Recent years have seen demand skyrocket for short-term rentals promoted on sites such as Airbnb and VRBO. Investors are increasingly attracted to these properties to generate passive income, and they are moving aggressively into the market. Listings grew 9.4% in 2021 and are
The good news is that depreciation will allow many of these investors to realize significant tax savings. Completing cost segregation or other strategies to maximize these deductions can increase these savings even further. However, taxpayers will first need to determine if they will be able to utilize these deductions. Many short-term rental properties are owned as passive investments by non-real estate professionals. These owners need to consider the limitations on passive investments as they might reduce the amount of deductions they can utilize. However, if the owner is not subject to the passive limitations, or if they generate enough income, depreciation deductions can help to reduce the associated tax liability.
When figuring depreciation, the first issue to determine is the amount of land associated with the property. When a property owner acquires a rental property for $500,000, the entire amount is not depreciable — the IRS requires the taxpayer to separate out the non-depreciable land from the depreciable building. The easiest way to do this is to look at the tax assessment of the property and utilize the ratio of land to building. For example, if the assessment for a property lists the land at $100,000 and the building at $300,000, the IRS would consider the property 25% land. This means that with a purchase price of $500,000, the buyer can depreciate $375,000 of the purchase, with the other $125,000 attributed to the land. If a buyer considers the assessment ratio to be inaccurate, the land can be reappraised to determine its fair market value. However, this can often be cost prohibitive.
Many investors think they do not have land because they own a rental in a condominium building. But they are typically mistaken, as the condominium owner also owns a share of the common elements, including land, lobbies, elevators, etc. The IRS addresses this specific issue in Publication 527, “Residential Rental Property.” In Chapter 4, for example, the IRS explains that while condominium owners may pay dues to the condo association, the assets are owned by the condominium owners.
The second issue that short-term rental owners need to consider is the correct depreciable life to utilize. Most owners assume their rental will be depreciated over 27.5 years as residential rental property. However, this is often not the case. According to the IRS, 27.5-year assets are reserved for assets in which 80% or more of the income is being generated from dwelling units. To get the 27.5-year life, these dwelling units cannot be utilized on a “transient basis.” The IRS traditionally defines “transient” as stays of 30 days or less. This means most short-term rentals would be considered nonresidential and have a depreciable life of 39 years, similar to a hotel.
Not all is grim if a property needs to be depreciated as a 39-year asset. The Tax Cuts and Jobs Act of 2017 created a new class of property — Qualified Improvement Property. QIP consists of nonstructural improvements to the interior of nonresidential property after the property is placed in service. If a short-term rental is considered nonresidential, this means any interior renovations may qualify as QIP, which is good news — QIP is currently eligible for 100% bonus depreciation and can be written off in the year the assets are placed in service.
Additionally, owners of short-term rentals can look at other ways to maximize depreciation, such as cost segregation studies. These studies can help an owner maximize depreciation deductions, offsetting the income generated from the property. In the end, the owner maximizes cash flow, which can be used to pay down debt or acquire additional properties.
While the short-term rental market may be red hot, investors will do well to understand the tax implications of plunging in. Depreciation is just one of the many aspects to consider when building out an investment portfolio.
