Short term rental cost segregation is a potent tax-saving strategy that allows Airbnb owners to depreciate certain residential real estate property components faster than the typical recovery period of 27.5 years. Cost segregation keeps the overall amount of applicable depreciation unchanged while moving some depreciation forward, providing higher tax deductions during the first few years after launching your Airbnb business. This reduction in taxable income leads to major tax savings, which work alongside other Airbnb tax deductions and are particularly important for investors in high income tax brackets.
Looking for the best way to start a short term rental business? The team at STR Search has more than a decade of experience matching Airbnb investors with top-performing short term rental properties across the nation. Many of their clients leverage cost segregation for their investments to offset the high investment costs.
What Residential Cost Segregation Is
Residential cost segregation is a tax strategy that accelerates depreciation for eligible components of residential real estate. Typically, under US tax law, residential real estate property gets depreciated over a standard period of 27.5 years, while commercial real estate buildings are depreciated over 39 years. This means that owners can spread tax deductions related to the loss of their property value evenly over 27.5 or 39 years, respectively. This allows them to realize major tax savings due to wear and tear. In the case of a residential property, the owner can deduct 3.636% of its market price, in the form of loss, from their annual taxable income for 27.5 consecutive years. Understanding these basic tax calculation principles becomes especially important for property investors managing multiple rental units.
The IRS has defined four specific requirements for property depreciation to be applicable:
- You can claim depreciation only on a property that you own.
- You must use the property in your business or an income-producing activity.
- The property must have a determinable useful life.
- The property is expected to last more than one year.
The components of a real estate property can have useful lives that differ from the useful life of the building itself. Residential cost segregation addresses these differences. This tax strategy allows residential property owners to break down, or segregate, their property into different components and depreciate certain categories of assets faster, over a shorter period than 27.5 years. Items that get reclassified as personal property can undergo depreciation over 5, 7, or 15 years, depending on their specific type. Although the value of assets that can be depreciated faster differs in each case, an average of 20-30% of a property's purchase price can fall under this category. Cost segregation represents a legitimate IRS-approved strategy for maximizing property depreciation benefits.
Residential cost segregation keeps the total value of depreciation applicable to your property unchanged. It allows you to push more depreciation forward so that you benefit from larger deductions in your taxable income during the first 5-15 years after buying a property.
So, how does all this affect short term rental property investors?
The residential cost segregation strategy can be applied to short term rental properties, in which case it is referred to as short term rental cost segregation. This means that certain assets within an Airbnb rental property can be classified as personal property with a depreciation period of 5, 7, or 15 years.
This financial strategy allows vacation rental investors to reduce their taxable income during the first few years of owning a short term rental business. This can be a crucial period for investors as they figure out the Airbnb market, get used to vacation rental operations, and repay investment loans. In other words, short term rental cost segregation and accelerated depreciation allow Airbnb hosts to get started on the right footing and set themselves up for success in the short term rental business.
Cost Segregation Study Explained
A cost segregation study breaks a property into components and identifies the useful life of each component to establish the appropriate depreciation period. A real estate property must undergo this study to be eligible for residential cost segregation. A cost segregation study is usually performed by professionals, such as tax experts and engineers. A short term rental investor cannot conduct a study on their property on their own and use it for tax purposes.
The price of a cost segregation study is between $3,000 and $12,000, with an average range of $5,000-$7,000. This can be a substantial amount, especially for a beginner investor, and it can help you save a lot of money on taxes during the first few years of investing in an Airbnb property.
In terms of time, a cost segregation study takes 30-60 days to complete. The exact timeline depends on the type of property, the size of the home, the complexity of the house, and the available documentation that the team needs.
What Assets Qualify for Residential Cost Segregation
Assets that qualify for residential cost segregation fall into categories based on their useful lives. A residential cost segregation study divides real estate properties and the assets within them into these categories. Each category of assets can then be depreciated over the course of its assumed useful life.
The following are the standard types of assets that count for short term rental cost segregation:
1. Personal Property: 5 Years
Personal property generally qualifies for depreciation over 5 years. Also referred to as tangible property or movable assets, these are the fastest-depreciating assets in a real estate property because they have the shortest useful life, usually set at 5 years. Personal property includes a wide range of items that are required to make a short term rental guest-ready.
