The Basic Idea

Bonus depreciation (IRC §168(k)) lets you immediately write off the cost of certain property with a recovery period of 20 years or less. You can think personal property, land improvements, and some interior improvements identified in a cost segregation study. (We talked about this in our last blog post: The Section 168(k) Bonus Depreciation Purchased Requirement.)

A 1031 exchange lets you defer gain when you swap one property for another of like kind. (We’ve also described how these work in past. For example, see Like Kind Exchange Rules Powerful But Tricky )

Here’s the twist: Treasury regulations say that when you exchange into a new property, the basis that carries over from the old property and any new money you invest can be eligible for bonus depreciation. The key cite is Reg. §1.168(k)-1(f)(5)(iii)(A). And the main thing to know: Combining these two laws can potentially result in gigantic tax savings.

A Simple Example

Let’s start with a practical but simple example. Suppose you:

1. Buy a $1,000,000 rental property. A cost segregation study finds $300,000 of 15-year improvements. You claim 100% bonus depreciation = $300,000 deduction in Year 1.

2. In Year 2, you exchange that property for a replacement worth $1,000,000. Basis carries over at $700,000.

3. Regulations let you treat that $700,000 as if newly placed in service for bonus depreciation purposes. Another cost seg shows $210,000 of short-life property — and you get another big deduction.

4. Do it again in Year 3, and the same mechanics apply (though the numbers shrink as the basis shrinks).

It’s a bit like a geometric series of deductions: $300K, then $210K, then $147K…

Obviously, transaction costs matter. The timing needs to work right. (You can’t both acquire and dispose of a property in the same year, for example, to point out one of the important requirements.)

But, wow, that’s surprising, right?  If you’re a high income real estate investor, you may want to exchange existing properties for new properties simply to trigger bonus depreciation. Further, if you’re a high income taxpayer looking for a way to really dial down your federal tax burden? Now would not be a crazy time to look into this investment category.

Who Benefits?

This isn’t for everyone. To make it work you need:

• The right timing (properties bought and exchanged while bonus depreciation is available).

• A cost segregation study on each property.

• Enough participation in the rental activity to avoid falling into the passive activity category. (The three most practical ways to avoid passive losses are described here: real estate professional status, short-term rentals, and self-rentals to a business you own.)

But for active real estate investors, especially those moving up in property size, this can be a powerful way to defer gain through §1031 while still accelerating deductions with bonus depreciation.

The Bottom Line

Most investors think they must choose between a 1031 exchange or a large depreciation deduction. The truth? Under the right circumstances, you can have both.

As always, details matter. Talk with your tax advisor before trying to apply this in your situation.

The post Bonus Depreciation and 1031 Exchanges: A Hidden Opportunity appeared first on Evergreen Small Business.

The date part of that? Easy. You can read a calendar.

The tangible property part? Mostly easy, too. The main rule is anything with a class life of 20 years or less? You can bonus depreciate.

But that “purchase” requirement? Trickier that you might guess.

The Technical Purchase Requirement

So, the Section 168(k) statute says we look to Section 179(d)(2) to determine what a purchase is. And that chunk of the law says this:

For purposes of paragraph (1), the term “purchase” means any acquisition of property, but only if—

(A) the property is not acquired from a person whose relationship to the person acquiring it would result in the disallowance of losses under section 267 or 707(b) (but, in applying section 267(b) and (c) for purposes of this section, paragraph (4) of section 267(c) shall be treated as providing that the family of an individual shall include only his spouse, ancestors, and lineal descendants),

(B) the property is not acquired by one component member of a controlled group from another component member of the same controlled group, and

(C) the basis of the property in the hands of the person acquiring it is not determined—

(i) in whole or in part by reference to the adjusted basis of such property in the hands of the person from whom acquired, or

(ii) under section 1014(a) (relating to property acquired from a decedent).

Which provides most but not all the rules you need… so let’s just step through this.

No Bonus Depreciation for Related Party Acquisitions

A first observation? Someone can’t purchase property from a related party.

That simple rule makes sense just from a loophole prevention context. Without that prohibition, families and family-owned businesses could manipulate bonus depreciation deductions at will.

No Bonus Depreciation for Purchaser Contributed Property

A more subtle requirement. If you purchase some property and then contribute it to a partnership or corporation? No bonus depreciation.

