If you want make successful investments, you need to know how to optimize taxes for vacation rentals. The ability to claim depreciation deductions on your annual taxes is a significant advantage, allowing you to write off a portion of your investment cost basis over time. Knowing how to calculate and apply these deductions optimizes returns from the rental property. Uncover the basics of rental property depreciation, how it works, and strategies for maximizing its benefits when investing in short-term rentals or other real estate ventures.
For informational purposes only. Always consult with an attorney, tax, or financial advisor before proceeding with any real estate transaction.
What is Rental Property Depreciation?
Depreciation is a loss in value caused to age, use, or obsolescence, referring to physical damage or degradation. In a short-term rental property, depreciation refers to the allowable tax deduction for wear and tear on the property. This deduction helps offset some of the expenses of running a short-term rental. Rental property depreciation is a valuable tool for real estate investors because it allows them to reduce taxable income while increasing cash flow.
How Does it Work?
Rental property depreciation works by letting owners deduct certain expenses related to their investment from annual taxable income. Cost recovery periods and cost basis play the most important roles. By accurately estimating these figures, investors can be confident in reporting accurate depreciation every year.
Benefits of Depreciation
The primary benefit of rental property depreciation is that it lowers your tax liability, which means more money in your pocket. Besides that, these deductions help offset other costs associated with successful real estate ventures, such as repairs and maintenance, insurance premiums, and so on.
Finally, depending on the profit made during ownership, you may be eligible for capital gains tax relief if you maintain documentation on purchases/repairs made throughout ownership.
Calculating Rental Property Depreciation
To calculate the amount of depreciation you can claim on your taxes each year, divide the cost basis by the recovery by the recovery period.
What Is the Cost Basis for a Short-Term Rental Property?
The cost basis refers to the original cost of financing your vacation home, along with any additional expenses incurred to acquire, improve, or rehabilitate the property. It is an important factor in determining the taxable gain or loss when you sell or dispose of the rental property.
The cost basis typically includes the following:
Purchase Price: This is the amount you paid to acquire the rental property. It includes the purchase price itself, along with any additional costs such as closing costs, legal fees, and real estate agent commissions.
Capital Improvements: Any substantial improvements or additions made to the property that increase its value or extend its useful life can be added to the cost basis. Examples include renovations, additions, or significant repairs.
Closing Costs: Expenses incurred during the purchase or sale of the property, such as legal fees, title insurance, and recording fees, may be added to the cost basis.
What Is the Recovery Period for a Short-Term Rental Property?
The recovery period of a rental property is the timeframe for which you can claim depreciation for your investment. The IRS allows you to account for the gradual decrease in value over a span of 27.5 years. However, commercial properties (e.g. rental buildings with 5 or more units) depreciate over 39 years. The annual deduction amount is determined using an IRS-approved method that accounts for criteria such as recovery period, asset type, and adjusted basis.
Different recovery periods may apply when figuring depreciation deductions, depending on the type of assets in your rental property portfolio. Improvements made to enhance efficiency or safety are commonly depreciable assets and may include structures, fixtures, and appliances.
Applying Rental Property Depreciation to Vacation Rentals and Airbnb Investments
All vacation rental investors need to be aware of the rules and limitations of claiming a deduction. Depreciation allows you to deduct a portion of the cost of certain assets over time, reducing your taxable income.
You can reduce your taxes by spreading out the costs of owning rental properties over several years instead of having them all hit at once. For example, if your cost basis is $100,000, you can divide that by 27.5 (the standard residential real estate recovery period), then deduct $3,636 from your annual taxable income annually.
IRS criteria for being depreciable:
- You must own and use the asset for business or investing
- You must use one of two methods approved by the IRS (straight-line or accelerated) when calculating depreciation deductions.
There are also limits on claimable depreciation. If an asset fully depreciates before its recovery period ends (for instance, if you sell it before then), remaining deductions are not allowed. Any improvements made after purchasing an asset may not qualify for additional deductions beyond what was already allowed based on the original purchase price. Finally, the depreciation recapture rules imposed by the IRS only allow deductions of half of any gain realized upon sale.
Understanding how rental property depreciation works is essential for maximizing returns from vacation rentals and Airbnb investments while minimizing tax liabilities. By taking advantage of bonus depreciation rules and utilizing cost segregation studies where applicable, investors can ensure maximum benefit without running afoul of IRS regulations.
Strategies for Maximizing Rental Property Depreciation Benefits
Taking Advantage of Bonus Depreciation Rules
Introduced in 2017, the Tax Cuts and Jobs Act brought about a new category of property known as Qualified Improvement Property (QIP). QIP specifically pertains to non-structural enhancements made to the interior of commercial properties after they have been put into service.
If you buy a short-term rental investment that falls under the categories of transient or commercial and you undertake interior improvements, you might be eligible for accelerated depreciation benefits through QIP. This particular property classification enjoys a shorter depreciable lifespan, allowing you to claim bonus depreciation in the tax year when the property is placed into service. By taking advantage of these provisions, you can potentially enhance your tax deductions for the qualifying improvements made to your rental property.
Utilizing Cost Segregation
An option for investors to optimize their rental property depreciation benefits is to do a cost segregation study. Based on the depreciation of investment real estate, this is a deduction that real estate investors can claim on income taxes each year to help recover the cost of owning, operating, and maintaining that property.
A cost segregation study can help you get the most out of your investment property depreciation by breaking down assets into smaller ones, allowing for various rates. The yearly deduction amount rises due to the accelerated depreciation schedule, lowering the taxes owed each year.
Maximize Your Rental Income With Depreciation
Vacation rentals can be a great investment if you know how to leverage your depreciation. By understanding how rental property depreciation works and utilizing strategies for maximizing its benefits, investors can ensure their vacation rental business is as profitable as possible.
For informational purposes only. Always consult with an attorney, tax, or financial advisor before proceeding with any real estate transaction.