For many of our clients, it is common for rental real estate to be part of their household asset mix. In recent years, the topic of owning short term rental properties has become even more common as the short-term rental movement has spread like wildfire.
One area that could potentially benefit you, if you own or are interested in purchasing a property for short-term rental use, is in completing a cost segregation study to accelerate the tax deductions that are available.
For a short-term rental property, think Air BNB or VRBO, the IRS looks at it as a “boutique hotel” and the standard depreciation timeline for this type of property is 39 years rather than 27.5 for a long-term rental. This means that the cost of purchasing the property is divided over the 39 year time horizon, and the cost is used as an expense accordingly to lower your taxable income.
A cost segregation study is an engineering-based study that breaks a rental property down into its components and allows for faster expensing of those components. Rather than simply depreciating the entire property on a 39 or 27.5 year schedule, different components can be depreciated, or written off as an expense, according to their classification per the IRS guidelines. Ultimately, the idea is to accelerate the expenses which could lower your taxable income faster.
To do this, the property is broken down into 5, 7, 15, and 27.5 year components (for a long-term rental) or 39 year property (for a short term rental or commercial property) depending on its “useful life” per the IRS guidelines. For example, the flooring, appliances, water heater, furnace, plumbing, cabinets, siding, roof, etc. are all categorized and accounted for independently, versus being included in the lump-sum value of the property.
Interestingly, land improvements that have already been completed, such as retaining walls, can be depreciated separately via cost segregation. Once a cost segregation study is completed, the cost allocated to the retaining walls can be depreciated over 15 years as a land improvement. Without the cost segregation study, the cost of the retaining walls is depreciated with the value of the home over a 39 or 27.5 year period.
It is important to remember that the land itself cannot be depreciated because land does not wear out, but land improvements like drainage systems, landscaping, driveways, patios, and sidewalks can.
Under the One Big Beautiful Bill Act of 2025, a first-year bonus depreciation deduction of 100% may be used for property purchased or placed in service on or after January 19, 2025. This only applies under certain circumstances, so please consult your advisor or tax professional before assuming that it applies to your property.
If the property is already in service and it is determined that a cost segregation study would be beneficial, then a Change of Accounting Method form would have to be completed by a competent CPA to change from straight-line depreciation to the schedules developed during the cost segregation study process.
Lastly, a very important consideration is that faster depreciation can lower taxable income now. However, recaptured depreciation will be taxable in the future if the property is sold. This is taxable up to 25% at the federal level. A 1031 exchange can avoid recaptured depreciation tax, but you will have to buy another property of “like and kind” to defer any unrecaptured depreciation or unrealized gain into the future. So, your estate plan also comes into consideration here, as we need to know what your ultimate goal for the property is long before we consider a cost segregation study.
So, why might this strategy benefit you? The faster depreciation of each asset class can be used to offset income from the property now, which could lower or eliminate your tax liability on the rental income. Depending on a few other factors, losses from the rental operation may offset other income you have, but that topic is a bit of a rabbit hole that we should go down another time.
If all of this sounds overwhelming, feel free to give us a call to see if a cost segregation study would be beneficial for your rental property. That is what we are here for; everything money touches.