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Airbnb Tax Savings: Understand Bonus Depreciation, Cost Segregation, and Tax Deduction Strategies
Written By: Parker Place on July 17, 2023
If you have income from a W2 job or self-employment and are unsure about the tax savings associated with real estate, particularly from a Short Term Rental (Airbnb) purchase, this guide is for you. It aims to clarify the implications of tax cuts and how they can benefit you.Try our free tax calculator
Who is this for?
This guide is intended for short-term rental investors who want to reduce their taxable income and retain more cash flow. The objective is to utilize real estate tax deductions and depreciation to lower your taxable income from your primary income source, such as a W2 job.
The Real Estate Professional (REP) Qualification. Hint, you probably don't qualify
Most real estate investors, including yourself, do not qualify as real estate professionals under IRS guidelines. To be considered a REP, you must spend at least 750 hours per year and more than 50% of your working hours in real estate businesses where you materially participate. Meeting these requirements means making real estate your primary job, which most part-time or casual investors fail to achieve.
As a REP, the primary tax benefit is the ability to deduct rental real estate losses against non-passive income, such as income from your day job. This deduction is typically not available for passive investors and can significantly reduce your taxable income, resulting in substantial tax savings.
The good news is that as a Short Term Rental investor, you can reduce your taxable income by thousands without qualifying as a Real Estate Professional.
But, you still may qualify for the Short-Term Rental Tax Loophole
The tax code's Reg. Section 1.469-1T(e)(3)(ii)(A) provides a significant tax-saving opportunity for rental properties. Here are the six exceptions where income from a rental property is not considered passive:
- The property is rented out for an average of seven days or less.
- The property is rented out for an average of 30 days or less, and significant services like daily cleaning or meals are provided.
- Extraordinary services are provided to customers, irrespective of the rental period.
- The rental is incidental to a non-rental activity of the taxpayer.
- The property is made available for non-exclusive use during regular business hours.
- The property is used in a partnership, S corporation, or joint venture activity in which the taxpayer has an interest.
To take advantage of this loophole, you must meet one of the seven "material participation" criteria. Most Airbnb investors qualify for 1-3. These criteria determine your eligibility for "Material Participation" and are as follows:
- Spend more than 500 hours on the short-term rental business.
- Do substantially everything for the STR business.
- Commit over 100 hours, and no one else spends more time than you.
- Participate significantly for more than 100 hours, with combined activities exceeding 500 hours.
- Engage in the business for five of the prior ten taxable years.
- Provide non-income producing personal services for three of the past taxable years.
- Show regular and continuous participation exceeding 100 hours.
Once you qualify for both the Short-Term Rental loophole and Material Participation, you can use deductions and depreciation from your STR property to reduce your personal taxable income because your property is considered active, not passive.
Utilizing Depreciation for Tax Savings
Depreciation allows you to lower your taxes by covering the aging and wear and tear of your property's structure or equipment. It deducts a portion of the property's cost each year, gradually reducing your taxable income. For short-term rentals, you can benefit from accelerated depreciation.
How to Lower Your Taxes via STR Depreciation:
To maximize your STR tax benefits, consider conducting a Cost-Segregation study on your property. This study separates your property's structure into different components, enabling you to depreciate them over 5 and 15-year accelerated depreciation schedules. A Cost-Segregation study typically costs around $1-3,000. Without it, you would have to depreciate the entire property structure over a traditional 39year schedule, resulting in lower annual depreciation amounts. Usually, 20-30% of a property qualifies for accelerated depreciation.
Bonus Depreciation - the JUGGERNAUT of STR Tax Savings
Bonus Depreciation, a significant tax incentive, allows you to claim 80% of your accelerated depreciation in the first year. It permits an immediate deduction of a large percentage of the purchase price of eligible business assets instead of spreading them over the asset's "useful life." The Tax Cuts and Jobs Act allows for 80% bonus depreciation through 2023, with a 20% per year reduction in subsequent years.
Example Property Tax Analysis:
Suppose you earn $100K a year and purchase a $500,000 property for short-term rental.
- After separating the land value from the home's value, let's say the home's structure is worth 75% of the purchase price, which amounts to $375,000.
- A cost segregation study reveals that 40% of the structure qualifies for accelerated depreciation. So, $375K (structure value) x 40% = $150K of accelerated depreciation.
- In year one, you can claim 80% of the $150K in bonus depreciation, which amounts to $120K.
- Additionally, you can claim A) the remaining 20% depreciation over 5/15 year schedules, B) Standard Depreciation, which is 60% of the structure value over a 39year schedule, C) mortgage interest payments, and D) renovation and furniture setup costs.
- The total deduction for year one would be approximately A) ~$4.5K + B) ~$9,500 + C) $24,000 + D) ~$10K = $148K. Keep in mind that you should also factor in the cash flow from your STR into your income.
By purchasing a $500K STR property, you could deduct approximately $148K from your personal W2 or self-employed income in the first year. If your income is taxed at 30%, this could result in approximately $44K in savings.
Your Next Steps as an Airbnb Investor
- Understand the tax code's short-term rental loophole and its exceptions.
- Check if you meet one of the seven material participation criteria.
- If you qualify, use deductions and depreciation from your STR to reduce personal taxable income.
- Hire a real estate CPA and conduct a Cost-Segregation study on your property to identify components qualifying for accelerated depreciation schedules.
- Understand and apply bonus depreciation rules for the current tax year.
- Separate the land value from the property's structure value in your tax records.
- Factor in STR cash flow into your income calculations.
- Calculate potential deductions and tax savings based on your income tax bracket.