The short-term rental (STR) market segment continues to grow and draw significant interest from real estate investors. AirDNA, a leading provider of data and analytics for the STR industry, estimates that overall demand for STRs and the total number of STR listings in 2022 will increase by >20% over 2021. 

2022 will be a record year for STRs, with more nights stayed in a rental than at any other point in history

Source: AirDNA 2022 Mid-Year Outlook Update

The high growth rate will continue to pull capital and new real estate investors into the STR market in 2022 and beyond. With the increased investments and number of individual and corporate investors operating in the STR space, comes a renewed focus on tax planning strategies that can help increase overall returns for investors. One tax planning strategy that is particularly popular amongst STR investors is Cost Segregation.

What is Cost Segregation?

Cost Segregation is an engineering analysis of real estate assets that is performed to identify and segregate the costs associated with components that can be depreciated more quickly for federal and state income tax purposes. Typically, rental properties are depreciated over 27.5 or 39 years for tax purposes. The primary purpose of a Cost Segregation analysis is to identify those assets which can be depreciated over 5, 7, or 15 years and are eligible for additional first year bonus depreciation (100% through the end of 2022). Depending on the property, as much as 20% or more of the building cost may be eligible for accelerated depreciation. The process of accelerating depreciation can defer income taxes and increase short-term cash flow (potentially freeing up more capital for additional investments).

How does Cost Segregation typically apply to real estate investors?

Cost Segregation is a strategy that has been around for decades, but has historically been reserved for large real estate investors and corporate property owners utilizing the real estate in their active trade or business (for example, a software company building a new corporate headquarters). These organizations have large amounts of income from active sources that can be offset by the accelerated depreciation deductions generated by a Cost Segregation study. 

However, the facts and circumstances for small real estate investors are typically much different than for those previously mentioned large real estate investors and corporate property owners. Rentals are generally considered passive activities and subject to passive loss limitations, meaning that a taxpayer typically cannot use losses from rental activities to reduce their income from active sources. A passive loss is generated, when the expenses (including depreciation) from rental activities exceed the income generated by the rental properties. Cost Segregation frequently results in passive losses, as the accelerated depreciation can greatly exceed the yearly income generated by the rental property. And unless certain exceptions are met (discussed in more detail later), these passive losses are essentially useless.

Example

Let’s consider a $500,000 single-family rental property as an example. It’s reasonable to assume that such a property is operating at a 5% cap rate, meaning it is generating net operating income or NOI (total operating income less operating expenses) of $25,000 per year. Assuming a 25% down payment on a 30 year fixed rate mortgage at 4% annual interest, the yearly interest expense will be approximately $6,200. Which brings the total net income down to $18,800 before considering depreciation expense.

After accounting for land, which is non-depreciable, we have $425,000 of depreciable building basis remaining (assuming 15% of the value of the property is associated with land). Without completing a Cost Segregation study, this property should be generating approximately $15,500 of depreciation expense on a yearly basis (residential rental property is depreciated over 27.5 years, so the yearly depreciation expense is equal to $425,000 x 1/27.5). 

Meaning our $25,000 of NOI is now down to $9,500 after considering interest and depreciation expense. Assuming no other expenses or considerations (i.e., additional passive activity losses), a taxpayer would be looking at a relatively small federal income tax liability associated with the rental property. If they are in the top marginal tax bracket, the federal income tax liability would be approximately $3,500.

Completing a Cost Segregation study for this property would likely generate an additional $40,000-$80,000 of first year depreciation expense (assuming 10-20% of the depreciable basis is reclassified as 100% bonus eligible property). But given that the taxpayer only has $9,500 of taxable income to offset, they would not be able to take full advantage of the accelerated depreciation for many years. Which greatly reduces the overall benefit of performing the Cost Segregation study.

How does Cost Segregation work for Short-Term Rentals?

