Cost Seg and Short Term Rentals
A concise, practical explanation of how cost seg delivers tax benefits to short term rental owners.
TLDR: Short term rentals and cost segregation studies can be a highly effective strategy to lower taxes on your active income (W-2 salary income).
Short Term Rentals
Over the past decade, short term rentals (or "STRs") have grown dramatically with the rise of AirBnB, VRBO, and others and are projected to continue to grow quickly. STRs are an attractive way to monetize real estate assets, because of their ability to access global demand, unique locations, and uncommon footprints.
The Role Of Cost Segregation
As with any income generating property, owners can offset their income with depreciation deductions to lower their taxes. Typically, owners of rental properties recognize depreciation deductions over 27.5 or 39 years using the straight-line method (the appropriate depreciation period for STRs is 39-years). This results in a small amount of depreciation taken each year over a long period of time.
Cost Segregation is an IRS-approved tax planning strategy that allows short term rental owners to accelerate the depreciation deductions associated with their property. The purpose of a cost segregation study is to identify and reclassify the property into shorter tax life components (e.g., 5, 7, or 15 years) so you can accelerate depreciation deductions and improve cash flow. And with the return of 100% bonus depreciation in 2025, STR owners can claim significant depreciation deductions in year 1 of their ownership.
The Limits of Passive Losses
Real estate rental income is generally considered a passive activity in the tax code and so can be subject to passive activity loss limitations. These limitations can prevent a taxpayer from utilizing losses from rental activities to reduce their taxable income from other non-passive or active sources (i.e., W-2 salary income).
A passive loss is generated, when the expenses (including depreciation) from rental activities exceed the income generated by the properties. Cost Segregation frequently creates such losses, as the accelerated depreciation can greatly exceed the yearly income generated by the rental property. But the limits on passive activity losses often causes small actual cash tax savings from this accelerated depreciation.
The Short Term Rental Tax Loophole
Historically, the primary method for avoiding the passive activity loss limitations was to qualify as a real estate professional. Real estate professional status is difficult to achieve as it requires a taxpayer to work more than 750 hrs per year in a real property trade or business and have that be a “majority” of their working time (i.e., >50%).
The STR loophole lowers this threshold dramatically! The qualifications are:
- The average period of customer use must be 7 days or less, and
- The taxpayer must “materially participate” in the business, typically meaning they worked more than 100 hours operating the rental AND no one else worked more than the taxpayer (there are several different ways to meet the “material participation” requirement, but this is the most commonly utilized one).
If these requirements are met, owning an STR can significantly offset W-2 income and lower taxes paid by the property owner. Bonus depreciation has further increased the year 1 benefits of a new STR purchase.
We always recommend you discuss with your CPA or qualified tax preparer to ensure you qualify.
Check out our free calculator tool to estimate how much your STR could reduce your taxes with a cost segregation study.
Cost Seg Example
| Purchase price for a short term rental property | $1,000,000 |
| % of purchase price allocated to land (which is non-depreciable) | 20% |
| Depreciable basis | $800,000 |
| % of depreciable basis reclassified into shorter life categories with a cost seg | ≈ 25% |
| Assets eligible for Year 1 100% bonus depreciation with a cost seg | ≈ $200,000 |
| Year 1 tax savings at a 37% federal income tax rate with a cost seg | ≈ $74,000 |
Higher depreciation → lower taxable income → improved cash flow
Note: This estimate is provided for informational purposes; actual results will depend on the specific features of your property (e.g., quality of the property, condition, year of purchase, renovation work, location, etc.).
Why Choose Us
We help real asset owners navigate the complex worlds of tax credits and incentives. Our team has 20+ years of experience performing cost segregation studies.
We are unique in the market by offering a full range of cost seg services, from DIY studies for single-family residential properties to fully engineered studies for more complex properties and situations (under our sister brand MVO). We focus on delivering the highest quality reports, at a price that ensures a high ROI.
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