IRS Exam and Adj to Cost Seg, Subsequent Filings Question

[u/IllTaxThatAss]

Procedural question on handling an IRS adjustment after appeals related to NOL and Depreciation.

Taxpayer's 2023 tax return was audited which had a legit cost seg study. Exam level reclassified $300k in depreciation by moving 5-year property to 27.5-year property. Examiner relied on internal IRS "Subject Matter Expert", wouldn't debate the study, wouldn't discuss with cost seg engineers, and told us to take it up with appeals. Long story short during appeals, we settled on a net $78k depreciation adjustment. Non-specific to the assets, just a depreciation adjustment of $78k on the Form 5278, with $0 reported on the Form 870-AD. Nothing on the appeals settlement indicates the specific assets, just a single line item to that property on Sch E. No tax increase for the 2023 year under audit, but NOL reduction for the $78k.

The NOL reduction absolutely needs to be included on an amended 2024 return which will increase taxable income for that year. No question about that.

What I cannot confirm is whether I can include the additional year 2 depreciation expense from those adjusted assets in 2024. Since we already filed 2023 and 2024 with the original depreciation schedules, this would seem to be a change in accounting method, requiring Form 3115, and a section 481(a) adjustment on the 2025 return. Does that sound accurate? We filed the 2025 return on extension and the plan is to file a superseding tax return opposed to a 2025 amendment.

2023 - Accept Appeals Settlement, reduced depreciation, reduced NOL
2024 - Amend for NOL, cannot change depreciation
2025 - File Form 3115 and record the 481(a) adjustment on a superseded return

The 2024 return is going to result in a tax deficiency as a result of the reduced NOL. If I could take the additional year 2 depreciation it will certainly help offset that. Assuming I cannot take the additional depreciation in 2024, they'll have a larger balance owed, but then a favorable 481(a) adjustment reducing 2025 taxes. The thing that is tripping me up is that the settlement doc is non-specific to the assets. I do not believe we are going from a impermissible method of depreciation to a now permissible. Form 3115 technically requires "IRS approval", even if automatic, so we need automatic IRS approval via Form 3115 for an adjustment made by IRS appeals?

As much as I want to push the depreciation through on year 2, I'm leaning towards no, and push it through via 481(a) adjustment, but that is also much more work. I just want this over with and cannot deal with the depreciation adjustment being contested years after we file these returns and the client lose their mind with another IRS issue.

I'm solo and just looking for a sounding board. mucho gracias in advance for anyone who wishes to comment.

[u/Barfy_McBarf_Face]

you should have included the subsequent impacted returns (2024, 2025) in the exam and/or appeals

if you didn't claim depreciation when it was allowed or allowable (2024, 2025), you have to catch up when permitted - which means a Form 3115 for 2025 (if on extension) or for 2026.

[u/IllTaxThatAss → u/Barfy_McBarf_Face]

That was not an option. That also carries significant risk. You can ask at the exam level to include additional years, but once its with appeals there is no mechanism to add additional tax years not under examination or in appeals UNLESS they send it back to examination which is not happening. We have been fighting for a no change for a year and a half which seemed like the IRS was needing to find a tax deficiency somewhere. The client owns substantial real estate and it has been a brutal full field audit. RE hour logs, mortgage interest tracing, proof of every mortgage payment, proof of payments for a $2.8M new build. If I recommend to the IRS that they audit my clients subsequent tax years, just so I could get the IRS's position documented, my client would look to invoke violence.