Had a couple of conversations this past week as well as reviewed some depreciation schedules and more often than you would think, we see schedules that have the Airbnb or VRBO (STR) listed as a 27.5 year asset. It’s not. It’s considered more like commercial and gets treated as such. So, short-term rentals like Airbnbs and VRBOs are 39 year assets. Keep that in mind as you are forecasting your depreciation.
Should you study your short-term rental? Well, that depends. Are you going to hold it for at least a few more years? Is it profitable? If it’s not profitable, are you managing the property so that you might be able to utilize the depreciation to offset your other income? Be sure to discuss this with your tax advisor. We can always run the numbers for you but then you need to consult with your own advisors to see if it makes sense to do a study. No need for you to spend $2,500 – $5,500 or so to get a study done only to find out you really can’t use the depreciation. That said, we study a lot of Airbnbs and VRBOs. The cost is not a lot of money for the tax benefits you receive. Many owners see a 10x return on their investment in the study.
Reach out to me if you’d like to discuss. Feel free to also check out the other site I’m building over at Cost Seg Estimate.
Do you operate a short-term rental such as an Airbnb or VRBO? Is it profitable? I.e. are you having to pay income taxes because you are turning a nice profit on your STR? In this blog post, we’ll explore what cost segregation is, how it works, and the benefits it can offer to Airbnb and VRBO owners.
What is Cost Segregation?
Cost segregation is a tax planning strategy that allows property owners to accelerate depreciation deductions by reclassifying certain property-related expenditures. Instead of depreciating the entire property over the standard 27.5 or 39 years (for residential and commercial properties, respectively), cost segregation identifies and reclassifies specific components of the property into shorter depreciation periods (5, 7, or 15 years). These components can include items like landscaping, fixtures, and certain building improvements. BTW, short-term rentals are considered 39 year property.
How Does Cost Segregation Work?
A cost segregation study is typically conducted by a team of professionals, including engineers, architects, and tax advisors. They analyze the property in detail to identify which parts of the property can be reclassified for accelerated depreciation. The study involves:
Reviewing Architectural Plans and Costs: Examining blueprints, invoices, and other documentation to identify qualifying assets.
Site Visit: Conducting an on-site inspection to verify and document the assets.
Reclassification: Reclassifying the property components into appropriate depreciation categories.
Report Generation: Providing a detailed report that outlines the reclassified assets and their depreciation schedules.
Benefits of Cost Segregation for Airbnb and VRBO Owners
Increased Cash Flow: By accelerating depreciation, property owners can significantly reduce their taxable income in the early years of ownership. This reduction translates to increased cash flow, which can be reinvested into the property or used to expand the rental business.
Tax Deferral: Accelerated depreciation provides a deferral of tax liabilities. By reducing taxable income now, owners can take advantage of the time value of money, allowing them to utilize funds that would otherwise be paid in taxes for other investments or property improvements.
Enhanced Property Value: Reinvesting the tax savings into property improvements can enhance the property’s value, making it more attractive to potential renters. Upgraded properties can command higher rental rates and improve occupancy rates, further boosting income.
Improved Competitive Edge: The savings from cost segregation can be used to offer competitive pricing or to enhance amenities and services, making the property more appealing compared to other listings in the area.
Compliance with Tax Laws: Cost segregation is an IRS-approved method of accelerating depreciation. By conducting a professional cost segregation study, property owners ensure they are in compliance with tax laws while maximizing their deductions.
Flexibility in Planning: The insights gained from a cost segregation study can aid in future tax planning and financial decision-making. Knowing the detailed breakdown of property components and their depreciation schedules allows for better forecasting and budgeting.
Is Cost Segregation Right for You?
While cost segregation offers significant benefits, it may not be suitable for every property owner. One of the things we often will say is that if the owner is planning to hold the property for at least 3 more years, cost segregation will often make sense. If you’re going to hold shorter than that, then it probably doesn’t make sense. We always recommend you consult with your own tax advisor when it comes to cost segregation. The initial cost of the study and the complexity of the property are important considerations. Typically, properties with a cost basis of $200,000 or more are candidates for cost segregation. The more expensive the property, the better the results will be with cost segregation. Depending upon the size, cost and complexity of the property, these studies can often range from about $2,500 to $5,500.
Conclusion
Cost segregation is a powerful tool that can unlock substantial tax savings and enhance the profitability of short-term rental properties on platforms like Airbnb and VRBO. By accelerating depreciation, property owners can increase cash flow, defer taxes, and reinvest in their properties to gain a competitive edge. If you own a short-term rental property, it’s worth exploring whether cost segregation can help you maximize your investment and take your rental business to the next level.
Do you own property on beautiful Lake Keowee in the Upstate of South Carolina? Is it a short-term rental? Long-term rental? Either way, you might benefit by doing cost segregation for tax savings.
I’m based here in the Upstate of South Carolina and work with many owners not only in South Carolina, but across the U.S. to study their investment properties for tax savings that can be the result of applying cost segregation to your properties.
Cost segregation is a tax planning strategy that can be applied to various types of real estate investments, including short-term rental properties. Short-term rentals, such as vacation homes or Airbnb properties, can benefit from cost segregation studies in order to maximize tax deductions and reduce taxable income. Here’s how cost segregation can be applied to short-term rentals:
What is Cost Segregation? Cost segregation is the process of identifying and classifying certain components of a real estate property into shorter depreciation periods for tax purposes. This allows property owners to accelerate their depreciation deductions, which in turn can reduce their taxable income and improve cash flow.
