The Short-Term Rental (STR) Loophole already offers a tremendous advantage for STR owners, allowing you to offset W-2 income with losses from rental properties. But did you know you can take this even further by leveraging cost segregation studies and bonus depreciation? This combination allows real estate investors to dramatically accelerate tax deductions, often resulting in massive first-year tax benefits.
In this post, we'll explain how cost segregation and bonus depreciation work together and how you can use them to maximize the tax advantages of owning a short-term rental.
What is a Cost Segregation Study?
A cost segregation study is a detailed analysis performed by a tax professional or an engineer that breaks down the different components of a property into categories with shorter depreciable lives. Typically, real estate assets are depreciated over a long period of time—27.5 years for residential rental properties and 39 years for commercial properties. However, many components of the building, such as appliances, carpets, and lighting fixtures, have shorter useful lives, typically 5, 7, or 15 years.
A cost segregation study identifies which parts of the property can be depreciated faster, allowing you to front-load depreciation expenses. By segregating certain assets into shorter life categories, you can accelerate your depreciation deductions, creating a larger paper loss in the first few years of ownership.
How Bonus Depreciation Supercharges Your Savings
Bonus depreciation is a tax provision that allows you to immediately deduct a large percentage of the cost of qualifying property in the year it’s placed in service, rather than spreading it out over the asset’s useful life. Under the Tax Cuts and Jobs Act (TCJA) of 2017, the bonus depreciation rate was set at 100% through the end of 2022, allowing real estate investors to deduct the full cost of many assets in the first year. Though bonus depreciation starts to phase down after 2022, it’s still incredibly valuable.
When you combine cost segregation with bonus depreciation, you can take immediate deductions on the items identified in the cost segregation study that have useful lives of 20 years or less. This includes many of the assets segregated into 5-, 7-, and 15-year categories, such as:
Appliances (refrigerators, stoves, washers, dryers)
Furniture
Carpets and flooring
Landscaping
Driveways, parking lots, and fencing
By using bonus depreciation, you can deduct 100% (or a significant portion) of these costs in the first year the property is placed in service, resulting in a substantial first-year tax deduction.
Combining Cost Segregation and Bonus Depreciation for STRs
For short-term rental properties, the ability to combine a cost segregation study with bonus depreciation offers an exceptional opportunity to create significant tax savings. Here’s how this combination can work for your STR:
Conduct a Cost Segregation Study: When you purchase a short-term rental property, hire a tax professional to perform a cost segregation study. This study will break down the property into its component parts, identifying which parts of the property can be depreciated more quickly.
Apply Bonus Depreciation: Once the study is complete, you can apply bonus depreciation to the components with useful lives of 20 years or less. Under current tax law, this allows you to deduct 100% of the cost of these assets in the first year of ownership. For example, if your cost segregation study identifies $100,000 worth of assets in the 5-, 7-, and 15-year categories, you can deduct the entire $100,000 in the first year.
Offset W-2 Income: As long as you meet the requirements to avoid passive activity loss limitations (such as materially participating in the management of the property), these paper losses from bonus depreciation can be used to offset your W-2 income or other active income. This is where the STR loophole comes into play, as it allows short-term rental owners to treat their STR activities as non-passive, enabling them to use these losses to offset their ordinary income.
Example: First-Year Tax Savings for a Short-Term Rental
Let’s break down an example to see how this combination works in practice:
You purchase a short-term rental property for $500,000, with $400,000 allocated to the building and $100,000 to the land (since land isn’t depreciable).
After conducting a cost segregation study, $100,000 worth of components (such as appliances, fixtures, and landscaping) are identified as having useful lives of 5, 7, or 15 years.
By applying 100% bonus depreciation, you can deduct the entire $100,000 in the first year of ownership.
If you earn $150,000 from your W-2 job, this $100,000 bonus depreciation deduction could offset most of your taxable income for the year, potentially dropping your taxable income to just $50,000. Depending on your tax bracket, this could result in tens of thousands of dollars in tax savings.
Depreciation and Cash Flow Benefits
One of the most significant advantages of combining cost segregation with bonus depreciation is that it generates paper losses—meaning, you’re deducting depreciation expenses without actually losing any cash. In fact, your short-term rental may be generating positive cash flow, but you can still use these depreciation deductions to reduce your taxable income.
This is a huge win for STR owners because it allows you to keep more of your rental income while simultaneously reducing your tax liability.
Considerations for Cost Segregation and Bonus Depreciation
While combining cost segregation with bonus depreciation offers tremendous tax savings, it’s important to keep a few considerations in mind:
Professional Help: Cost segregation studies require detailed analysis and are typically performed by tax professionals or engineers with expertise in real estate. While there’s a cost to performing these studies, the tax savings often far outweigh the expense.
Phase-Out of Bonus Depreciation: The 100% bonus depreciation provision is in place for property acquired and placed in service before 2023. After 2022, bonus depreciation starts to phase down: 80% in 2023, 60% in 2024, and so on, until it phases out completely by 2027. However, even partial bonus depreciation can provide significant benefits.
Recapture: When you eventually sell the property, you may need to recapture the depreciation you’ve taken, which could result in a larger tax bill at the time of sale. However, this can often be mitigated by tax strategies such as 1031 exchanges, which allow you to defer taxes on the sale by reinvesting in another property.
Conclusion
For short-term rental owners, the combination of a cost segregation study and bonus depreciation is one of the most powerful tools available for maximizing tax benefits. By accelerating depreciation on qualifying assets and applying bonus depreciation, you can generate substantial first-year tax deductions, offset W-2 income, and potentially create positive cash flow while significantly reducing your overall tax burden.
However, navigating the complexities of tax law and ensuring you’re maximizing every available benefit requires expert guidance. Whether you’re a new investor or a seasoned real estate professional, it’s essential to work with experienced financial experts who can tailor these strategies to your specific situation.
That’s where sebCFO comes in.
As a trusted outsourced CFO firm with deep expertise in real estate tax strategies, sebCFO can help you take full advantage of the Short-Term Rental Loophole, cost segregation studies, and bonus depreciation to ensure you’re optimizing your tax savings. We provide personalized, Fortune 500-level financial services tailored to your business, whether you’re looking to offset W-2 income, generate positive cash flow, or grow your real estate portfolio.
Contact us today to learn more about how we can help you:
Conduct a detailed cost segregation study for your STR
Apply bonus depreciation to maximize first-year deductions
Navigate the complexities of IRS regulations to unlock massive tax savings
Build a comprehensive tax and financial strategy tailored to your goals
At sebCFO, we pride ourselves on being available to our clients 24/7. You’ll have direct access to our team of experts, who can provide guidance and support whenever you need it. Let us help you transform your short-term rental investment into a financial powerhouse.
Ready to get started? Reach out to sebCFO today for a consultation and discover how we can help you maximize the tax benefits of your real estate investments.
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