Recovering Missed Depreciation

Basis and depreciation, briefly

Before talking about what you can recover, it helps to be precise about what depreciation actually is. Depreciation is the slow return of your basis in a property, deducted against income year by year, until your basis hits zero.

Your basis in a building starts at what you paid for it, plus closing costs that get capitalized, plus the cost of any improvements made over time, minus the value allocated to land. Land does not depreciate. If a property cost two million dollars and the land is worth four hundred thousand, you start with one and a half million dollars of depreciable basis sitting in the building.

The default rule is simple and slow. Residential rental property depreciates over twenty-seven and a half years using a straight-line method. Nonresidential real property depreciates over thirty-nine years. Divide your depreciable basis by those numbers and you get the deduction you are entitled to claim each year, every year, until basis runs out or you sell.

That is the slow path. The fast path involves two things. First, cost segregation, an engineering-based study that breaks a building into its component pieces and reclassifies many of them into shorter-lived asset categories. Carpeting, appliances, certain millwork, and decorative lighting can sit in a five-year class. Office furniture and certain specialized fixtures can sit in seven-year. Land improvements like parking lots, sidewalks, landscaping, and exterior lighting sit in fifteen-year. The structural shell, the HVAC, the roof, and the plumbing rough-in all stay on the long schedule. But the portion that moves to shorter lives suddenly depreciates much faster.

Second, bonus depreciation, a separate provision that lets owners deduct a large percentage of the basis of qualifying short-lived property (generally property with a recovery period of twenty years or less) in the first year it is placed in service. When bonus is at one hundred percent, the entire reclassified amount is deductible immediately. When it is lower, the bonus percentage applies in year one and the remainder depreciates over the normal life.

Combine the two and a two million dollar building bought in 2022, with six hundred thousand reclassified by a cost segregation study, could have generated roughly six hundred thousand dollars in first-year deductions just from the bonus portion of the reclassified assets, plus the normal depreciation on what remained. If the prior preparer did not do this, that deduction is sitting there waiting to be picked up. The mechanism for picking it up is what the rest of this paper covers.

Why depreciation gets missed in the first place

It is worth naming the common reasons, because the recovery strategy depends partly on what went wrong.

• No cost segregation study was performed. The most common scenario. The building was depreciated as a single twenty-seven and a half or thirty-nine year asset, and nothing was reclassified to shorter lives.
• Bonus depreciation was not claimed when it could have been. Either the preparer was conservative, or the software defaulted to slower options, or the owner did not realize the property qualified.
• An ADS election was made that probably should not have been. Sometimes a real property trade or business elected out of the business interest limitation under section 163(j), which forces ADS treatment and disqualifies certain bonus depreciation. Worth checking whether that election was deliberate or accidental.
• Improvements were capitalized incorrectly. A roof replacement that should have been a thirty-nine year improvement got lumped into expense, or vice versa. Either creates a mismatch worth fixing.
• Placed-in-service dates were wrong. Depreciation cannot start until the property is ready and available for its intended use. A few weeks one way or the other can shift a full year of deduction.

Each of these can be repaired. But the specific year a property was placed in service determines what bonus depreciation rate is available, and that is where the timeline gets interesting.

The bonus depreciation timeline, 2017 through today

This is the single most useful table to keep close at hand when evaluating recovery opportunities. The bonus percentage tied to the year a property was acquired and placed in service determines how much of the reclassified basis can be deducted in year one.

A property placed in service in 2020 has a one hundred percent bonus rate available to it. A property placed in service in 2024 has sixty percent available. A property placed in service on January 25, 2025 has one hundred percent again. The acquisition date matters as much as the placed-in-service date, because of binding contract rules, but the principle is straightforward: the year tied to the property dictates the rate, regardless of when the catch-up is filed.

What the OBBBA changed in 2025, and what it didn't

The One Big Beautiful Bill Act, signed into law on July 4, 2025, did three things that matter for this conversation.

First, it permanently restored one hundred percent bonus depreciation for qualified property acquired on or after January 20, 2025 and placed in service after that date. The original TCJA phase-down was scheduled to take bonus depreciation to zero by 2027. OBBBA reversed that and locked the rate at one hundred percent indefinitely.

Second, it expanded section 179 expensing. The annual cap moved from one million to two and a half million dollars, and the phaseout threshold moved from two and a half million to four million. For smaller-portfolio investors who never quite hit bonus depreciation eligibility, section 179 became materially more useful.

Third, it created a new one hundred percent depreciation election for qualified production property, a specialized category aimed at certain newly constructed nonresidential real property used in manufacturing, production, or refining. This is narrower than it sounds, and most real estate investors will not touch it, but worth noting because the framing in the press release was broader than the actual provision.

What OBBBA did not do is reach backward. Property placed in service before January 20, 2025 keeps whatever bonus rate was in effect for its placed-in-service year. The phase-down rates of eighty, sixty, and forty percent remain the law for 2023, 2024, and early-2025 acquisitions respectively. A property bought in 2024 that was depreciated without cost segregation still has a sixty percent bonus opportunity sitting there, not one hundred percent. Worth being precise about this when modeling.

