Smart investors know short-term rental properties offer significant tax advantages. Combining a cost segregation study with bonus depreciation rules allows you to accelerate deductions, creating immediate tax savings and improving cash flow from your investment.
If you own a rental property, you already know about the benefit of depreciation. It's an excellent way to reduce your taxable income without spending an actual dollar. However, for a traditional long-term residential rental, you must spread out most of your deduction over a long 27.5-year period. That timeline can feel like forever when you are looking for tax relief right now.
Short-term rentals—properties with an average guest stay of seven days or less—are different. Under the tax code, if your STR activity meets certain requirements, it is not automatically classified as a passive activity. This non-passive classification is the key that unlocks a much more powerful tax strategy, especially when it comes to leveraging the largest deductions. It allows you to use property losses to offset other kinds of income, like salary or business profits, which is a massive win for high-income investors.
The real challenge for most property owners isn't knowing that depreciation exists; it's figuring out how to get the most benefit as quickly as possible. That is where the power of combining a cost segregation study with bonus depreciation comes into play. You don't have to wait decades for your tax breaks.
Think of your rental property not as one single building, but as a collection of many smaller assets. Most people simply depreciate the building as one large asset over its 27.5-year life. A cost segregation study changes that perspective entirely.
A cost segregation study is a detailed, engineering-based analysis of your property. A qualified professional literally walks through the property, analyzes blueprints, and reviews construction costs to identify and reclassify specific components.
The study provides a detailed report you must use to support your depreciation claims on your tax return. Without this formal analysis, the IRS requires you to stick to the standard, slower depreciation schedule. This process is complex, but the potential savings make it worth the effort for most commercial property owners.
Once the cost segregation study identifies those shorter-lived assets (5, 7, and 15-year property), the next step is to apply bonus depreciation. This is where the strategy becomes truly impactful.
Bonus depreciation is a tax incentive that lets you immediately deduct a large percentage of the cost of qualified property in the year it is placed in service, instead of spreading it out over its recovery period. This deduction is allowed for tangible personal property with a tax life of 20 years or less, which is exactly what a cost segregation study is designed to find.
For assets placed in service today, the bonus depreciation percentage has phased down from the previous 100% rate. You must check the current year’s percentage as it changes over time. Even with a reduced rate, claiming a large percentage of the cost of all those fixtures, furniture pieces, and land improvements as a first-year deduction creates substantial tax savings.
The combination of these two tools is exceptionally powerful. The cost segregation study identifies the components eligible for rapid write-off, and the bonus depreciation provision allows you to take that write-off almost entirely upfront.
Imagine you purchase a property for $\$500,000$. A typical cost segregation study might reclassify 25% of the cost, or $\$125,000$, into the shorter-lived categories. Without the study, you would get a small depreciation deduction on the whole building. With the study, you can take a significant deduction on that $\$125,000$ in the first year, drastically lowering your taxable income. This difference can generate a five-figure tax saving in the acquisition year alone. That money stays in your pocket, ready for reinvestment or other uses.
Generating a massive paper loss from depreciation is great, but you need a way to use that loss against your most important income sources—your W-2 salary or business profits. For most rental activities, losses are "passive" and can only offset other passive income. However, as noted earlier, STRs are different.
To fully use the accelerated deductions from cost segregation and bonus depreciation, you generally need to show the IRS that you materially participate in the short-term rental activity.
The IRS has several tests to determine material participation. You must meet any one of these seven tests. The most common one for STR owners is:
If you meet this test, your STR is treated as a non-passive activity. This means the large depreciation loss created by the combination of cost segregation and bonus depreciation can offset your non-passive (ordinary) income, leading to a much larger tax refund or a significantly reduced tax bill. You must keep very careful records of the time you spend on the rental activity to support this claim.
This is an advanced tax strategy. While the rewards are significant, there are pitfalls you must avoid to ensure you maximize your benefit and stay compliant with the IRS.
The best time to perform a cost segregation study is in the year you buy, build, or significantly renovate a property. This allows you to claim the maximum bonus depreciation rate in the first year the asset is placed in service. However, if you already own an STR and never had a study, it is not too late. You can still apply the strategy retroactively by filing a Form 3115, Change in Accounting Method. This lets you claim all the previously missed depreciation in the current year without having to amend past tax returns. It's like finding money you didn't know you had.
A key consideration is depreciation recapture. When you eventually sell the property, the depreciation you claimed must be "recaptured" and may be taxed at a less favorable ordinary income tax rate. By accelerating deductions now, you are essentially deferring tax into the future. It is a brilliant cash flow strategy that gives you the use of that money immediately. A good CPA will help you model this future tax liability so you can plan for it properly.
Trying to tackle a cost segregation study and bonus depreciation rules alone can be a recipe for headaches and potential errors. These studies are highly technical and must follow specific IRS guidelines, often requiring engineering expertise. Misclassifying assets or failing to properly document your claims can lead to issues later.
You need a qualified Certified Public Accountant who specializes in real estate and understands the nuances of short-term rental tax law, including the material participation rules specific to your area. These professionals provide clear guidance on the entire process, from performing the study to correctly filing the required forms. This level of expert help ensures you are maximizing your tax benefit while maintaining strict compliance. If you own a short-term rental property in the Fremont, Newark, Union City, Hayward, or Milpitas areas and want to discuss how this strategy can work for you, you should reach out to a trusted advisor who can offer a free consultation at their website.
Typical depreciation spreads the cost of your building over a long period, usually 27.5 years for a residential rental. A cost segregation study is a detailed analysis that reclassifies parts of the property—like carpeting, fixtures, or landscaping—into shorter tax lives, such as five, seven, or fifteen years. This process allows you to claim deductions much faster, giving you tax benefits sooner.
Yes, you can. While the best time to do a study is in the year the property is placed in service, you can perform one retroactively. The IRS allows you to file a Change in Accounting Method using Form 3115. This lets you catch up on all the depreciation you missed in past years and claim it as one large deduction in the current tax year, without having to amend your previous tax returns.
No, bonus depreciation only applies to qualified property with a recovery period of 20 years or less. This includes the shorter-lived assets—such as 5-year and 15-year property—that are identified and reclassified through a cost segregation study. The main structure of the building, which has a 27.5-year life, does not qualify for bonus depreciation.
For most commercial real estate and short-term rental properties, especially those valued over $\$250,000$, the answer is typically yes. The tax savings generated in the first year often outweigh the cost of the study itself. You should look at the calculation of the tax savings versus the study fee to confirm a short payback period.
For the best guidance, find a Certified Public Accountant who focuses on maximizing tax deductions for short-term rental investors, including the specialized strategies like cost segregation and bonus depreciation.