Types of Property Components: Cost segregation typically focuses on reclassifying certain building components from a standard 27.5 or 39-year depreciation period to shorter periods, such as 5, 7, or 15 years. Short-term rental property owners can benefit by reclassifying assets like:
Personal property: Furniture, appliances, fixtures, and equipment.
Land improvements: Landscaping, outdoor lighting, parking lots, and sidewalks.
Tenant improvements: Renovations or improvements made to cater to guests’ needs.
Benefits of Cost Segregation for Short-Term Rentals:
Increased depreciation deductions: By reclassifying assets to shorter depreciation periods, property owners can deduct a larger portion of the property’s cost in the early years, reducing their taxable income.
Improved cash flow: Higher depreciation deductions mean lower taxes, leading to increased cash flow for the property owner.
Enhanced ROI: The upfront tax benefits can significantly improve the return on investment for short-term rental properties.
Cost recovery: Cost segregation can uncover previously overlooked deductions, allowing property owners to amend past tax returns and claim retroactive deductions.
Cost Segregation Study: To implement cost segregation for a short-term rental property, property owners typically hire a qualified cost segregation specialist or firm. The specialist will conduct a thorough study, which involves inspecting the property, identifying eligible components, and preparing a detailed report that outlines the reclassified assets and their respective depreciation periods.
IRS Compliance: It’s important to ensure that the cost segregation study is performed in compliance with IRS regulations and guidelines. The IRS provides detailed guidance on cost segregation in its Cost Segregation Audit Techniques Guide.
Documentation: Proper documentation is critical when applying cost segregation to short-term rental properties. Property owners should maintain records related to the cost segregation study, including the study report and any supporting documentation.
While cost segregation can provide significant tax benefits for short-term rental property owners, it’s important to work with tax professionals or specialists who are experienced in this area, as it can be complex and requires expertise to maximize its benefits while staying compliant with tax regulations.
Short-term rentals are great candidates for cost segregation. Whether your on the Airbnb, VRBO or some other short-term rental platform, these properties tend to do very well for their owners when it comes to utilizing this tax strategy.
Many of the short-term rentals that I see tend to be nicely finished on the inside and often will have decent land improvements like driveways, patios, outdoor kitchens, docks and extensive landscaping.
How might this work you ask? Let’s say you paid $800,000 for your property that you’ve converted into an Airbnb in 2023. We’ll say the land is $150,000. That leaves you with $650,000 as your basis. (BTW, this math works essentially the same if your Airbnb was 2x as much or 1/2 as much). Of that $650,000, let’s say we identify 20% as 5 year property and 5% as 15 year class life property. That means you can accelerate 25% of the $650,000 or $162,500. In 2023, you can take 80% of that as Bonus Depreciation so you could take a deduction of $130,000. If you made $150,000 in 2023 as your Airbnb income, you could knock that down by $130,000. If you’re at the 32% tax rate, that’s a savings of over $40,000 in income tax savings. A study like this might cost you between $3,500 – $4,000. That’s an expense to you so it nets down to $2,720. Your ROI is about 15:1 or 1,500%.
Owners should always consult with their tax professionals to see if this makes sense for you to do. Feel free to reach out if you’d like to discuss. I’m happy to run a no cost, no obligation analysis / estimate for you. Let’s connect on LinkedIn or find my on Twitter @costsegbuilding.
Short-term rental ownership exploded during Covid. The business model has been a good one for many investors throughout the country. These property owners can take advantage of cost segregation just like they would if they owned a commercial building or an apartment complex.
Short-term rentals, VRBOs, Airbnbs are considered 39 year property. It’s commercial property like a hotel is commercial property. It’s not 27.5 year property which is what a long-term rental would be such as a single family rental or an apartment building.
Is it worth is to doing cost segregation on an STR? Yes, of course. Where it might not be beneficial is if you just aren’t netting much profit or if you expect to sell your property within the next year or two. But generally, from what I hear, owners will net $25,000 – $50,000 per year.
In a cost segregation study, the property will be reclassified from all of it being 39 year depreciation to 5, 7, 15 and 39 year property giving you a much bigger deduction earlier on in the life of your ownership. Let’s use simple math to make some calculations. Let’s say you own an Airbnb and you have $600,000 all in. The land is about $100,000. That leaves you with $500,000 cost basis. Normally the FF&E is a separate expense from the real estate. In this case we figure you have this as a separate line item of $35,000 and it is not included in the real estate.
When we do a study on a building like this, we will generally see about 15-20% will be reclassified as 5 year class life property. The land improvements which are 15 year class life property will often come in somewhere in the 3-10% range depending upon the property. So for simple math, let’s say we identify 20% between the 5 and 15 year property. 20% of $500,000 is $100,000. You would get a $100,000 deduction against your income in year one or whenever you decide to do the study and apply it. Now in 2023, bonus depreciation has dropped to 80%. (If you own an STR that you placed into service between Sept. 27, 2017 and Dec. 31, 2022, you would qualify for 100% bonus depreciation). So that $100,000 in depreciation generated by our study would have 80% of that applied to reduce your taxes in 2023. Let’s say you net $50,000 in 2023. That’s after all your expenses, debt service and regular straight line depreciation. If you’re at the 32% tax rate, you’d owe the IRS $16,000. If you did cost segregation, you would owe ZERO and would have a loss carry forward that would eliminate most, if not all, of next year’s tax liability. The cost for such a study might be $3-4k. If you have owned the property for at least one tax year, you would need to file a 3115. That will end up costing you about another $1-2k to complete.
So if you own a short-term rental property and are making money, be sure to reach out to get a quote and see how it might work for you.
