Cost Segregation for the Airbnb Sensation

At this point, who hasn't booked a stay at an Airbnb or VRBO? Many of us have had our fair share of wonderful experiences at these "home away from home" stays. But... Have you ever thought about diving into the thrilling world of owning your own Airbnb? I know this thought has crossed my mind a time or two.

Well, saddle up because Airbnb and VRBO properties are like the golden ticket to a whole new level of real estate investing excitement. Imagine owning your own piece of paradise in those dreamy destinations you've always wanted to explore. But here's the twist: you're not just getting a property, you're getting a canvas to create memories and cash flow.

Think about it – you're not dealing with the same old rental game here. With Airbnb and VRBO, you're becoming the mastermind behind unique stays that travelers rave about. You get to sprinkle your personality into every nook and cranny – from that cozy cabin in the woods to that chic city pad with skyline views. And your guests aren't just looking for a place to crash; they're after an experience, and you're the host with the most.

But let's talk brass tacks. Sure, the potential for serious profit is sweet, but what's even sweeter is the tax savings benefits that turbocharge your profits and maximize your gains by tapping into clever strategies like cost segregation.

Let's embark on a journey where financial growth meets unforgettable experiences – all in the realm of Airbnb and VRBO real estate investing.

Short-term Rental Tax Savings Strategy

Short-term rental properties (AirBnb/ VRBO) have emerged as compelling investment avenues for high-income earners and new to the scene real estate investors. Beyond delivering impressive cash-on-cash returns and appreciating asset values, they offer a unique opportunity to significantly reduce tax burdens. Effective utilization of these tax benefits, demands sophisticated strategies and not loopholes as they are sometimes referred to. The objective is to work within the confines of the tax code to maximize your tax savings. This strategy is a fully sanctioned IRS method of tax savings. But still, it is advisable to work closely with tax advisors and CPAs that understand the tax code and real estate to ensure you meet all qualifications.

And if you do… The tax savings can be immense! Let’s begin.

?Whether you're a prospective short-term rental investor or a seasoned one, adopting the right tax approach could translate into substantial savings spanning years. Here’s how to Unlock the Power of Short-Term Rentals. But first, let's take a step back and see how and where this strategy derived from.

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A Historical Perspective

Short-term rental properties have traversed a dynamic journey, with pivotal tax milestones influencing their appeal. In the 1980s, the Tax Reform Act of 1986 reshaped tax landscapes and introduced key alterations:

• Tax Reform Act of 1986: Decreased federal income tax rates and introduced Passive Activity Rules, impacting rental property taxation
• Passive Activity Rules: Transformed rental properties into passive activities, changing the rules for tax deductions against active income
• Real Estate Professional Status (REPS): Introduced in the mid-1990s, allowed non-passive losses from rental properties for real property business owners and professionals within the real estate industry

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The Short-Term Rental Tax Strategy

The short-term rental tax strategy provides a potent avenue to trim taxes without requiring real estate professional status (REPS). This concept, found in Reg. Section 1.469-1T(e)(3)(ii)(A) of the tax code, excludes specific short-term rental income from being automatically classified as passive. This distinction is vital for generating tax savings:

• Criteria for Exclusion: Six conditions exempt income from the definition of rental activity, making it non-passive
• Key Conditions Include: Average stays of seven days or less, or 30 days with substantial personal services

Material Participation Tests: The tax code provides seven ways to qualify, but you only need to satisfy one. Here are the requirements.

1. You spend more than 500 hours working in your short-term rental business
2. You carry out all the necessary tasks to run the business yourself
3. If working with someone else, your participation must be greater than 100 hours and equal to the number of hours they put in
4. You significantly participate in activities for more than 100 hours, with 500 combined hours of participation in the business
5. You participated in the activities in five of the last 10 years
6. You participated in a personal service activity for three of the previous taxable years
7. You worked more than 100 hours in the business on a regular, continuous basis

Strategies for Short-Term Rental Tax Benefits

Unlocking the full tax-saving potential of short-term rentals involves leveraging two powerful strategies: non-passive losses and accelerated depreciation (Cost Segregation). These approaches form the cornerstone of a comprehensive tax reduction plan:

