Cost segregation study for Airbnb rentals

Why are we talking about the cost segregation study?

Why pay more taxes than you need to pay? A cost segregation study for short-term rentals can produce many tax benefits and impact your cash flow. 

The value of a cost segregation study increased significantly following the passage of the Tax Cuts and Jobs Act (TCJA). During COVID, under Cares, bonus depreciation increased to 100% through 2022, and the Tax Cuts and Jobs Act (TCJA) was expanded to include acquired properties. 

Like with everything else, there are a lot of benefits of cost segregation study but also some drawbacks. The benefits by far outweigh the drawbacks. 

Key benefits: 

• Great way to save on taxes and improve your cash flow
• Decrease your current tax liability. Especially beneficial for high-income earners in higher-income brackets
• Ability to defer taxes, possibility to defer indefinitely with 1031 exchange

Key drawbacks:

• Can be expensive, especially when using engineering methods. If you are flipping the property then it’s not worth it
• May trigger depreciation recapture when you sell the property (it can be avoided with 1031 Exchange)

What is a cost segregation study?

There are two primary methods for expensing real estate costs: the traditional straight-line method and an engineering-based cost segregation method. 

When you purchase real estate, you need to split the purchase price between the building and the land. A cost segregation analysis helps you determine the proper allocation of your investment. Doing this study allows the taxpayers to depreciate the property over much shorter periods of time than typical 27.5 or 39-year periods that are standard for a real property using the traditional straight-line method. 

By conducting this study, you can separate various components of your property whose costs can be depreciated over a much shorter timeframe or even deducted at full cost by leveraging bonus depreciation. Please note there are changes to bonus depreciation. We will write about this in our next blog post. Sign up for our newsletter. 

Five and 7-year schedules can be applied to items such as decorative building elements, carpeting, and more. Fifteen-year schedules can be applied to landscaping, paving, etc. 

Connect With a Cost Segregation Expert

Also if you made significant improvements to your property such as redoing flooring, adding a hot tub, or new windows you should definitely consider doing this study. A cost segregation study can help you reduce your tax burden by allowing you to write off the costs of these improvements on a much faster schedule, often in the same year thanks to bonus depreciation.  

With traditional straight-line depreciation, you will still depreciate the total amount over the property’s lifetime. With a cost segregation study, you can take your deductions a lot sooner. The real value associated with cost segregation is the time value of money and what you can do with it now rather than leaving it sitting with the Treasury Department for 27.5 or 39 years. This money can also be used as a down payment for another property, to invest in renovations, or just to go on a nice vacation. 

Cost segregation study and Airbnb rentals

Short-term rental properties are a great investment tool for high-income earners. Airbnb rentals have a higher cash flow potential and very often outperform traditional rentals. Beyond that, they also offer massive opportunities to reduce the tax burden, especially for those with high ordinary income (W2 income). To maximize your deduction, we recommend speaking to professionals. Reach out now to get connected with a depreciation specialist. 

To maximize the benefits you need to qualify for using the short-term rental property losses as Non-passive losses. The goal of this strategy is to show losses on your rental investment. Those losses can be used to offset your W-2 income. Please note that these losses do not mean cash flow losses, you are just depreciating the value of your investment over time. 

According to Investopedia, Nonpassive income and losses constitute any income or losses that cannot be classified as passive. Nonpassive income includes any active income, such as wages, business income, or investment income. What is important to note is that nonpassive income and losses cannot be offset with passive losses or income. In this case, you need to ensure that your nonpassive losses from your Airbnb rental can reduce your tax liability from ordinary income (also nonpassive income). 

For the Airbnb rental loss to qualify as a non-passive loss you have to be a material participant in the business. Investopedia states that there are seven material participation tests and you must pass at least one. 

Real estate CPAs have a great article on Cost Segregation and Bonus Depreciation. According to the article: “First, Treas. Reg. Sec. 1.469-1T(e)(3)(ii)(A) provides an exception that states an activity is not a Section 469 rental activity if the average period of customer use for the property is seven days or less.”

This means most AirBnB and VRBO properties are not considered “rental activities” under Section 469 of the code. This also means that you don’t need to qualify as a real estate professional under IRC Sec. 469(c)(7)(B) to claim your losses from a short-term rental activity as non-passive. You just need to demonstrate that you materially participated in the short-term rental activity in the tax year and your losses will be non-passive. 

Example

John Doe has $200k of taxable income on his W2 and buys an $800k 6-unit property. A cost segregation study may allow you to deduct $150k in depreciation expense in the tax year of acquisition.

This would create a large tax loss (notably different than an actual operating loss). Let’s assume that John Doe lives in Colorado and that his filing status is Married Filing Jointly. See this example from Smart Asset. Assuming that John’s wife is managing the Airbnb Rental and qualifies as a material participant, John Doe’s family can deduct $150k from their w2 income for the year 2022 (Bonus depreciation 100%).

This would equal $33,000 in a tax refund for the family. These are non-negligible numbers and can serve as a downpayment for the next property.

Chalet cofounders are doing a cost segregation study for one of their properties for the tax year 2022:

A Cost Segregation Case Study

Our case study at GetChalet.com showcases how we slashed $36,000 in taxes by taking advantage of cost segregation. This tangible example underscores the potential savings and the impact on an investor’s bottom line.

Who conducts it?

A cost segregation study can be performed by a CPA, Appraiser, real estate professional, and/or engineering team. 

The best practice here is the engineering approach that separates property into four categories: land, personal property, building, and land improvements. An engineer report is not a must but is highly recommended in case of an audit. It will cost more but will give you a piece of mind. 

The price will depend on the type of property and method used to conduct the study.

Gotchas?

When you sell your property this may trigger depreciation recapture so you might have an unexpectedly high tax bill. This can be avoided if you choose to buy another property of the same kind with 1031 exchange. 

If you hired a full-service property management company, your losses do not qualify to count against your W2 income as your loss is not classified as non-passive loss. The loss can only be used to offset income from Airbnb rentals. As we mentioned above, please ensure that you qualify as an active participant in your Airbnb (Short-term rental) business. 

Please also remember that if you can’t use all the depreciation in the first year of a cost segregation study, you can roll it forward until it is all used.

Should you do it?

If you plan to flip the property, then this strategy is definitely not worth it. If you are a high-income earner, you are an active participant in your business and plan to hold the property for the long term, then this could be the right strategy for your short-term rental. 

Reach out now to speak to one of our Cost Segregation Specialists.

GetChalet Inc. does not provide tax advice and therefore cannot advise investors on the applicability of tax law. If you are considering depreciation strategies, you should consult with your tax advisor.