This wrinkle may matter more than you think. For example, if you and your spouse buy a short-term rental thinking you should be able to get giant bonus depreciation deductions? That may work, sure.

But then if you contribute that property to an LLC which you and your spouse both own and then treat that LLC as a partnership? Okay, now we got a problem. The reason? The bonus depreciation deduction would need to go on a partnership tax return. Except the partnership didn’t purchase. You and your spouse did.

No Bonus Depreciation on Inherited Property

Bonus depreciation doesn’t apply to inherited property someone acquires from a decedent and for which tax law (specifically Section 1014) resets the basis to the fair market value usually at time of death.

You can read this rule right in the statute I quoted above. But so you understand and so this makes sense, assume you and your spouse own property—maybe it’s an income rental—and you’ve already depreciated it fully. Maybe you bought the property for $200,000 decades ago and have long since deducted all the available depreciation meaning the adjusted for depreciation “cost basis” now seats at $50,000.

In a community property state, the death of one spouse resets the basis to the fair market value. If the above property at the date of death of the first spouse is now worth $1,000,000? The surviving spouse can again begin depreciating the property. And based on that new $1,000,000 basis. But he or she can’t use bonus depreciation. Rather, the surviving spouse uses regular old MACRS depreciation.

Note: Bonus depreciation would not apply to much of an income rental. Only the parts of the property that represents tangible personal property with of 20 years or less.

No Bonus Depreciation for Section 754 Elections

A sort of related issue: If someone buys into a partnership with tangible property or inherits an interest in a partnership with tangible property? Their purchase price or the Section 1014 basis adjustment can, if a Section 754 election has been made, cause the partnership to adjust the basis and depreciation numbers for that partner’s share of, say, the machinery.

However, the regulations for Section 168(k) specifically exclude taking bonus deprecation on this amount created via the Section 754 election. (Let me cite the actual regulation in case you’re a tax practitioner and want to read this: Reg 1.168(k)(f)(9).)

Yes Bonus Depreciation on Section 1031 Like-Kind Exchanges

So, you might guess that the statute quoted earlier prevents you from deducting bonus depreciation on a least some of the basis you count after a like-kind exchange. But that’s not exactly right. In general, if you want, you can take bonus depreciation on the new property you acquire via a like kind exchange.

Example: You trade land worth $1,000,000 but with a basis equal to $100,000 for a building worth $1,000,000. You can use Section 1031 to avoid paying taxes on the $900,000 realized gain. And the probably you can bonus depreciate the part of the new building that counts as tangible personal property. If 20% of the new building is tangible personal property and your basis is only that $100,000, probably you can deduct $20,000 of bonus depreciation.

If you trade the $1,000,000 piece of land and use a $2,000,000 mortgage to acquire a $3,000,000 building and 20% of that building counts as tangible personal property, you can probably bonus depreciate 20% of the $2,000,000 and the $100,000 so roughly a $420,000 bonus depreciation deduction.

Yes Bonus Depreciation on Section 1033 Involuntary Conversions

A quick final point: If you use Section 1033 to handle an involuntary conversion? Roughly, the accounting for a Section 1033 involuntary conversion works like the accounting for a Section 1031 like-kind exchange.

In other words, if the involuntary conversion causes you to lose one property (a vehicle, a building, or whatever) and you replace that property, you can potentially use bonus depreciation on the carryover basis and the new property’s excess basis.

A fire destroys equipment with basis $400,000 and FMV $1,000,000. The taxpayer receives $1,000,000 insurance and reinvests it all in similar equipment (qualifying under §1033). Basis in replacement equipment = $400,000 (carryover). Under the §168(k) regs, that $400,000 basis qualifies for bonus depreciation (since equipment has a recovery period <20 years)

The post The Section 168(k) Bonus Depreciation Purchased Requirement appeared first on Evergreen Small Business.

But you need to know the rules. And plan ahead. The paragraphs below give the low-down. And maybe the good news here? None of these tips are hard to use. Or too complicated.

Tip #1: Invest in Short-term-rental Properties for Profit

Let me start with a subtle but probably the most important point. Your short-term-rental investment? You need to be doing this to make money. As a way to build wealth. Maybe to prepare for retirement.

Vey frankly? The right way to plan this all out is that you will ultimately invest in multiple properties. Gain some economies of scale. Build expertise.