1. Non-Passive Losses:

• The Goal: Generate non-passive losses to offset non-passive income (like W-2 earnings)
• Material Participation Tests: Satisfy at least one of seven tests menetioned above
• Excluded Income: Non-passive losses derived from non-passive activities can be used to reduce tax liability

2. Accelerated Depreciation:

• The Mechanism: Reclassify specific components within the property into their shorter depreciable lives
• Depreciation Period: Short-term rentals depreciate over 39 years. In the eyes of the IRS, STRs are seen like a hotel with annual stays 7 nights or less
• Cost Segregation Study: Accelerate the shorter depreciation timelines (i.e. 5 & 15 years) to maximize deductions
• Bonus Depreciation: Currently at 80% (2023), allows immediate expensing of certain components specified in the study
• Phased Approach: Bonus depreciation decreases 20% annually and is set to phase out by 2027. Good News- The property is "grandfathered" in to the Bonus amount for the year the property was placed in service.

Here’s why this is powerful:

5 and 15-year property can generally represent anywhere from 20-35% or more of a property’s purchase price. Let's see the numbers to help drive this point home.

Back of the napkin Example:

If I purchase an Airbnb for $750,000 and perform a cost segregation study on the property, anywhere from $96,000 - $168,000 could be accelerated and depreciated.

Show your work:

• $750k purchase price

Let’s allocate 20% to land (non-depreciable)

Yields a Cost Basis: $600,000

• $600,000 x 20%-35% (avg reclassification for STRs)

Yeilds $120k - $210k that can be reclassififed and accelerated.

• $120k - $210k x 80% bonus (2023 Bonus allotment)

Yields $96,000 – $168,000: This is the accelerated amount from the cost seg study to be used in the first year of ownership.

Now let's calculate the After-tax savings:

Simply take the above numbers ($96,000 -$168,000) and multiply them by your tax bracket. In this case, 35%

After-Tax Savings: $33,600 - $58,800

Now this is an overly simplified version of what actually takes place during an actual cost segregation analysis, but this example can give you an idea of what to expect.

In this example, I could expect anywhere from $33,600 to $58,800 or more in after-tax savings which could be directly applied to my Airbnb income or personal W2 income (as long as I meet the qualifications mentioned above). Moreover, I can apply this same principle to all of my Airbnb rentals and drastically increase my tax savings. I can then roll forward any additional tax savings not utilized in my tax year until they are all accounted for.

This is powerful since my losses qualify as non-passive, the tax savings I received from the cost segregation analysis can be used to offset taxes derived from my personal W-2 income; making this a tremendous tax-saving strategy for high-income earners, medical professionals, attorneys, etc. By lowering my tax bill to the IRS or wiping it out entirely, I have now created cash flow to either:

• Reinvest and purchase more property
• Renovate/ design current portfolio
• Take a trip arond the world!

The short-term rental strategy has become a great avenue for everyday individuals to enter the real estate market and reap the same benefits as real estate professionals without giving up their day job.

Partnering for Success: Expert Real Estate Tax Strategies

Optimizing short-term rental tax strategies requires seasoned guidance. Engaging experienced professionals ensures precise execution and maximum benefits. I strongly encourage aligning with Cost Segregation experts like CSSI that perform engineering base studies that provide peace of mind for potential IRS scrutiny as well as partnering with Tax and CPA professionals proficient in real estate tax strategies to ensure you meet the material participation requirements.

In a Nutshell:

Short-term rental investments offer everyday real estate investors a friendly tax haven to qualify as their own Real Estate Professionals under specific provisions outlined for STR investors. This strategy allows for these investors to now pass through tax savings from their rental(s) depreciation to offset tax liability derived from their W-2 income. Keep in mind, effective tax strategies encompass non-passive losses and accelerated depreciation through cost segregation. Partnering with experienced real estate tax advisors and cost Segregation specialists is the key to harnessing these strategies for optimal tax savings and long-term prosperity.