The most popular tangible assets for cost segregation purposes are:
- Furniture
- Cabinetry
- Appliances
- Electronics
- Window treatments
- Carpentry
- Flooring
- Decor items
- Supplies
- Safety equipment such as smoke detectors, fire alarms, carbon monoxide detectors, and fire extinguishers
- Smart home devices such as a security system, smart thermostats, smart lighting, smart TVs, smart Wi-Fi routers, and others
The typical cost of furnishing a house for Airbnb is between $5,000 and $50,000, which means that investors can achieve major tax benefits if they take advantage of accelerated depreciation.
2. Office Furniture: 7 Years
Office furniture generally qualifies for depreciation over 7 years. It is estimated to have a slightly longer useful life than home furniture. This means that you can depreciate any office furniture items that go into your vacation rental over 7 years.
Standard items that go under this category of assets include:
- Desks
- Office chairs
- Filing cabinets
- Bookshelves
This can be particularly helpful for hosts who furnish a home office in their short term rental property to cater to the needs of digital nomads and remote workers.
3. Building Systems: 10-15 Years
Building systems generally qualify for accelerated depreciation based on their specific useful lives. These useful lives vary and are usually in the range of 10-20 years, though they sometimes reach 25 years. Once you complete a cost segregation study on your STR, you will know exactly how many years you can use to depreciate them.
Building systems cover:
- Electrical system
- Plumbing fixtures
- HVAC system
These systems are rather expensive, so being able to claim their depreciation over a shorter period will help you achieve sizable tax savings at the beginning of your real estate investing career.
4. Land Improvements: 15 Years
Land improvements generally qualify for depreciation over 15 years. This category of real estate assets depreciates faster than the actual building.
Land improvements include:
- Roads
- Bridges
- Driveways
- Sidewalks
- Parking lots
- Landscaping
- Fencing
- Walls
- Gardens
- Swimming pools
- Outdoor lighting
- Drainage systems
Once again, the total cost of land improvements around your vacation rental property can add up to a large sum, so it’s important to depreciate it as quickly as possible.
- Residential Building: 27.5 Years
Finally, actual buildings that fall under residential real estate have a useful life of 27.5 years for tax purposes.
This category includes:
- Building foundation
- Structural walls
- Roof
Because each property is unique and there are many different asset categories, you must hire a professional team to conduct a cost segregation study on your rental property and maximize the benefits.
Cost Segregation Tax Implications
Short term rental cost segregation can significantly affect an Airbnb investor’s tax situation by accelerating depreciation and increasing early deductions. Savvy investors have to use all available tax benefits and deductions to boost their cash flow and profit, especially when they are getting started and repaying loans.
The most important tax implications of residential cost segregation for vacation rentals include:
Property Deductions
Property deductions can increase during the first few years when eligible assets are depreciated over shorter recovery periods. The main idea behind the cost segregation strategy is to claim depreciation on personal assets and other categories of assets associated with your short term rental over a recovery period of 5-15 years. This means that you can access significantly bigger property deductions on your taxable income during the first few years of running an Airbnb business. This leads to tax savings.
Loss Deductions
Loss deductions can offset income from other sources when the applicable tax rules allow it. Faster-depreciating assets can lead to losses, which can be used against income from sources such as your 9-to-5 job or other investments. This helps you reduce your taxable income even more, leading to bigger tax advantages.
You should keep in mind that rental income is usually considered passive income for tax purposes, so you can use losses against other sources of passive income. However, if you have material participation, to be discussed shortly, in your short term rental business, rental income is considered non-passive or active. In that situation, losses can be used to offset other types of active income.
Self-Employment Tax Reduction
Larger depreciation from short term rental cost segregation can reduce self-employment tax when an investor has material participation in the business. Under normal circumstances, real estate investors pay no self-employment tax on their rental income. Material participation requires them to pay self-employment tax, and the larger depreciation can be used to lower this tax.
Cost Segregation and Short Term Rental Tax Loophole
Cost segregation can maximize the benefits of the short term rental tax loophole. This relationship is arguably the most important tax implication of residential cost segregation because the loophole is another strong tax benefit available to Airbnb investors.
The short term rental tax loophole is a tax law provision that allows vacation rental owners to turn their Airbnb property from a passive investment producing passive income into an active business producing active income. Active business income has access to more deductions than passive income, allowing Airbnb hosts to increase their tax savings.
According to legislation, there are two main criteria that an Airbnb business needs to meet to qualify for this tax strategy:
- 7-day rule: The average guest stay at your property should be 7 days or less for it to be considered an active business activity.
- Material participation: You have to actively and substantially participate in the management of your short term rental. The IRS applies 7 tests to prove material participation. These tests aim to measure how much time you devote to the day-to-day operations of your vacation rental and how this compares to the work provided by others.