Historically, the primary method for avoiding the limitations of the passive activity loss rules was to qualify as a real estate professional. In a nutshell, real estate professionals may treat rental activities as non-passive if certain requirements are met and thus can use the losses to reduce their income from active sources. The requirements for qualifying as a real estate professional are complex and should be discussed with your tax advisor. But generally speaking, an individual must spend the majority of their time in real property businesses (i.e., development or redevelopment, construction or reconstruction, acquisition or conversion, rental, management or operation, leasing, or brokerage) in order to be considered a real estate professional. “Majority” meaning that they spend more than 50% of their time working in real property businesses AND more than 750 hours of service during the year. 

But real estate professional status is a high bar which is typically not attainable for small real estate investors (not many people have an additional 750 hours, or 15 hours per week, to spend working in real estate outside of their 9-5 job). Enter short-term rental properties and the ability they provide to avoid the passive loss limitations.

There are two primary factors for determining whether owning and operating an STR (or portfolio of STRs) is considered an active activity:

1. The average period of customer use must be 7 days or less, AND
2. The taxpayer must materially participate in the business, meaning they worked more than 100 hours in the activity during the year AND no one else worked more than the taxpayer

The average length of stay for most vacation rentals is between 5 and 6 days, so most STRs should meet the first requirement. It is also reasonable to assume that most STR owners are spending more than 2 hours per week managing their rentals, so would likely meet the 100 hour requirement. But the owner must also work more hours than anyone else works in the business, including property managers, cleaners, contractors, and maintenance workers. So the taxpayer must be prepared to prove that none of those other individuals spent more time working on the STR during the year then they did. This becomes easier for STR owners who self-manage and/or self-clean their properties.

Considering the same example discussed above, an individual who owns an STR and meets the requirements discussed above could use the additional $40,000-$80,000 of first year depreciation expense to offset their income from active sources. Assuming again that this individual is in the top marginal tax bracket, their year 1 federal income tax liability could be reduced by as much as $15,000-$30,000 (this tax liability is typically deferred to future years). More than enough to justify the cost and effort associated with completing a Cost Segregation study.

This is a huge amount of potential savings for a relatively small costs (typically < $3,000 for small STRs). It is easy to see how these savings could provide a small real estate investor with the additional capital needed to make additional investments (either capital improvements to existing properties or purchasing additional investment properties for their portfolios). This is the value of Cost Segregation for STR and it can be significant.

Other Considerations

In addition to the considerations discussed above, there are additional factors that STR investors should consider prior to completing a Cost Segregation study. These factors include the following:

• Cost Segregation is a tax deferral strategy. Unless the taxpayer plans on executing 1031 exchanges until they die or investing the capital gains in a qualified opportunity zone fund, the taxes will come due eventually. This happens in a combination of two ways. First, the accelerated depreciation in the early years results in less depreciation in the later years. Second, when the property is sold, the taxpayer will likely be subject to capital gains taxes and depreciation recapture. These considerations are complex in and of themselves and could be the subject of an entirely separate blog post.

• The federal income tax system is progressive, meaning that taxpayers with higher taxable incomes pay higher federal income tax rates (or vice versa). But each marginal tax rate only applies to taxable income over and above the taxable income that was taxed at the rate for the previous bracket. The brackets vary based on filing status, but are narrow enough that the accelerated depreciation from a Cost Segregation study could move a taxpayer 1 or 2 tax brackets lower. Meaning that their marginal tax rate could be reduced significantly and that the tax savings from each additional dollar of depreciation will decrease.

• The documentation requirements for supporting the treatment of a STR business as non-passives can be complex and onerous. Taxpayers should be prepared to defend this treatment with to the IRS with detailed records.

Conclusions

There is a lot to consider when it comes to short-term rental properties and Cost Segregation studies. Each taxpayer’s facts and circumstances are different and should be discussed with a tax professional prior to implementing any tax planning strategies. If you have any questions regarding Cost Segregation for STRs, please reach out to Andrew Kohrs at [email protected] or visit our dedicated STR Cost Segregation website at www.strcostsegregation.com.