What Is Form 3115 and How Does It Relate to Cost Segregation?

IRS Form 3115, Application for Change in Accounting Method, is the mechanism that allows property owners to apply a cost segregation study to a property they have already been depreciating -- and claim all of the missed accelerated depreciation in a single tax year. It is one of the most valuable yet least understood tools in the real estate investor's tax toolkit, and understanding how it works is essential for anyone considering a retroactive cost segregation study.

Why a Change in Accounting Method Is Needed

When you purchase a rental or commercial property and begin depreciating it over 27.5 or 39 years on a straight-line basis, you are making an accounting method election for how each asset within that property is depreciated. If a cost segregation study later identifies components that should have been classified as 5-year, 7-year, or 15-year property, switching to the correct classification constitutes a change in your depreciation accounting method under IRC Section 446(e).

Rather than requiring you to go back and amend every prior-year return -- which would be impractical and in some cases impossible due to the statute of limitations -- the IRS allows you to make this correction prospectively through Form 3115, with a cumulative catch-up adjustment in the current year.

The Section 481(a) Adjustment

The heart of Form 3115 is the IRC Section 481(a) adjustment. This is the difference between the total depreciation you actually claimed on the reclassified components under the old method and the total depreciation you would have claimed under the new (correct) method. When the new method produces more depreciation than the old method -- which is almost always the case with cost segregation -- the result is a negative Section 481(a) adjustment, meaning you receive a deduction.

For example, suppose you purchased a rental property eight years ago with a depreciable basis of $400,000. Under straight-line over 27.5 years, you claimed approximately $14,545 per year, or $116,364 total over eight years. A cost segregation study now identifies $120,000 as 5-year property that qualified for bonus depreciation at the time of purchase. Under the correct method, you would have deducted $120,000 in Year 1 (bonus depreciation) plus the standard depreciation on the remaining $280,000 structural components. The total depreciation under the correct method over eight years would have been approximately $201,455. The Section 481(a) adjustment is $201,455 minus $116,364, or approximately $85,091 -- taken as a deduction in the current year.

Filing Requirements and Procedures

Form 3115 is filed under the automatic consent procedures outlined in Revenue Procedure 2015-13 (as modified by subsequent guidance). This means you do not need to request IRS approval in advance -- you simply file the form with your tax return and send a copy to the IRS national office in Ogden, Utah. The designated change number (DCN) for depreciation changes is typically found in Section 6.01 of Revenue Procedure 2024-23 (or the most current revenue procedure, which is updated periodically).

Key requirements include filing the form with a timely filed return (including extensions), attaching it to the return as a separate statement, and mailing a signed copy to the IRS national office. The form requires detailed information about the property, the old and new methods, and a complete computation of the Section 481(a) adjustment.

Common Mistakes to Avoid

One frequent error is attempting to claim missed depreciation by amending prior-year returns instead of filing Form 3115. The IRS has made clear in multiple pieces of guidance that a change from an impermissible to a permissible depreciation method must be made via Form 3115 -- not through amended returns. Amended returns filed to change depreciation methods may be rejected by the IRS.

Another pitfall is failing to account for bonus depreciation eligibility in the year the property was actually placed in service. The Section 481(a) adjustment must be calculated based on the correct method that should have been used at the time, including whatever bonus depreciation percentage was in effect during that tax year. This requires knowledge of the bonus depreciation phase-down schedule and any retroactive changes made by subsequent legislation.

Finally, taxpayers should be aware that Form 3115 cannot be filed for a property in the year it is placed in service or the year it is disposed of. The change must be made in an intervening year while the property is still held and in service.

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This article is for informational purposes only and does not constitute legal or tax advice. Consult a qualified tax professional regarding your specific circumstances. AE Tax Advisors, 935 Lake Elmo Dr, Suite B, Billings, MT 59105. Phone: (631) 614-5762.