Short-Term Rental Property Depreciation Considerations
The past few years have seen a surge in demand for short-term rentals promoted on sites such as Airbnb and VRBO. Investors are increasingly drawn to these properties to generate passive income, and they are aggressively entering the market. Enrollment increased by 9.4% in 2021 and is expected to grow by 20.5% in 2022. However, investors and their CPAs should be aware of the depreciation rules that apply to the short-term rental market.
The good news is that depreciation will provide many of these investors with significant tax savings. Completing cost segregation or other strategies to maximize these deductions can further increase these savings. However, taxpayers will first need to determine whether they will be able to use these deductions. Many short-term rental properties are held as passive investments by non-real estate professionals. These owners should consider the limits of passive investments, as they could reduce the amount of deductions they can use. However, if the owner is not subject to the passive limitations, or is generating enough income, capital cost allowances can help reduce the associated tax liability.
When calculating depreciation, the first question to determine is the amount of land associated with the property. When a landlord acquires a rental property for $500,000, the entire amount is not depreciable – the IRS requires the taxpayer to separate the non-depreciable land from the depreciable building. The easiest way to do this is to look at the property’s tax assessment and use the land to building ratio. For example, if a property’s appraisal lists the land at $100,000 and the building at $300,000, the IRS would consider the property to be 25% land. This means that with a purchase price of $500,000, the buyer can depreciate $375,000 of the purchase, with the remaining $125,000 going to the land. If a buyer considers the appraisal report to be inaccurate, the land may be reappraised to determine its fair market value. However, this can often be expensive.
Many investors think they don’t have land because they own a rental in a condominium. But they are usually wrong, because the condominium owner also owns a share of the common elements, including grounds, halls, 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 can pay dues to the condominium association, the assets belong to the condominium owners.
The second issue owners of short-term rentals need to consider is the correct amortization period to use. Most landlords assume that their rental will be amortized over 27.5 years as a residential rental property. However, this is often not the case. According to the IRS, assets at 27.5 years are reserved for assets where 80% or more of the income is generated by housing. To achieve the 27.5 year service life, these housings cannot be used on a “transitional basis”. The IRS traditionally defines “transient” as stays of 30 days or less. This means that most short-term rentals would be considered non-residential and would have a depreciable life of 39 years, like a hotel.
All is not bleak if a property is to be depreciated as a 39 year old asset. The Tax Cuts and Jobs Act 2017 created a new class of property – qualified improvement property. The QIP consists of non-structural improvements to the interior of a non-residential property after the property has been put into use. If a short-term rental is considered non-residential, that means any interior renovation qualifies as a QIP, which is good news – the QIP is currently eligible for 100% bonus depreciation and can be depreciated over the year. where the assets are put into service.
Additionally, owners of short-term rentals may seek other means of maximizing depreciation, such as cost segregation studies. These studies can help a homeowner maximize capital cost allowances, thereby offsetting the income generated by the property. Ultimately, the owner maximizes cash flow, which can be used to pay down debt or acquire additional properties.
Although the short-term rental market is hot, investors would do well to understand the tax implications of an investment. Depreciation is just one of many aspects to consider when building an investment portfolio.