The IRS considers rental income passive income, meaning you cannot use the associated passive losses to offset your active business or W-2 income.
In this post, we’ll explore powerful exceptions allowing you to make your losses non-passive. Moreover, with a cost segregation study for short-term rentals, you’ll learn how to take a substantial depreciation deduction early to create a loss to lock in massive tax savings.
Your short-term rental property will likely benefit from cost segregation. Contact our team today to find out how much you can save with a cost segregation study.
Why Do Real Estate Investors Choose Cost Segregation on Rental Property?
Cost segregation is one of the most powerful tax strategies available to you as a short-term rental property investor. Consider a typical beach-front vacation home. The property likely consists of:
- Appliances: refrigerator, stove, oven, washing machine, dryer, coffee maker, blender, toaster, etc
- Electronics: television, sound system, etc
- Beautiful (and likely costly) furniture
- Plumbing and electrical systems
- Elaborate window treatments
- Decorative light fixtures
- Seawall or bulkhead
- Swimming pool
- Data cabling
- Landscaping
- Kitchenware
- Hot tub
- Linens
- and more
All the above-listed components are unlikely to last more than 20 years. In fact, the IRS expects these components to last 5, 7, or 15 years.
What does the average short-term rental owner do, though? They depreciate the entire property, including its short-life components, linearly over 27.5 years.
The smarter approach would be to separate the shorter-life property components from the longer-life real property and subject them to different depreciation schedules consistent with their actual useful lives. To do this accurately, you must do a cost segregation study.
Tax Benefits of Cost Segregation for Vacation Rentals
Because the typical vacation home has substantial personal property that only lasts 5, 7, or 15 years, cost segregation offers short-term rental investors significant benefits.
The shorter depreciation schedules create bigger deductions early, leading to significant tax savings when you really need them to grow your portfolio. Because of the time value of money, the savings are worth more to you now.
Benefits of cost segregation include:
- It helps you front-load depreciation so you can take a bigger deduction early.
- Bigger tax savings improve your cash position, reducing your dependence on expensive mortgage loans.
- It allows you to take advantage of bonus depreciation.
Bonus depreciation is an incentive allowing you to deduct a substantial percentage of a property’s depreciable value in the first year.
Assets with a recovery period of 20 years or less qualify for bonus depreciation. Therefore, all the components of your property that would benefit from accelerated depreciation under cost segregation would qualify as the recovery periods are 5, 7, and 15 years.
The 2017 Tax Cuts and Jobs Act (TCJA) allowed for 100% bonus depreciation through 2022 with the following phase-out schedule:
- Up to 2022 – 100%
- 2023 – 80%
- 2024 – 60%
- 2025 – 40%
- 2026 – 20%
- 2027 – 0%
TCJA has been largely a success. The One Big Beautiful Bill Act signed into law on July 4, 2025 made some of its key elements permanent. Bonus depreciation is now back to 100% for properties purchased and put in service after January 20, 2025.
What does, say, 60% bonus depreciation mean? Take a property put in service in 2024 with a depreciable building value of $900,000. If you do cost segregation and find that $252,000 in components are 5-, 7-, and 15-year properties, you can deduct $151,200 in the first year (60% of $252,000).
Claiming a substantial amount like $151,200 in the first year might create a scenario where depreciation outpaces your income. Note that you also get standard depreciation (27.5 years) on the remaining depreciable building value. You will likely have a paper loss.
Ordinarily, this is a passive loss, and you can only carry it forward to offset future passive income. For vacation rentals, however, depreciation rules for short-term rentals might give you some interesting wiggle room.
Depreciation Rules for Short-Term Rental Properties
You can only use passive losses to offset passive income. Rental income is generally classified as passive income. However, with short-term rentals, conditions exist where the IRS will treat your income as active income.
Such conditions will make your losses ordinary losses, meaning you can use the loss you created by taking substantial depreciation in the first year to offset any income, including your active business and W-2 income.
You need to pay attention to three exceptions if you want to make your rental income non-passive. Let’s explore how you can qualify for them.
1. Short-Term Rentals (STR)
If guests stay in your short-term rental for an average of seven days or fewer, the IRS can treat your rental income as active income.
The nature of the operation requires you to spend time communicating with guests and doing tasks like cleaning. Therefore, it’s more like an active business.
You’d still need to prove material participation, though. Because the IRS no longer considers your rental income passive, you can deduct losses against other active income, including your W-2.
2. Material Participation
If you or your spouse participates materially in managing the property, you might pass the IRS’s material participation tests.
