Extensions and Cost Segregation

Cost segregation is an IRS-accepted tax strategy that accelerates depreciation deductions by reclassifying real property assets into shorter-lived personal property categories. Rather than depreciating an entire building over 27.5 or 39 years, a cost segregation study identifies components (e.g., carpet, cabinetry, land improvements) that can be depreciated over 5, 7, or 15 years.

Eligible Properties Include:

• New construction
• Property acquisitions
• Renovations or improvements
• Properties already in service

The primary benefit is a significant acceleration of depreciation, which lowers taxable income and increases cash flow, especially useful in the early years of property ownership.

For properties already placed in service, applying cost segregation retroactively requires a change in accounting method. This is achieved by filing IRS Form 3115 (Application for Change in Accounting Method) and calculating a Section 481(a) adjustment.

Key Elements:

• Form 3115 is filed with the extended tax return.
• The Section 481(a) adjustment allows the taxpayer to take the full amount of “missed” depreciation in the current tax year.
• There is no need to amend prior-year tax returns; the adjustment is implemented entirely in the year of change.

Taxpayers filing under an extension—such as individuals filing by October 15 or partnerships by September 15—can take advantage of the extended timeline to:

• Complete a cost segregation study
• Prepare and submit Form 3115
• Incorporate the Section 481(a) adjustment into the extended return

This strategy provides time to execute a depreciation adjustment before filing, potentially resulting in a significant reduction in current-year taxable income or a refund. This is especially valuable for taxpayers facing underpayment penalties and/or interest charges.

Bonus depreciation allows for the immediate expensing of a percentage of the qualifying property basis in the year the property was placed in service. For 2024, the bonus depreciation rate was 60%. This means that qualified property placed in service in 2024 that’s identified through a cost segregation study may be eligible for an immediate 60% write-off. Qualifying property placed in service between 2017 and 2022 is eligible for 100% bonus depreciation and qualifying property placed in service in 2023 is eligible for 80% bonus depreciation. Note: the One Big Beautiful Bill Act would bring back 100% bonus depreciation for certain qualifying property acquired and placed in service after 1/19/25 and before 1/1/30.

Additional Considerations:

• Passive Activity Loss Rules: Accelerated deductions may be subject to limitations unless the taxpayer qualifies as a Real Estate Professional.
• State Tax Compliance: Not all states conform to federal depreciation or bonus depreciation rules.
• Audit Preparedness: Work with a provider experienced with the IRS Cost Segregation Audit Technique Guide to reduce audit risk.

Using cost segregation in tandem with a change in accounting method is a time-sensitive yet highly effective way to reduce taxable income for real estate investors filing under extension. By acting before the extended due date, taxpayers can unlock retroactive depreciation deductions and strategically enhance after-tax cash flow.

This approach not only provides compliance with IRS procedures but also offers a compelling tax planning opportunity that can materially affect current-year results.