A cost segregation study performed on a property placed in service in years past, where a tax return has already been filed, is known as a look-back study. Properties already in service are often overlooked when it comes to cost segregation, however a property does not need to be newly constructed to reap the benefits of this tax planning strategy.
The IRS permits taxpayers to use a cost segregation study to adjust depreciation on properties placed in service as far back as January 1, 1987. Many property owners and tax advisors share a common misconception that once the three-year statute to amend has expired, the taxpayer can no longer make a change. Fortunately, this is not the case.
Upon completion of the study, the taxpayer is allowed to make an adjustment under IRC §481(a) to catch up on depreciation. The catch up, which is taken in a single year, is equal to the difference between what was depreciated and what could have been depreciated if a cost segregation study was performed on day one. Expectedly, these benefits can be quite substantial. As an added bonus, the change can be made without filing an amended return. The taxpayer simply files Form 3115 (Change in Accounting Method) with the cost segregation study attached.
Perhaps the best way to explain the benefits of a look-back study is to provide an example. Let’s use a $10M office building that was placed in service in March 2005, where 100% of the property is being depreciated using a 39-year recovery period. We’ll assume that a study was performed for the 2010 tax year which identified $800K (8%), that could be reallocated to a 5-year recovery period.
In this scenario, the taxpayer realizes a §481(a) adjustment just over $655K. Combined with the first year depreciation, the total deduction in year one is more than $680K. Using a 35% effective tax rate, the taxpayer realizes over $238K in first year savings. Ten years out, the Net Present Value (NPV) is still almost $190K and in year 40 of the property’s life the NPV is still more than $136K. Needless to say, the financial benefits of front loading depreciation deductions via a cost segregation study are huge.
A cost segregation consultant, working in conjunction with the tax advisor, will be able to help determine the appropriate strategies to take advantage of this technique. Since look-back studies often identify significant amounts of reclassified assets as well as very large §481(a) adjustments, there is a slightly higher probability that the study may be subject to IRS scrutiny. This further underscores the need to choose a highly qualified cost segregation provider, with experience performing look-back studies, which will stand behind their work in the event of an IRS challenge.