms will not be updated unless the reporting rules change.

If you want to learn more about how a cost segregation study works and how much it can save you in taxes you can review this post  and here if you want a very short review on how to apply a cost segregation study on a a tax return.

The Cost Segregation Study

A cost segregation study can run 30 pages or more. For tax preparation purposes, the pages you are interested in are the Cost Detail and Cost Summary pages. Depending on the property, there can be multiple pages in the cost segregation study that apply to these different area of the property. Example: there might be a Cost Summary and Cost Detail page for the apartments on the property and a summary and detail for a detached garage area.

The example used here has just one Cost Detail and Cost Summary page. If multiple pages exist you just need to go through the process in this post for each detail/summary.

The Cost Summary page in the cost segregation study is straight forward. It lists the total building cost with an allocation between class lives.

This is enough information to complete an accurate tax return. However, the Cost Detail also plays an important role.

Some tax professionals like to use the depreciation adjustments used in this post on every item of each class life. This is helpful when a component is taken out of service or replaced.

Example: If a roof or flooring are replaced before the asset is fully depreciated the remaining basis is deducted at that time. If you entered each component separately the process will be easy. If not entered separately you will need to keep a note in your files, along with the Cost Detail, to handle the calculations of replacement when they occur.

Many times replacing a roof or flooring is a repair expense instead of an improvement. This allows for a deduction for the current expense, plus the additional deduction for the remaining basis of the property replaced. This is another benefit of a cost segregation study.

Filled-in Form 3115

The biggest question I get from readers involves Form 3115. Few tax professionals have seen a cost segregation study or only a few over their career. Filling out Form 3115 to deal with the change in accounting method can be daunting.

Form 3115 is 8 pages. The good news is that you only need to fill out four of them.

Form 3115 is sent along with your tax return and the depreciation adjustments from the cost segregation study; the change of accounting method is automatic. The IRS will not respond when Form 3115 is filed unless there is an issue. You must attach a copy of the cost segregation study with the tax return.

Page one of Form 3115 asks for basic taxpayer information at the top. My example involves an individual, but the same application applies to entities. Be sure to indicate if you are an individual, partnership, corporation or one of the other designations. On the right check the “Depreciation and Amortization” box.

Part I and II have questions you need to answer. You only need one DCN if the only issue is a cost segregation study — code 7 — because you are going from a impermissible method to a permissible method.

Page 2 of Form 3115 contains more questions. My answers are the most common. Some questions do not apply. Adjust your answers to your personal situation as needed.

Page 3 of Form 3115 is also questions. As my example shows, only two questions need answering. Part III does not apply to cost segregation studies.

Pages 4-7 are left blank on Form 3115 when a cost segregation is the only issue.

The top of page 8 also does not need to be filled in for cost segregations. Schedule E on Form 3115 does need questions answered. I listed the most common answers. Pay attention to Question 4b. If you lived in the property before renting it you need to indicate so.

Question 4a requires a statement. My software generates this statement automatically. Attaching the cost segregation study probably is enough, but I always include the statement shown below.

Depreciation Adjustments When Applying Cost Segregation

I encourage you to print out the images in this section. They provide everything you need to complete an accurate tax return with adjustments reflecting a cost segregation study. It might also be helpful to print out the Cost Summary and Cost Detail presented at the beginning of this post.

We start with basic information. The property was purchased and placed in service at the beginning of 2014 and the cost segregation study will apply to tax year 2020.

The tax return will look like this without the cost segregation study:

And the depreciation schedule:

Now we need to make adjustments to reflect the cost segregation study. Prior to the study the entire building was depreciated over 27.5 years, straight line. The cost segregation study allows us to depreciate $85,600 over 5-years and $6,893 over 15-years. These amounts reduce the amount of 27.5-year class life property to $266,816.

This information is provided by the cost segregation study. See the Cost Summary and Cost Detail above.

We need to know how much depreciation should have been used in each class life if cost segregation was applied from day one. Setting our example with a property purchased January 1st simplifies our example. You will need to adjust for depreciation based on months rather than our simplistic 6-years of ownership before the cost segregation study if any other date of purchase is involved.

Our accumulated depreciation would be as follows if cost segregation were applied from the beginning:

27.5-year Class Life:

$262,816 / 27.5 = $9,557

$9,557 x 6 years = $57,342

15-year Class Life:

$6,893 / 27.5 = $250.65

$250.65  x  6 = $2,504

Because I rounded numbers there is a small error that I account for in this class life. The difference is $2 and reconciles with the actual previous depreciation claimed.

5-year Class Life

$85,600 / 27.5 = $3,113 x 6 = $18,638

The new depreciation schedule will look like this:

We need these numbers to determine how much prior depreciation to apply to each class life and calculate our catch-up depreciation for the current year.

Our last step is determining how much additional depreciation to claim the year the cost segregation study is applied when cost segregation wasn’t applied in prior years.

The easiest part is the 5-year property since all the 5-year property should have been depreciated by this time. The remaining basis is a deduction:

$85,600 – $18,678 = $66,922

The $18,678 comes from our calculation above where we allocate depreciation from the 27.5 class life to the 5-year class life.

The $66,922 is added to the current year’s depreciation.

The 15-year property is only partially through its depreciation schedule.

As you can see, only 48.81% of the 15-year property should be depreciated out at this point, including the current year depreciation.  Note that we claim the current year of depreciation as well since we will use this number to override the depreciation calculated by the tax software The math is as follows:

$6,893 x 48.81% = $3,3433

$3,3433 – $1,502 = $1,931

The $1,931 includes the current year’s depreciation.

Your tax software will handle the depreciation for the 27.5-year class life. The depreciation schedule above listing cost segregation shows the current year’s depreciation deduction.

The tax savings can be substantial as the before and after Schedule E show.

That is all there is to it. Follow this guide to simplify the application of cost segregation to a tax return.

If there is anything I can do to clarify the process, let me know. A comprehensive guide has been needed for a long time online. My goal is to have this page as the go-to resource when dealing with cost segregation on a tax return.