Can Short-Term Rental Properties Be Depreciated?

Short-term rental properties, also known as vacation rentals, have become a popular investment option in recent years. Platforms like Airbnb, Vrbo, and Booking.com have simplified the process of renting out properties for short stays, making it a lucrative venture for property owners. But as with any investment, understanding the tax implications is crucial for maximizing returns and staying compliant with tax laws. A common question among short-term rental property owners is: Can these properties be depreciated? The answer is yes, but there are specific rules and nuances involved. This blog will explore the concept of depreciation, how it applies to short-term rentals, and strategies to make the most of this tax advantage.

What is Depreciation?

Depreciation is a tax deduction that allows property owners to recover the cost of wear and tear, deterioration, or obsolescence of an asset over its useful life. For rental properties, the IRS considers them tangible assets that lose value over time due to use and age. Depreciation lets owners spread the cost of the property over several years, reducing taxable income.

How Does It Work?

For real estate, depreciation typically applies to the structure (the building itself) but not the land. The IRS assigns a useful life of 27.5 years for residential rental properties, meaning the value of the building can be deducted incrementally over this period.

The formula for calculating annual depreciation is straightforward: Depreciation Amount=Cost of Building / Useful Life (27.5 years)

For example:

If you purchase a rental property for $300,000 and allocate $250,000 to the building and $50,000 to the land, your annual depreciation would be: $250,000/27.5≈$9,091 per year

Depreciation Rules for Short-Term Rental Properties

Is Depreciation Allowed for Short-Term Rentals?

Yes, short-term rental properties can be depreciated, provided they meet specific IRS criteria. These properties are treated as rental real estate, allowing owners to deduct depreciation as a business expense. However, the distinction between short-term and long-term rentals is critical for determining how depreciation and other tax rules apply.

What are the Key Factors to Consider?

1. Active vs. Passive Income:

Short-term rentals may be classified as “active” businesses if you materially participate in the property’s management. This classification can affect how depreciation deductions are applied.

If the property operates more like a traditional rental (passive income), depreciation follows standard rental property rules.

2. Personal Use Limitations:

If you use the property for personal purposes, such as vacations, the time spent for personal use must be subtracted from the depreciation calculation. This is determined by dividing the number of days the property is rented by the total days it is available for use.

3. IRS Definition of a Dwelling Unit:

To qualify for depreciation, the property must meet the IRS definition of a dwelling unit used for rental purposes. Properties rented for less than 14 days per year may not qualify.

4. Short-Term Rental Specifics:

If guests stay for less than 7 days (on average), the IRS may consider the property a trade or business rather than a traditional rental property. This can lead to different tax treatments but does not disqualify depreciation.

Here are the steps to depreciate a short-term rental property:

1. Determine the Depreciable Basis

The depreciable basis is the cost of the property minus the value of the land. Obtain an appraisal or use local property tax assessments to allocate the purchase price between the land and the building.

2. Identify the Useful Life

For residential properties, the useful life is 27.5 years. For commercial properties, it’s 39 years. Most short-term rentals fall under the residential category.

3. Select a Depreciation Method

The most common method for rental properties is the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, depreciation is calculated using the straight-line method for residential properties.

4. Adjust for Partial-Year Depreciation

If the property was placed in service (ready for rental) partway through the year, calculate depreciation proportionally for the months it was available.

5. Track Personal vs. Rental Use

If you use the property personally, you’ll need to adjust the depreciation based on the percentage of time the property was rented. For instance, if the property was rented 70% of the year, you can only deduct 70% of the depreciation.

Benefits of Depreciating a Short-Term Rental Property

1. Reduces Taxable Income: Depreciation is a non-cash expense, meaning you can lower your taxable income without impacting your cash flow.

2. Offsets Rental Income: Depreciation can offset rental income, reducing the overall tax liability on earnings from the property.

3. Allows for Repairs and Upgrades: Depreciation helps property owners recover the cost of significant repairs or upgrades over time.

4. Tax Advantages for Active Participation: If you actively manage the property, depreciation may be used to offset income from other sources, provided IRS criteria are met.

Depreciation Recapture at Sale

While depreciation offers significant tax advantages during property ownership, it comes with a catch when you sell the property. The IRS requires you to “recapture” the depreciation, which means paying taxes on the amount of depreciation claimed during ownership. This tax is applied at a maximum rate of 25%.

For example:

If you claimed $50,000 in depreciation over the years and sell the property for a gain, you’ll owe depreciation recapture taxes on the $50,000 in addition to any capital gains tax.

Strategies to Minimize Depreciation Recapture:

1. 1031 Exchange: Defer depreciation recapture by reinvesting the proceeds into a like-kind property through a 1031 exchange.

2. Hold Long-Term: The longer you hold the property, the more depreciation you can claim to offset rental income, potentially outweighing recapture taxes at sale.

3. Plan for Lower Income Years: If you anticipate a lower tax bracket in the year of sale, the depreciation recapture tax burden may be reduced.

Here are some of the mistakes to avoid:

1. Neglecting to Depreciate: Some property owners fail to claim depreciation, thinking they can avoid recapture taxes. However, the IRS assumes depreciation was claimed and will still impose recapture.

2. Incorrect Basis Allocation: Overestimating the land value reduces the depreciable basis, leaving valuable deductions unclaimed.

3. Misclassifying Personal Use: Failing to track personal use accurately can lead to incorrect depreciation claims and potential penalties.

Short-term rental properties can indeed be depreciated, providing significant tax benefits to property owners. By leveraging depreciation, investors can reduce taxable income, offset rental earnings, and improve cash flow. However, the process requires careful planning, especially regarding personal use, IRS classifications, and potential depreciation recapture upon sale. Understanding these rules and consulting with a tax professional can ensure you maximize the benefits of owning and operating a short-term rental property.

If you’re an investor or thinking about entering the short-term rental market, depreciation is a powerful tool that can work in your favor. Take advantage of this benefit to grow your portfolio while staying tax-efficient.