The reason this “pursuit of profits” angle is so important? The best and really the only big tax savings come when you invest in short-term-rentals for profits. And to grow your wealth.

Note: Section 183, commonly known as the hobby loss rule, and Section 162 set this requirement.

Tip #2: Average Rental Intervals of Seven Days or Less

The next tip: You want to average rental intervals of seven days or less. And for a simple reason: If your average rental interval is more than seven days? You probably won’t be able to use the big tax deductions your property or properties generate.

With intervals of seven days or less, you can probably get big tax savings if you (and your spouse if married) spend more than 100 hours a year. You may even be able to get big savings if you spend just a few hours a year.

With intervals of more than seven days? Tax law considers your short-term-rental a real estate trade or business. And in that case, Section 469(c)(7) of the Internal Revenue Code says you or your spouse will need to qualify as a real estate professional by spending more than 750 hours and more than half your work hours on real estate businesses if you want to deduct losses. That qualification? Obviously much harder for new and very part-time investors to achieve.

Tip #3: Track Your Time

A third really important tip. You need to track the hours you spend on your short-term-rental business starting with the minute you begin your search for your first property. Here’s why: Even if your average rental interval averages seven days or less, you also need to materially participate in the short-term-rental business.

The lowest-hour route to achieving material participation: Be the only person who spends time on the rental. For example, you’re single. You buy a property late in the year. Say mid- to late-November. You rent the property once for a week in December. And the only person who works on the rental—the only person—is you. (For example, if the property is a cabin in the woods? You do any maintenance. And you do the housekeeping before and after your guests stay.)

The most practical route to achieving material participation however? Spend more than 100 hours working on the rental and more time than anyone spends. You can combine the hours that spouses work. But some hours don’t count. (More details on that here: Grouping activities to achieve material participation.) And then this predictable tip: You want to document your hours—and the hours others spend.

Tip #4: Expense as Supplies Everything You Can

Assuming you’ve followed the first three tips, you’re ready to begin loading up your tax return with deductions.

And here’s the tip for doing that: Expense any individual thing that costs $2500 less as “supplies.” So, the $400 chair, the $800 sofa, the $1800 TV, and so on. Appliances, you should be able to expense too.

One caution: You can’t expense individual components of some bigger thing. For example, if master suite bed includes an $800 mattress, a $600 box spring, and a $1200 antique frame thing? You look at the total $2600 of cost to provide someone a place to sleep.

If just writing off as supplies seems funny? You should know that Treasury regulation 1.263(a)) says you can do this by making an election in your tax return.

Tip #5: Pay for a Cost Segregation Study (Maybe)

Another tip related to ginning up deductions. You maybe want to pay for a cost segregation study. That study, conducted by a civil engineer or consultant (so not your tax accountant probably), breaks apart the price of the building into real property and personal property.

Without a cost segregation study, you’ll depreciate the building part of the short-term-rental over 27.5 or 39 years. For example, if you buy a $1,000,000 property, you might call $200,000 of that land and $800,000 of that building. And you depreciate the $800,000 of building over basically three or four decades.

With a cost segregation study, probably, you might instead (in effect) look at the $1,000,000 of purchase price representing $200,000 of land, $600,000 of building, and $200,000 of personal property. That $200,000 personal property chunk you will write off in the first few years of ownership. That frontloads the depreciation into the first few years.

Note: We have a short-term rental depreciation calculator you can use to estimate what a cost segregestion study does to your depreciation deductions.

Tip #6: Consider Bonus Depreciation

By the way, if you do a cost segregation study? Consider using bonus depreciation to immediately deduct some large percentage of the personal property. The bonus depreciation percentage is slowly deflating: 60% in 2024, 40% in 2025, 20% in 2026 and 0 in 2027.

But if you can use bonus depreciation to create a big deduction? And then use that big deduction to save highly taxed income? That’s a no brainer.

Tip #7: Consider Section 179 Depreciation

Bonus depreciation, if it’s available, works best for frontloading depreciation. But some short-term-rental investors may be able to use a similar depreciation trick: the Section 179 election. A Section 179 election allows a short-term-rental business to deduct 100% of most of the personal property shown in the cost segregation study.

