Problem: Rental real estate is typically a passive activity. If depreciation deductions generate a tax loss, those losses may be limited, and you won’t be able to use them immediately to reduce your current tax bill.

Solution: If your rental business qualifies for a key exception, those depreciation-generated losses may be treated as nonpassive, making tax strategies like cost segregation significantly more valuable.

We’ve heard it from our clients: landlords often feel like the tax code is actively working against them. And we get it; rental real estate isn’t always given the same tax advantages as other businesses. But that doesn’t mean opportunities don’t exist. Once you know the rules, the restrictions, and — more importantly — the exceptions, you may be able to position your rental activity in a way that capitalizes on some worthwhile tax planning opportunities.

The main strategy we want to focus on today is related to short-term rentals and their use of cost segregation. But let’s first describe the problem before we outline potential solutions.

Why Rental Losses Are Often Limited

By default, the IRS treats rental real estate as a passive activity — even if you materially participate. This has one main implication: you generally can’t use rental losses immediately to offset other types of income, like W-2 wages, active business income, or portfolio income. Unless an exception applies, these losses can only offset passive income.

So… what happens if you don’t have passive income?

If rental losses exceed passive income for the year, that unused portion becomes a suspended loss. Suspended losses can be used in future years to offset other passive income, but they remain inextricably tied to the activity that generated the loss. If you don’t generate enough passive income in future years, those losses remain suspended until you sell off or dispose of the activity.

The “activity” could be (and often is) just one single property. But it’s possible and sometimes advantageous to group certain properties, treating them as one larger activity. We won’t get into grouping election strategies in this article, but it’s smart to talk about your options with a tax advisor since they can affect how you’re able to use suspended losses.

Exceptions to the Passive Loss Rules

The passive activity loss rules are hard to avoid, but there are three well-known exceptions:

Real Estate Professional Status

Taxpayers who qualify as real estate professionals may be able to treat their real estate activities as active, thereby skirting the passive loss limitations. Taxpayers must meet hefty hour and service requirements to qualify.

$25,000 Special Allowance for Non-Real Estate Professionals

Taxpayers that aren’t real estate professionals may still deduct up to $25,000 of rental losses if they (1) have adjusted gross income below a certain threshold, (2) own at least 10% interest in the property, and (3) make management decisions.

Short-Term Rental Exception

Short-term rentals are not considered rental activities for purposes of the passive loss rules if either scenario is true:

• The average customer stay is seven days or less.
• The average customer stay is 30 days or less and you provide your guests with significant personal services (like daily housekeeping, concierge services, transportation, etc.).

However… qualifying for one of the short-term rental exceptions does not automatically save you from the passive activity loss rules. You must also show that you materially participate in the activity.

Why Landlords Don’t Always Benefit from Depreciation

The passive activity loss rules don’t prevent landlords from claiming depreciation deductions. But if your depreciation deductions put you into a loss, you won’t see any immediate benefits from them. That’s why qualifying for one of the exceptions is so important.

If you materially participate in a rental business that meets the short-term rental exception, the losses you produce will not be passive. This means losses generated by depreciation deductions may be used to offset earned income, portfolio income, or other passive income, rather than becoming suspended passive losses.

This leads us to a powerful tax strategy for short-term rentals: cost segregation.  

How Cost Segregation Increases Depreciation Deductions

Cost segregation isn’t a new strategy, nor is it exclusive to short-term rentals, but it’s a tax strategy that can accelerate depreciation deductions.

How Rentals Are Typically Depreciated

Most residential rental buildings, including many short-term rentals, are depreciated over 27.5 or 39 years depending upon the use of the structure. This long recovery period ensures that taxpayers only get small depreciation deductions each year.

How Cost Segregation Accelerates Depreciation

When you purchase a house, condo, or other residential property, you’re often paying for both building and non-building components. These non-building components are assets inside the building or on the property that aren’t considered part of the building itself for tax purposes. Cost segregation identifies these assets and separates them from the cost of the building so they can be depreciated more quickly.

Here are some assets that might be identified during a cost segregation study:

5-Year Personal Property

• Carpeting and flooring
• Appliances
• Decorative lighting fixtures
• Window treatments
• Furniture
• Specialty wiring

15-Year Land Improvements

• Landscaping
• Driveways
• Retaining walls
• Outdoor lighting
• Fencing
• Irrigation systems
• Patios

Once these assets are identified, they’re depreciated over a much shorter recovery period.

How Bonus Depreciation Amplifies Benefits from Cost Segregation Studies

The One Big Beautiful Bill Act made 100% bonus depreciation a permanent addition to the tax code. If a cost segregation study identifies assets that are eligible for bonus depreciation (like many in the 5-year recover period category or in the 15-year Qualified Improvement category), landlords may be able to immediately deduct the full cost of those assets.

How This Affects Short-Term Rentals

Landlords that meet both the short-term rental exception and the material participation requirement may be able to use depreciation-generated losses to offset other forms of income.

In other words… the combination of cost segregation and permanent 100% bonus depreciation may provide noteworthy tax benefits for short-term renters.

Should All Short-Term Rentals Get Cost Segregation Studies?

Cost segregation studies are not the right fit for every rental property, but short-term rentals may offer opportunities for greater tax benefits than other types of rental businesses. The potential savings depend on factors such as the property, your tax situation, and how the rental is operated. Contact your CRI advisor to discuss whether a cost segregation study makes sense for your short-term rental and to evaluate the potential costs and tax benefits.