This page describes a composite hypothetical. It is not a real client or a real result, and the numbers are assumptions chosen to keep the arithmetic simple.
The Scenario in Brief
An investor bought a 12-unit apartment building three years ago and has depreciated the entire building over 27.5 years since then. A colleague mentions cost segregation, and the investor wonders whether a study on a property already owned could still matter. The investor asks an advisor to evaluate a lookback study. This scenario walks through the questions and the arithmetic.
Assumptions Used
- Purchase price: 2,400,000 dollars.
- Land allocation: 20 percent, or 480,000 dollars, leaving depreciable basis of 1,920,000 dollars.
- A study, if performed, is assumed for illustration to reclassify 20 percent of depreciable basis, or 384,000 dollars, into shorter-life property such as appliances, flooring, and site work.
- Bonus depreciation of 80 percent is assumed to apply based on the acquisition date. The actual percentage depends on the date the property was acquired and placed in service.
- The investor has high wage income and no other passive income, and does not qualify as a real estate professional.
Questions the Advisor Would Ask
The advisor would first confirm that the property is still owned, that depreciation has been claimed on the original schedule, and that the investor is not under examination for the same item. Next, the advisor would ask about the investor's ability to use losses. Because the investor has no passive income and income above the range for the small landlord allowance, any additional depreciation would likely create a suspended passive loss. That fact shapes the decision more than the size of the deduction does.
Worked Arithmetic
Under the original approach, the reclassified 384,000 dollars would have been depreciated with the rest of the building:
| Item | Amount |
|---|---|
| Straight-line rate on 27.5 years | about 3.64 percent per year |
| Annual depreciation on the 384,000 dollar portion | about 13,964 dollars |
| Approximate deduction over three years | about 41,900 dollars |
With a study and bonus depreciation, the same components might have been treated differently:
| Item | Amount |
|---|---|
| Bonus depreciation at an assumed 80 percent | 307,200 dollars |
| Remaining 76,800 dollars, regular recovery over three years (rough estimate) | about 25,000 dollars |
| Approximate deduction over three years | about 332,000 dollars |
The difference, about 290,000 dollars in this simplified example, would be the catch-up deduction reported through a Section 481(a) adjustment in the year of change. The figures are rounded and are not a calculation for any real property.
How It Might Play Out
Because the investor has no passive income, the catch-up deduction would probably be added to suspended passive losses instead of reducing tax this year. Those losses are not forfeited. They can offset future passive income, and they may be released when the property is sold in a fully taxable transaction to an unrelated party. The investor would then compare the cost of the study with the value of a deferred and uncertain benefit. If the investor plans to hold the property for many years, the suspended losses might sit unused for a long time. If the investor plans to sell in a few years, a portion of the accelerated depreciation may be recaptured as ordinary income on the components.
The advisor would also model the state tax effect, since some states do not follow federal bonus depreciation, and would confirm the current Form 3115 procedures before recommending a filing.
Risks and Limits
- The study cost is real, and the benefit depends on the ability to use the deduction.
- Accelerated depreciation increases recapture on sale.
- The percentages in a real study can differ widely from the assumption used here.
- Procedures for accounting method changes are updated periodically and must be followed exactly.
- A weak study may not withstand review.
What This Scenario Teaches
The scenario shows that the size of a depreciation deduction and the value of that deduction are different things. A large catch-up adjustment can be worth less than it looks if the loss is suspended. It also shows why the loss rules and the exit plan belong in the analysis from the start. A study can still make sense for some investors in this position, for example those who expect passive income or a taxable sale in the near term, but that judgment depends on facts that this hypothetical does not have.
Questions to Bring to Your Advisor
- Is my property eligible for a lookback and what would the adjustment be?
- Can I use the resulting deduction now or would it be suspended?
- How does my expected holding period change the analysis?
- What are the state tax effects?
- What does the study cost and what will it include?
Frequently Asked Questions
Is this scenario based on a real client?
No. It is a composite hypothetical created for education, and its numbers are assumptions.
Does a lookback study always produce a large deduction?
No. The result depends on the property, its purchase price, its components, and the rules in effect when it was acquired.
Want to Talk Through Your Own Situation?
These scenarios are illustrations only. Book a discovery call with AE Tax Advisors to discuss the facts of your own business or portfolio.
Book a Discovery CallEducational purposes only. This page is an illustrative educational scenario, not tax, legal, or accounting advice, and it does not describe a real client or a real result. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.