Two paths to recovery

For prior returns that missed depreciation, there are two procedural options. The choice between them depends mostly on how far back the reach needs to go, what income looks like in different years, and how comfortable the owner is with paperwork.

For most cost segregation catch-ups on properties owned more than three years, Form 3115 is the cleaner instrument. For situations where a specific prior year offers something unusual, like a real estate professional designation that no longer applies, an amendment may produce a better result. The honest answer is that both paths should be modeled before deciding, and a good preparer will run the numbers both ways before recommending one.

Form 3115 in plain terms

Form 3115 is the IRS application for a change in accounting method. It sounds intimidating. Mechanically, what it does is tell the Service: "I have been depreciating this property one way, I am switching to a different way, and here is the cumulative difference between what I claimed and what I should have claimed." That cumulative difference is the section 481(a) adjustment, which is deducted (or added back) in the year of change.

For cost segregation, the change is typically filed under automatic consent procedures, which means the IRS does not have to pre-approve it. The form is filed with the timely-filed return for the year of change, a copy is sent to the Ogden service center, and the change is effective. The designated change number assigned depends on the property type and the nature of the change. Residential rental cost segregation typically falls under DCN 7. Nonresidential real property changes generally fall under DCN 244, which replaced parts of the older DCN 7 family in recent procedural updates. The preparer will assign the correct one based on current revenue procedures.

The catch-up adjustment is a one-time deduction in the year of change, which can be quite large. A property bought in 2019, depreciated as a single twenty-seven and a half year asset for six years, suddenly being reclassified through cost segregation with one hundred percent bonus on the eligible portion, can generate hundreds of thousands of dollars in a single year. That is real money, and it is also the reason filing timing matters. A high-income year coming up may be the year to do this. A low-income year may suggest waiting, or amending a specific high-income prior year instead.

The cost segregation angle, year by year

Cost segregation is the engine behind most depreciation recovery, so it is worth being concrete about what it actually delivers in different acquisition years given the bonus depreciation that was available.

Consider a two million dollar commercial building with a four hundred thousand land allocation, leaving one and a half million dollars in the building. A typical cost segregation study might reclassify twenty-five to thirty percent of the building basis into shorter-life property, which would be roughly four hundred to four hundred and fifty thousand dollars in this example. The amount of that reclassified basis deducted in year one depends on the bonus rate available for the placed-in-service year.

The numbers above represent only the bonus portion of the reclassified basis. The remainder of the reclassified property still depreciates over its accelerated life of five, seven, or fifteen years, generating additional deductions in subsequent years. And the structural portion of the building continues on its twenty-seven and a half or thirty-nine year schedule.

For an owner who has been depreciating a two million dollar building as a single asset for several years, picking up this catch-up through Form 3115 can produce a deduction in the year of change that often exceeds the entire annual rental income from the property. The tax savings, depending on the owner's bracket and passive activity status, frequently land in the range of one hundred to one hundred and eighty thousand dollars per million dollars of building basis. That is the math worth doing carefully before deciding what year to file in.

California, taken separately

California does not conform to federal bonus depreciation, has not for any of the years discussed above, and does not under OBBBA. California also does not conform to the federal section 179 limits at their current levels. The state caps section 179 at twenty-five thousand dollars, with a phaseout starting at two hundred thousand of property placed in service. These are dramatically lower than the federal numbers and have been stable for years.

What this means for recovery filings is straightforward. The federal Form 3115 catch-up adjustment will be substantial. The California Schedule CA adjustment will add most of that back, because the state would have depreciated the asset over its full life regardless. Owners end up running parallel schedules: one federal, one California, with the gap between them tracked on the state return year after year until the federal basis is fully recovered.

This is not a reason to skip federal recovery. The federal benefit is still very real, and most California-domiciled investors pay considerably more in federal tax than in California tax in any given year. But it is a reason to model the state side specifically rather than assuming the federal result is the full picture. We typically present clients with three numbers: the federal benefit, the California adjustment, and the net after-tax outcome. The third number is the one that matters.

Pitfalls worth flagging

The recovery mechanism is well-established and the IRS has handled it routinely for decades. That said, the failures that show up most often are procedural rather than substantive.

• Filing Form 3115 with the wrong year's return. The form goes with the return for the year of change, not retroactively.
• Missing the Ogden copy. The form requires an original attached to the return and a signed copy sent separately to the Ogden service center. Skip either step and the change may not be effective.
• Inconsistent placed-in-service dates. The date on the cost segregation study, the date on the depreciation schedule, and the date on Form 3115 all need to match.
• Forgetting the section 163(j) interaction. A real property trade or business election made under 163(j) forces ADS depreciation on certain property and disqualifies bonus. If that election was in place, the recovery math changes. Worth confirming before the study is commissioned.
• Ignoring recapture on eventual sale. Accelerated depreciation increases ordinary-income recapture when the property is sold. This is not a reason to avoid the recovery, because the time value of the deductions almost always wins, but it is a reason to plan exit timing intentionally and to consider section 1031 exchange treatment, particularly for California-situated property where Form 3840 tracking applies.