The most common IRS tests for material participation are:
- You do all the work, or
- You spend 500+ hours total, or
- You spend 100+ hours total, and no one else clocks more than you.
You can handle bookings, clean the property, communicate with guests, and perform other relevant tasks to qualify.
3. Real Estate Professional (REP) Status
You can achieve REP status if you or your spouse:
- Spend 750+ hours in a real estate trade or business, and
- Earn more than half of your total income from your real estate trade or business
In meeting the above STR, REP status, or material participation conditions, your rental losses from your short-term rental are no longer passive – you can use them to offset all income.
That said, we advise you to consult a CPA familiar with short-term rentals, cost segregation, and bonus depreciation before making such deductions.
When to Perform a Cost Segregation Study
You want to do a cost segregation study in the year you put a property in service, or as soon as possible.
Cost segregation at its core is a proactive tax strategy. Instead of waiting for tax season to start scrambling for deductions, you can do cost segregation year-round to lock in predictable tax savings.
By capturing the tax savings now, you get to benefit from the compounding benefits of the time value of money.
We believe most properties valued at $450,000+ can benefit from cost segregation. As a real estate investor, you should always be running the numbers. If a cost segregation study costs you a couple of grand and saves you, say, $80,000 in taxes, it’s an easy call.
Speak with our team to get a free preliminary analysis of your property to see how much you can save.
Steps to Conduct a Cost Segregation Analysis
When working with a reputable cost segregation company with established processes, a cost segregation study will be pretty straightforward. The analysis will likely involve the following steps:
- Gathering ownership documentation as well as building/architectural plans.
- A virtual or on-site inspection of the property.
- A comprehensive analysis to identify and reclassify building components.
- Creation of a detailed report supporting the analysis and cost allocations.
You and your CPA can then review the report and use it to inform your tax strategy. Seneca Cost Segregation offers post-study support to help you and your CPA implement the findings of the study effectively.
Common Mistakes to Avoid in a Cost Segregation in Short-Term Rental Strategy
You want to avoid the following mistakes when considering cost segregation for a short-term rental.
- Not engineering an “active income” scenario: You want the IRS to consider your rental income non-passive so you can offset active income.
- Not paying attention to personal use days: A temptation exists to use your own vacation rental. If personal use exceeds 14 days or 10% of the total rental days, you run the risk of your property being reclassified as a home, making you unable to claim deductions.
- DIY cost segregation: We advise against doing your own cost segregation study as it increases audit risk significantly. The IRS provides extensive guidelines that every study must abide by. It is best to let a professional firm like Seneca Cost Segregation handle the exercise.
Frequently Asked Questions (FAQs)
Let’s answer some commonly asked questions about cost segregation.
What Is the Minimum Property Value for a Cost Segregation Study?
You can do cost segregation on any property of any value as long as the potential tax savings justify the cost of the study.
Cost segregation is likely feasible if you have a property worth $450,000+.
Can I Do a Cost Segregation Study After Renovation?
Yes, you can do a cost segregation study after renovations. In fact, it’s encouraged as such improvements often include adding shorter-life personal property that can benefit from accelerated depreciation under cost segregation.
Does a Cost Segregation Study Trigger an Audit?
Cost segregation is a legitimate tax strategy. Because it’s approved by the IRS, it’s unlikely to trigger an audit if done well.
Big real estate companies have been doing cost segregation for decades. You are probably considering it now because firms like Seneca Cost Segregation have made it accessible to most real estate investors.
How Long Does a Cost Segregation Study Take?
How long a cost segregation study takes depends on the capacity of the cost segregation company and the size or complexity of the property.
At Seneca Cost Segregation, we conclude most studies within two to four weeks.
Can I Apply Short-Term Rental Accelerated Depreciation in the First Year?
If you place the property in service in the said tax year and conduct a cost segregation study to classify shorter-life assets, you can take bonus depreciation in the first year.
That said, pay attention to STR, REP status, and material participation rules to determine if you can also offset your active business income.
Who Should Perform a Cost Segregation Study for Rental Property?
Most rental property investors with properties worth $450,000+ will benefit from a cost segregation tax strategy. If you are looking for immediate tax relief to improve cash flow, consider commissioning a cost segregation study.
Conclusion
Short-term rentals, due to the substantially shorter life of the personal property they contain and the possibility of offsetting active income, are a gold mine for tax planning.
If you own short-term rentals and want to improve cash flow, a cost segregation study can be a slum dunk. Contact us today to lower your tax bill with a cost segregation study.
