2023 Short-Term Rental Bonus Depreciation Update and more…

2023 is a new year….  There is a lot of uncertainty in the air with rising interest rates and fears of recession. These fears are stoked by gurus proclaiming a housing bust is coming and some have coined it the Airbnb bust. Meanwhile, others claim that housing inventory remains low and that price decreases will be mild.

In the end, it is very hard to predict the market. It is likely, that rising interest rates will have a downward pressure on housing prices but how much is tough to predict. This is definitely something to consider when making a purchase. Evaluating properties with a long term, buy and hold strategy, will help mitigate this risk. The thing about real estate is that there are tons of market specific variations and inefficiencies. Blanket statements like “the housing bust and airbnb bust” may not apply to your market or even to specific properties.

The key to investing in 2023 is the same as any other year. As an investor, you must learn to analyze your market, short-term rental properties and make educated investment decisions. Maybe that means that you hold on purchasing in the first quarter or maybe you find a diamond in the rough, while others are running scared. Either way, right now is a great time to learn your market and watch for opportunities.

The year of 2023, is the beginning of the phase out schedule of bonus depreciation. This year bonus depriciaiton decreases from 100% to 80% and will continue to phase out over the coming years.

Why is that important?

Well if you are looking to begin investing in Short-term rental properties then this year you can still claim 80% bonus depreciation. 

How can this be achieved?

To maximize your tax savings you will need to purchase a short-term rental property in 2023 and place it into service (rent it) in 2023 and materially participate in the management of that property.

If you can do that and meet one of the 7 material participation test then you can deduct your “losses” against your non-passive income (w-2,1099)

What are material participation tests and why is this important to short-term rental investors?

To claim your losses as non-passive you will need to demonstrate that you materially participate in the management of your Short-Term Rental. 

That means you will need to manage your Short-Term Rental via Airbnb, VRBO or other services and demonstrate that you materially participated in the management of your property. (IRS link, Material Participation)

Although, there are 7 material participation tests there are three that matter most for Short-term rental investors.

1. You participated in the activity for more than 500 hours. 

(This would be the goal for an investor purchasing multiple properties in 2023.  The nice thing about meeting this test is that your participation does not need to be more than anyone elses)

2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity. 

(To meet this criteria, you need to do it all… no cleaners, handymen, rehabs etc… this would be hard to meet purchasing in January but might be possible at the end of the year… but still if that is your plan you are better off pursuing test #3)

3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.

(This test may be the most common test to qualify for material participation for investors purchasing one property.  One strategy here would be to purchase in the fourth quarter.  With that said, it is never too early to start learning about short-term rental investing and determining your ideal market… Plus you never know… you may decide that you want to purchase multiple properties and qualify using the 500-hour test…)

Brandon Hall describes this concept perfectly in “The Ultimate Guide to Eliminating Your Tax Bill While Sleeping Well at Night” by Brandon Hall CPA (The Real Estate CPA)

He writes most “AirBnB and VRBO properties are not considered “Rental Activities” under Section 469.”  Treas. Reg. Sec. 1.469-1T(e)(3)(ii)(A) provides an exception that states an activity is not a Section 469 rental activity if the average period of customer use for such property is seven days or less“.

Therefore, if Short Term Rentals do not count as Rental Activity then you do not need to qualify for REPS (Real Estate Professional Status) to claim losses as non-passive.  This means you can still practice medicine while enjoying your property and the tax benefits associated with short term rentals (As long as you pass the Material Participation test). 

How can you maximize your tax savings by purchasing a Short-term rental and materially participating in the management of that property?

One the most powerful strategies to implement is to perform a Cost Segregation combined with Bonus Depreciation…

What is a Cost Segregation study?

Cost segregation study: is a detailed property analysis performed by an engineer.  This study breaks down a property into components and identifies the components of the property that can be depreciated over 5, 7 and 15 years. The components that are in the 5, 7, 15-year category (qualified assets) can account for approximately 25% of the property purchase price (cost of land is excluded). Using 100% Bonus Depreciation you can deduct the 25% identified via the Cost Segregation study, in the first year of purchase. 

A general “napkin math” calculation is you can deduct approximately 25% of the property purchase price in the 1st year of purchase when you combine a cost segregation study with Bonus depreciation. In years past depreciation would be spread over 27.5 years (residential) to 39 years (commercial).

100% Bonus Depreciation

100% Bonus Depreciation: allows businesses to expense 100% of the components identified in the cost segregation study (5, 7, 15-year components) in the first year they acquire them, rather than depreciating them over a period of years.

This change was put into effect with The Tax Cut and Jobs Act (TCJA) from 2017 which added provisions to the IRS code Section 179 deduction, allowing business owners to take a bonus depreciation of 100% for qualified assets (Identified by a Cost Segregation Study) in the first year.  In years prior, bonus depreciation was limited to 50%. The 100% Bonus deprecation will begin fading out in 2023. 

100 percent After September 27, 2017, and before January 1, 2023

80 percent After December 31, 2022, and before January 1, 2024

60 percent After December 31, 2023, and before January 1, 2025

40 percent After December 31, 2024, and before January 1, 2026

20 percent After December 31, 2025, and before January 1, 2027

None After December 31, 2026

An Example of Cost Segregation combined with Bonus Depreciation: 

You purchase a property for $1,000,000 and perform a cost segregation study. 

The cost segregation study identifies that $250,000 worth of the property’s components fall into the 5, 7, 15-year category and qualify for bonus depreciation (25% of the purchase price).

After discussing with your CPA you elect to take 80% bonus depreciation of the cost segregated components for the tax year that you acquired the property.

If you pass one of the 7 material participation tests in managing your Short-Term Rental(s) you can take a depreciation expense of $200,000 (80% of $250,000) resulting in a tax saving of $74,000 depending on your Federal tax bracket (example uses the 37% tax bracket).

This is an unbelievable opportunity and incentives real estate investment.  Read about these principles and discuss with your CPA, financial advisors and investment team about these topics.

In addition, the Carpe Diem MD Short-Term Rental Course + Physician Burnout and Wellness CME is available

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