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Cost Segregation Study for Short Term Rental Owners

If you're reading this article, you have likely heard about a Cost Segregation Study, but are possibly a bit confused by the whole idea.  

I get it, I was too.  In fact, I read an entire book about tax laws surrounding Short Term Rentals, and guess what??

THE BOOK NEVER EVEN MENTIONED A COST SEGREGATION STUDY! 

In this article, I'll try to give you enough information necessary to wrap your mind around this idea.  

But first, please note.  This is not tax advice. I am a financial planner, not a CPA. These are my interpretations of the tax laws. Ultimately since you need a qualified CPA to execute this strategy, I feel comfortable laying out the general puzzle pieces.  

We'll talk about:

What is a Cost Segregation Study?

 

First, let's look at depreciation. 
When you purchase a rental property, you are allowed to depreciate a portion of your cost basis in the property annually.  Depreciation is essentially a "phantom" loss for taxes.  You can use these phantom losses to offset rental income & in turn, lower your taxes. 

Example - You purchased a short-term rental property for $500k

Since you cannot depreciate land, you must subtract this amount out. (20% can be used for a general calculation)

This gives us $400k ($500k * 80%) as our cost basis / depreciable amount. 

Short-term rentals are depreciated over a 39-year timeframe, this gives you roughly $10,000 in annual depreciation that you can claim on your taxes. ($400k / 39 years)

Home purchased for $500k

Subtract ~20% for the cost of the land

$400,000 can be depreciated over 39 years 

= ~$10,000 / year in depreciation 

Let's think about this for a bit... 

Isn't it likely that you'll have to replace your furnace, appliances, landscaping & other various elements of your property sometime BEFORE 39 years? 

That's where the cost segregation study comes in.  A cost segregation study looks at every aspect of your property & divides it into a number of different depreciable time schedules.  

Before a Cost Segregation Study

$400k

The entire property is depreciated over 
39 YEARS

~$10K / YEAR
 

 

After a Cost Segregation Study

5 YEARS
 

7 YEARS
 

15 YEARS
 

Roughly 20-30% of your total depreciation will be allocated between these shorter depreciation schedules

39 YEARS

Remainder is allocated here. 
~70-80% of depreciable value

~$80,000 - $100,000

The Rest... 

Here's the super cool part...

Right now, you can 100% bonus depreciate all of these assets in year one! (you can deduct this entire amount from your taxes)

*Starting in 2023, you can only depreciate 80%. This is currently set up to decrease by 20% per year (60% in 2024, 40% in 2025 etc.)

That sounds cool!

BUT

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Unless you qualify, you can only use this deduction against your PASSIVE income.  

Passive Income examples
 

  • Rental Property

  • Book Royalties

  • Stock Dividends

  • Business in which you do not "actively participate"

Active Income examples
 

  • W2 Wages

  • Self Employment Income

  • Commissions

  • Business in which you do "actively participate"

At a base level, having $80-100k of losses to offset passive income is not as great as it sounds. 

Many do not generate enough passive income to get the full benefit of this $80-$100k deduction. 

Unless...

1) You (or your spouse) qualify for Real Estate Professional Status (REPS) or
2) You (or your spouse) qualify for the "short-term rental loophole."  

Real Estate Professional Status:
 

  • More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.

  • You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

IRS Pub 925

"Short Term Rental Loophole"
 

​1) You "Materially Participate" in your rental activity and:

2) Your average rental period is less than 7 days.  

IRS Pub 925

If you qualify under either of these scenarios, you may be able to use this $80k-$100k deduction against your Active Income!

Oversimplified, take $80k - $100k & multiply it by your marginal tax rate, that is how much you could potentially save in taxes! 

($100k * 22% tax rate = a potential $22,000 tax savings!)

You still following along?  Okay...

 

Caveats, Nuances & Hidden Benefits

Caveats: 

  • Everyone's tax situation is unique, you will NEED to work with a CPA or competent tax professional (make sure you factor in this cost)

  • You will also need to pay for a cost segregation study.  For a single-family home, this could cost as low as $2,000, for a larger commercial property this could cost tens of thousands of dollars.  

  • Depending on how long you plan to own the property, your current year tax benefit may be offset when you sell due to deprecation recapture tax. 

Nuances:

  • This is not an "additional" tax benefit. You are simply accelerating your total depreciable amount. 

    • IE - Instead of a ~$10,000 deprecation loss every year, you will likely take $80k - $100k in year one, and then ~$7k per year for the remaining 38 years. (rough math for illustration purposes)​

  • While you may have a great CPA, they may not be familiar with a Cost Segregation Study. 

    • IE - you may need to be willing to swap CPAs.  ​

Hidden Benefits:

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Pre-Cost Segregation Adjusted Gross Income (AGI)

Post-Cost Segregation Adjusted Gross Income (AGI)

State & Local Taxes

Child Tax Credits

Child & Dependent Care Tax Credits

Capital Gains Taxability
Partial Roth Conversions

  • Depending on your situation you may be able to stop paying taxes for the year. 

  • You may potentially receive a very large tax refund for the taxes you have currently paid in. 

  • Because so much of the tax code is tied to Adjusted Gross Income (AGI), lowering your AGI may allow you to:

    • Save on state and local taxes​

    • Qualify for Child Tax or Dependent Care Credits

    • You could lower your taxable income enough to allow you sell other assets at a 0% Long Term Capital Gains rate! 

      • Stocks, Bonds, Precious Metals, Jewelry or OTHER REAL ESTATE (held for more than 1 year)​

    • You may qualify to make Roth Contributions or to do Partial Roth Conversions at a lower tax rate. 

As you can see, there is a myriad of potential benefits, both obvious and not so obvious. 

 

What next? 

1) Run some real-world calculations to see your potential tax benefit.  

2) Establish a relationship with a Cost Segregation Specialist. 

  • Links & recommendations to come

3) Talk to your current CPA about a Cost Segregation Study

  • If they don't immediately understand what you're talking about, consult one of these CPAs who is knowledgable in Cost Segregation Studies (list to come)

4) Start planning for how you're going to maximize all of this additional cash flow! 

We're a different kind of financial firm than you may be used to. ​