IRC §446(e) & §481(a) (Method Changes and Catch-Up)

The facts

A taxpayer who depreciated a building on an impermissible method or recovery period for two or more years has adopted a method of accounting for that property.

What it holds

Section 446(e) requires a taxpayer who changes a method of accounting to secure the consent of the Secretary, which the IRS grants automatically for depreciation classification changes through its automatic method change procedures (Rev. Proc. 2015-13 and the annual automatic changes list, via Form 3115). Section 481(a) requires the adjustments necessary to prevent amounts from being duplicated or omitted, which produces the one-time catch-up; for a cost segregation lookback it is typically a large negative (taxpayer-favorable) adjustment taken in the year of change.

Background

Many owners buy a building and depreciate everything over 27.5 or 39 years, never separating the short-life property inside it. Years later a cost segregation study shows what they missed. The question is how to claim those missed deductions without reopening old returns.

The answer lives in two code sections. A taxpayer who used an impermissible method or recovery period for property on two or more returns has adopted a method of accounting for that property. Fixing it is therefore a method change, and method changes have their own rules.

What it established

Section 446(e) requires a taxpayer who changes a method of accounting to secure the consent of the Secretary, meaning the IRS. For depreciation classification changes, the IRS grants that consent automatically: the taxpayer files Form 3115 under the automatic procedures of Rev. Proc. 2015-13 and the annual automatic changes list, rather than asking permission case by case.

Section 481(a) supplies the math. When a method changes, adjustments must be made to prevent amounts from being duplicated or omitted. The adjustment equals the difference between the depreciation actually taken and the depreciation the correct classification would have produced from the start. For a lookback study, that difference is typically a large negative adjustment, which is taxpayer-favorable: it is extra deduction recognized in the year of change.

How it shows up in a study

This pair is the engine of every lookback engagement. The study reclassifies the building's components and recomputes depreciation from the original placed-in-service date. Form 3115 reports the change, and the section 481(a) adjustment delivers all the missed depreciation on the current-year return, in one catch-up.

That is why an owner can capture years of missed deductions on a single return without amending any old ones. IRS guidance itself confirms the framing: Rev. Rul. 2003-54, for example, states that conforming a depreciation classification is a method change under sections 446 and 481.

What it does not mean

Not every depreciation fix is a method change. The method is adopted by using the treatment for two or more years. An error made on only one return is generally corrected by amending that return, not by Form 3115. Picking the wrong tool can invalidate the fix.

Automatic consent also does not mean no rules. The Form 3115 must be properly prepared and filed under the procedures, and the supporting study has to substantiate the new classifications, because the IRS can examine the method change and the numbers behind it. The catch-up is powerful, but it is paperwork-dependent.

Category

Methodology & procedure

Applies to

All property types

Status

Vetted

This page explains a tax authority in plain words. It is not tax advice for your situation. The way this authority applies to your property is reviewed by a licensed tax professional. Citation is provided so you or your advisor can read the primary source.