To use Section 179 for a short-term-rental, however, your short-term-rental operation needs to rise to the level of a “Section 162 trade or business.” That’s technical tax law concept that looks at your profit motive and then at whether you show continuous, considerable and regular involvement in the business.

Note: The Section 179 method of loading up deductions creates a depreciation recapture risk. Thus, confer with your tax advisor if you want to even think about using this tip.

Tip #8: No Personal Use

A quick caution: You should not use your short-term-rental for personal use. That use triggers Section 280A, a chunk of tax law that explicitly exists to limit or eliminate deductions stemming from a home or vacation home.

The one exception to personal use? If you stay at a property and you (or your spouse if you’re married) works full-time during maintenance.

By the way, if you go spend a week at the Hawaiian condo? And you work full-time during the regular work days but then “take the weekend off?” Now you have two personal days. And Section 280A will basically dial down your tax deductions because some of your use during the year was “personal.”

Tip #9: No Family or Friends

A related point: If you rent to a family member? That counts as a personal day, triggers the Section 280A formulas and probably limits your short-term-rental deductions.

And if you rent to someone at  discounted rate? A good friend you don’t want to charge the regular full price? That then counts as a personal day, triggers the Section 280A formulas, and again probably limits your deductions.

A consolation related to tips #8 and #9. A few years down the road? Once you’ve burned off a bunch of the depreciation? You’ll be able to use the property for personal days, family or friends with less disastrous consequences. But not early on. (And also, just to say this, not if you use the Section 179 election described in tip #7.)

Tip #10: Invest Out of State (Maybe)

A final big, move-the-needle tip. If you reside currently in a high-income tax state and you plan to someday move to lower tax state? Consider investing in short-term rentals in that other state.

The out of state property’s depreciation creates deductions and tax savings on your, say, California state income return while you’re a California resident. But later on, when you reside in some no-income-tax state, say, Florida, you can sell the property without having to pay any state income taxes. Including to your original home state.

Closing Comments and Caveats

Part-time real estate investors often struggle to harvest tax savings from their real estate properties. But for investors willing to plan ahead and think outside the box? The Short-term-rentals tax tips and tricks described above can allow most taxpayers to shelter very large chunks of income.

The post Short-term-rental Tax Tips and Tricks appeared first on Evergreen Small Business.

The phrasing often goes like this: Okay, Steve, so assume my rental income covers my expenses including the mortgage interest. A breakeven situation, in other words. I’m also going to get depreciation deductions on the property. And if that happens, how big are those deductions going to be?

The calculator below makes this estimate based on real-life guesses about how the cost segregation engineer breaks out the costs. Just enter your own numbers and click Calculate:

Tips for Using the Short-term-rental Depreciation Deduction Calculator

The initial default inputs reflect a cost segregation for a $1,000,000 residential property the engineer “segregates” as 30 percent five year property, 10 percent fifteen-year property, and 60 percent residential property. These percentages are just guesses–though also actual percentages we’ve seen in real-life studies.

Cost segregation engineers may alternatively assume a short-term-rental is not residental property but rather nonresidential. So, like a hotel. In that situation, you might use a different set of inputs. For example, .15 for the five-year property, .3 for the fifteen year property, and .55 for the nonresidential property. These would also be examples of real numbers we’ve seen on real studies.

Note: The actual percentage allocations depend on the property. Thus, use my examples for seeing how this works. Not for preparing an actual tax return.

The bonus depreciation percentage equaled .6, or 60% for 2024. In 2025, the percentage dropped to .4, or 40%. for property placed into service after December 31, 2024 but before January 19, 2025. Then, the Big Beautiful Tax Bill bumped the percentage to 100% permanently for property placed into service on or after January 19, 2025.

Some Caveats and Qualifications

The short-term-rental depreciation deduction calculator simplifies some of the calculations. It assumes, for example, you use a mid-year convention for the five year and fifteen year property. That’s often the case. But may be overly optimistic if you buy a property late in a year.

The calculator gives you a half year of depreciation on the real property for the first year. That will be close but probably a little too high or little too low in most cases. Depreciation of real property uses a mid-month convention and so looks the actual month you place a property into sevice. Thus, consider the depreciation numbers slightly rough for that first year. They should be close. But not perfect.

And one final comment: The depreciation deduction calculator assumes the short-term rental property is in the United States. Not outside the county.