If you meet these two requirements and qualify for the short term rental tax loophole, you can maximize the tax benefits from cost segregation. Specifically, the maximum loss of $25,000 that can be claimed against passive income no longer applies because your rental income is considered active. Active income has different limitations from passive income. This allows you to maximize the depreciation deduction during the first 5-15 years of your vacation rental business.
Short Term Rental Cost Segregation Benefits
Short term rental cost segregation can provide owners with larger early tax savings, stronger cash flow, and a better return on investment. The main advantages of this strategy highlight its importance.
Performing a cost segregation study on your Airbnb property and using the results in your tax strategy can bring the following benefits:
- Bigger tax savings in the first 5-15 years: First and foremost, residential cost segregation allows you to claim larger tax deductions at the beginning of your Airbnb hosting career, leading to significant tax savings.
- More cash flow: As you save on taxes, you end up pocketing more money from your Airbnb business, which you can use in a variety of ways. For example, you can invest money in upgrading your STR, repay the mortgage principal, cover the down payment on another Airbnb property, or simply enjoy the extra cash.
- Better return on investment: The higher cash flow immediately boosts the ROI on your Airbnb property, which is the ultimate goal of all real estate investors.
- Extra cash to give your STR a boost: One of the most productive ways to use the money from the tax savings is to improve your vacation rental by renovating it, refurnishing it with high-quality furniture, or adding new Airbnb amenities. As long as you plan and execute these upgrades carefully, you will end up with a more competitive listing that performs better in the local market and generates more money.
- Higher ADR and Airbnb occupancy: After you upgrade your short term rental, you can increase the daily rates for which you rent it and still get a lot of bookings because your property is better than everyone else’s in the area.
- Stronger rental income: The combined effect of the better daily rates and occupancy is more Airbnb income, which you can save to expand your portfolio.
- Improved competitiveness and guest satisfaction: In addition, your property will be able to generate more 5-star reviews from guests, which will boost its ranking on the Airbnb website and other booking channels, bringing more and more bookings over time.
- Risk mitigation strategy: Finally, having more disposable cash at the beginning of your Airbnb business as a result of tax savings gives you leverage to better protect your investment against different types of risk.
The potential impact of all these benefits is clear: a more profitable short term rental business that is better protected against volatility in the vacation rental market. That’s why you should use the power of cost segregation and apply it to your vacation rental.
Example of Short Term Rental Cost Segregation
This example shows how residential cost segregation can increase annual deductions and tax savings.
John bought a furnished and fully ready vacation rental property for $550,000.
A cost segregation study comes back with the following reclassification:
If John uses standard depreciation and depreciates all assets over 27.5 years, his annual deductions will be $20,000, or the total value of the property ($550,000) distributed over 27.5 years.
If John decides to implement the short term rental cost segregation strategy, his deductions during the first 5 years after purchasing the property will be $36,283. This means that John can reduce his taxable income by $16,283 per year over the 5-year period. If John pays income tax at a rate of 32%, he’ll save $5,211 per year, or $26,052 over 5 years.
This example clearly demonstrates the power of cost segregation when applied to a short term rental property. The tax savings can be significantly higher for luxury properties with expensive fixtures, high-end furniture, and unique amenities, as well as for investors who fall under higher tax brackets.
How to Apply Cost Segregation to a Short Term Rental Property
Apply cost segregation to a short term rental property by hiring professionals to conduct a study and using the results in your tax strategy. Cost segregation can offer a major opportunity to save on taxes and boost the performance of your short term rental property during the first few years of starting an Airbnb business. Implementing this strategy in practice might be harder than it sounds, especially for beginner investors with limited expertise in tax matters.
To find a property that matches your budget and investment goals and get personalized tips on the best tax strategies to maximize profit, get in touch with STR Search.
Bottom Line
Short term rental cost segregation accelerates asset depreciation so Airbnb investors can claim larger tax deductions at the beginning of their vacation rental investment careers. It is one of the many things you need to know when first getting started with Airbnb to maximize cash flow and enhance performance. You can use the freed-up cash to improve your property and generate more revenue or to expand your Airbnb portfolio. Either way, it’s crucial to seek professional help to maximize the results.
To be matched with a high-performing short term rental property within your budget in no more than 30 days, check out STR Search. The team will find the right match for your aspirations and provide you with tailor-made tax strategies. These strategies will help ensure that your property has cash flow and leverages tax benefits to enhance your bottom line.
