When investing in an Airbnb property, it’s important to take advantage of all possible tax savings in order to reduce expenditure, increase cash flow, and boost profitability. Short term rental cost segregation is a powerful strategy that allows vacation rental investors to depreciate certain property assets faster in order to reduce taxable income. This is a particularly beneficial approach for hosts who are already falling into higher-income tax brackets.
What Residential Cost Segregation Is
Residential cost segregation refers to a financial strategy which allows for the segmentation - or segregation - and classification of residential property assets in a way that allows accelerated depreciation of certain components.
This tactic can be applied to short term rental properties as well. It’s important to note right away that short term rental cost segregation does not affect the total size of applicable depreciation; it only allows you to claim a larger share in the early years of owning an Airbnb property.
Typically, a residential real estate property depreciates entirely over the course of 27.5 years. In other words, the useful life of a residential building is defined at 27.5 years for accounting purposes. This means that rental property owners can deduct the market value loss of their property from their taxable income each year, at a rate of 3.636%, for 27.5 years.
According to the IRS rules, in order to benefit from property depreciation, the following conditions need to be met:
- You need to own the property to claim tax deductions.
- The property needs to be used in a business or income-generating activities. Short term rentals definitely qualify.
- The property needs to have a determinable useful life.
- The property needs to last for more than 1 year.
With cost segregation, some vacation rental property assets can be reclassified as personal property and depreciated over a period of 5, 7, or 15 years, according to the asset. With faster depreciation, Airbnb hosts can deduct more business losses from their taxable income each year.
Short term rental cost segregation allows investors to:
- Raise tax deductions
- Lower taxable income
- Reduce tax liability
- Generate more cash flow
In order to make use of this tax-savings strategy, Airbnb owners need to conduct a cost segregation study to identify which parts of their property qualify and what recovery period they have.
Assets That Qualify for Residential Cost Segregation
Short term rental property owners would be excited to hear that there is a wide range of assets and elements that can qualify for cost segregation and accelerated depreciation.
The categories of assets that can be used in the residential cost segregation strategy and their useful lives are:
Tangible Property
- Useful Life: 5 years
Tangible property, also referred to as movable assets, combines all the property-associated items that can be touched and moved as they are not attached to the home. The list includes furniture, appliances, electronics, and decor items such as art works, mirrors, and more.
There are dozens of different items that go into furnishing, equipping, and decorating a property for running an Airbnb business out of it. The cost to furnish a house to rent out on Airbnb typically ranges between $3,500 and $40,000, so the tax savings can be substantial.
Building Systems
- Useful Life: 5 years
Building systems are all the crucial systems installed in a property that are needed for its operations and functionality. Electrical, plumbing, and HVAC systems are the most common and the most expensive examples.
Some covered components include wiring, lighting fixtures, outlets, pipes, and drains. All these systems add up to a major total cost that can be depreciated much faster than the house itself.
Flooring and Carpeting
- Useful Life: 5 years
Real property signifies permanent improvements to the real estate property. Flooring and carpeting are considered as such, and they can be depreciated over 5 short years for major reductions on taxable income.
Tech Equipment
- Useful Life: 5 years
Technology equipment that is necessary for the functioning and the management of the short term rental property also qualifies under residential cost segregation. Popular items include fire alarms, smoke detectors, carbon monoxide alarms, smart locks, and security systems. All these can be depreciated over the course of 5 years.
Office Furniture
- Useful Life: 7 years
Office furniture is another category of assets that can be depreciated faster for tax purposes. This includes desks, office chairs, bookshelves, filing cabinets, and other items that you purchase to furnish a home office in your short term rental. The useful lifetime of office furniture is a bit longer than other assets, at 7 years.
Land Improvements
- Useful Life: 15 years
Another costly category is anything that falls under land improvement. While land itself cannot be depreciated as it doesn’t have a limited useful lifetime, land improvements qualify under residential cost segregation.
This includes landscaping, plant gardens, fencing, walls, outside lighting, sidewalks, parking lots, roads, bridges, and others. Naturally, these get depreciated over a longer period of 15 years.
In order to maximize your tax benefits from cost segregation, it’s important to get a comprehensive list of all the items in your vacation rental property that qualify.
Tax Implications of Cost Segregation
Cost segregation comes with important tax considerations for the owners of a short term rental business. These should be taken into account and applied in order to optimize tax advantages.
Tax implications of cost segregation include:
- Property Deductions: With residential cost segregation, you can depreciate a number of property assets faster than the standard recovery period of 27.5 years. This translates into larger property deductions in the first few years of starting an Airbnb business, which reduces your taxable income over this period.
- Loss Deductions: The accelerated depreciation of assets can result in taxable losses. These losses can be used to offset income from other sources, bringing further tax benefits. It’s important to note that rental activities are typically considered a source of passive income, so loss can be used against other passive income. In case short term rental business rental qualifies as non-passive (active) income, the loss can be claimed towards other non-passive income.
- No Self-Employment Tax: Rental businesses do not usually pay self-employment tax. However, if the owner proves material participation to benefit from the short term rental tax loophole, this changes, and they start paying self-employment tax on Airbnb rental income, just like on other types of business income. In this case, the depreciation resulting from cost segregation can be used to reduce both taxable income and self-employment taxes.
Vacation rental investors who would like to take advantage of the short term rental cost segregation method need to carefully study their specific financial and tax situation and take into consideration all implications. This is the only way to stay on the legal side of taxation while also maximizing benefits for you and your business.
Benefits of Cost Segregation for Short Term Rentals
Residential cost segregation comes with important advantages for Airbnb hosts.