Additional Resources

The Vacation Rental Tax Strategy (A primer)

The Section 183 Short-term Rental Problem (How hobby loss rules can goof up your investment.)

Surviving Short-term-rental IRS Audits

The post Short-term-rental Depreciation Deductions Calculator appeared first on Evergreen Small Business.

What is Section 183?

First, some background. Section 183 is a part of the tax law that says you can’t deduct expenses of activities you’re not engaging in for profit. You possibly know this law by another name: the hobby loss limitation rule.

But it applies to short-term rentals too if you’re losing money most years. Or if you run up a string of losses in the early years.

To be clear, then, Section 183 creates another way you can lose your deductions on a short-term rental. This law adds to the headaches and requirements of the Section 469 “passive loss limitation” rules and Section 280A “rental of vacation homes” rules.

However, the good news here? The Section 183 risk falls entirely within your ability to manage and control. All you need to do is engage in your short-term rental activity for profit. Seriously, that’s it.

But let’s delve into the details because you’ll want to know the specifics.

Dodging the Section 183 Deduction

The Section 183 Treasury regulations outline nine factors used to determine if you’re engaging in an activity for profit. I list these factors next. Consider each carefully.

1. Manner in which a taxpayer carries on the activity: Is the activity carried on in a “businesslike manner” similar to other profit-oriented activities?
2. Expertise of the taxpayer or his/her advisors: Does the taxpayer rely on expertise or experts?
3. Time and effort expended: Does the taxpayer devote substantial time and effort to the activity, especially if it lacks substantial personal or recreational aspects?
4. Expectation of appreciation in the value of assets used in the activity: Even if the activity doesn’t produce an operating profit, will it produce a profit when liquidated?
5. Success of the taxpayer in carrying on other activities: Is the taxpayer a serial entrepreneur?
6. History of income and losses with respect to the activity: A history of losses during the early years may not be problematic, but sustained losses year after year might be.
7. Amount of occasional profits earned: Occasional small profits may suggest a lack of profit motive, while occasional large profits or the possibility of a large windfall profit may suggest a profit motive.
8. Financial status of the taxpayer: Someone who lacks substantial income or financial resources likely cannot afford to lose money in an activity unless they expect profits eventually.
9. Elements of personal pleasure or recreation: Deducting expenses from an activity others consider a hobby could be problematic.

In an audit, predictably, you want to be able to point to several of these and say, “See that? And that? And that? Yeah. Profit motive.”

Because the challenge with Section 183 and short-term rentals is convincing an IRS auditor, appeals officer or judge that your short-term rental activity was pursued for profits.

Examples Where Section 183 Short-term Rental Problems Crop Up

The Section 183 regulations (specifically Reg. Sec. 1.183-2(c)) provide examples of activities that probably qualify and probably don’t qualify. Practitioners should read these if they’re working with clients who may risk disqualification of deductions.

But let me highlight some situations that either strengthen or weaken the pursuit of profits argument.

In the category of situations that weaken? As compared to other alternatives in the area, you only infrequently or “lightly” rent the property. Maybe you never or almost never show a profit. Perhaps you operate only a single property. Maybe the property is a legacy your family appears to own because dad or grandma owned the property? The property is filled with family photos and personal items. Or, perhaps most problematic: After operating the short-term rental for a year or two, you convert it to personal use. All these situations? Probably bad. Maybe even really bad.

In the category of situations that strengthen your profit motive argument? You either have enjoyed or expect large gains on the sale of property. The deductions and any losses stem from cost-segregation studies (so in a sense Congressionally approved tax accounting tricks that create large losses). You book similar numbers of guests as competitive rental properties. Or you own multiple short-term properties, far more than you could ever personally use or enjoy. All of these situations? Probably okay. And possibly very helpful.

Final Comment about Section 183 and Short-term Rentals

If you’re investing in short-term rentals as a way to invest pre-tax money and build wealth—similar to investing in 401(k) or IRA accounts—you’re clearly doing this for profit. And you should be safe. However, develop and save good documentation to support this.

On the other hand, if you’re investing in a short-term rental to afford a second home for your family? Sorry. Section 183 likely limits your deductions.

Some Other Articles about Short-term Rentals

Vacation Home Rental Traps

Surviving Short-term Rental Audits

The Vacation Rental Tax Strategy

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