The main benefits of short term rental cost segregation are:
- Larger Tax Deductions in the Initial Years: First and foremost, accelerated depreciation means that investors can claim more property depreciation in the first years of establishing an Airbnb business. This leads to a lower taxable income.
- Tax Savings: Reduced taxable income comes with major opportunities for savings on taxes. This is particularly important for hosts in the higher-income tax brackets as savings can be more sizable.
- Higher Cash Flow: Paying lower taxes leads to improved cash flow, all else held equal.
- More Affordable Property Improvements and Furnishings: As investors are able to depreciate assets faster, they can afford to purchase higher-quality furniture, appliances, and decorations for their short term rental property. Moreover, they can upgrade and refurbish their property more often, keeping it up to date with local trends in the Airbnb market.
- Enhanced Daily Rates and Occupancy Rates: As a result of having a more up-to-date and more advanced Airbnb rental, owners can list it for higher nightly rates while still boosting occupancy. The combined result is improved revenue.
- More Competitiveness: As the property is always kept in an excellent shape and doesn’t suffer from major wear and tear, this increases its attractiveness compared to local competition.
- Better Guest Experiences: Airbnb guests appreciate well-maintained properties that offer modern appliances and stylish furnishings. Satisfied guests are more likely to write 5-star reviews, which will further boost the ranking and performance of a vacation rental.
- Improved Profitability: With higher revenue and lower costs (tax savings), a short term rental will bring better ROI to the owner.
Cost Segregation and the Short Term Rental Tax Loophole
Residential cost segregation is related to another important concept in rental property accounting: The short term rental tax loophole. This provision in the tax code allows STR investors to deduct rental business-related expenses from their taxable income and to accelerate depreciation.
To qualify for this tax loophole, however, hosts need to prove that income earned from their vacation rental is active as rental income is typically classified as passive.
To qualify for the short term rental tax loophole, a property needs to pass two major rules:
- 7-Day Rule: The average guest stay in the property should be no more than 7 days. The reason for this requirement is that the loophole was initially designed for the benefit of hotels and other actors in the hospitality industry, so Airbnb hosts need to prove that they are a part of this industry.
- Material Participation: An owner needs to materially participate in their short term rental property to be eligible. There are 7 different tests that prove material participation. Most frequently, investors allocate more than 500 hours of work to their property (DIY hosts), account for substantially all participation in the management of the business, or participate at least 100 hours per year and their participation exceeds the participation of any other individual.
The short term rental tax loophole can leverage cost segregation in two ways. First, it can accelerate the depreciation of qualifying business-related expenses, such as furniture, building systems, equipment, and land improvements.
This can lead to significant decreases in taxable income in the first 5-15 years of starting a vacation rental business. Second, if your short term rental income is classified as passive income, you avoid the $25,000 in cap on the real estate losses that you can claim against passive income. There is no such limit for non-passive income.
Short Term Rental Cost Segregation Example
To better understand the concept of cost segregation for short term rental properties, let’s take a look at a real-life example.
Axel purchases a property to rent out on Airbnb for $750,000. A cost segregation study concludes that the property comes with:
- Real Estate Property Structure: $609,000 (27.5-year useful lifetime)
- Electrical, Plumbing, and Other Systems: $20,000 (5-year useful lifetime)
- Kitchen Cabinets: $11,000 (5-year useful lifetime)
- Bathroom Fixtures: $15,000 (5-year useful lifetime)
- Entire Home Furniture: $28,000 (5-year useful lifetime)
- Electrical Appliances: $10,000 (5-year useful lifetime)
- Electronics: $5,000 (5-year useful lifetime)
- Decors: $2,000 (5-year useful lifetime)
- Flooring and Carpeting: $15,000 (5-year useful lifetime)
- Smart Home Systems: $5,000 (5-year useful lifetime)
- Landscaping: $30,000 (15-year useful lifetime)
Now, let’s consider two scenarios:
Scenario 1: No Cost Segregation
If Axel doesn’t conduct a cost segregation study, he needs to depreciate the entire price of his investment property - $750,000 - over the course of 27.5 years.
In this case, he can deduct the following amount in each of the next 27.5 years:
Deductions = $750,000 / 27.5 years = $27,273 per year
This means that Axel can reduce his taxable income by $27,273 per year.
Scenario 2: With Cost Segregation
However, after buying his property, Axel realizes that he can benefit from accelerated depreciation, so he does a cost segregation study that returns the results above. Now his deductions in the first 5 years of being an Airbnb host are calculated as follows:
Under this scenario, the total deductions in the first 5 years amount to $46,381.
Under this scenario, Axel is able to increase deductions by $19,108, or alternatively his taxable income is down by this amount.
If Axel is paying taxes at a rate of 32%, he will save $6,115 in taxes per year.
Over the course of 5 years, his tax savings will amount to $30,573.
This example clearly demonstrates the power of short term rental cost segregation to help owners save money on their tax bill.
How to Apply Cost Segregation to Your Short Term Rental
While tax savings can be considerable with cost segregation for vacation rentals, applying this method in practice is not that straightforward for regular investors.
The best way to get started with short term rental cost segregation for the benefit of your Airbnb business endeavor is to connect with an accountant.
Bottom Line
Short term rental cost segregation is yet another important Airbnb tax concept that many investors are not familiar with and lose thousands of dollars in foregone tax savings as a result. This provision in the US tax code allows owners to reclassify certain assets as personal property and depreciate them significantly faster than real estate property. This reduces taxable income and leads to tax benefits. To take advantage of this, investors need to get in touch with a qualified accountant to get started with a cost segregation study.
