Accelerated depreciation on primary residence turned STR?

[Larry King]

We are planning to turn our primary residence into an STR at the end of this year and are looking to take advantage of accelerated depreciation if we can meet the REPS requirements. To my knowledge I believe this is possible with a property purchased as an investment property, but would it apply to a primary residence turned investment property?

We absolutely plan on meeting with a tax professional to plan this out, but I’m curious if this is even possible before we push to that next step. Any feedback is appreciated, thanks!

[Michael Plaks]

@Larry King

Real estate professional status has nothing to do with STRs. You need to pass "material participation" test and personal use test, but that's for your future tax professional to explain.

Yes, bonus depreciation is possible, but only on the current value of the personal property and land improvements. For example, the current value of your fence in its current condition, not its original cost. 

You can also apply bonus depreciation to some additional upgrades to  your property. Again, I will leave the details to your tax pro.

[Randy Rodenhouse]

I believe you can convert your primary to a short term rental without an issue (but check with CPA). If you work and have a W-2 job then extremely hard to meet the REPs requirements...almost impossible. However, a STR is not considered a rental activity (section 469 of IRS code) if your rent it 7 days or less on average customer use and therefore not passive for tax purposes. But you have to material participate.

For short-term rental properties, the depreciable life is 39 years. This is longer than the depreciable life of 27.5 years for long-term rental properties. By default, the depreciation method for short-term rental properties is the straight-line method. This method allows you to deduct an equal amount of the cost of the property each year over its depreciable life. However, you can use a cost segregation study to break the property into different class lives and claim more depreciation up front. There are some limits on the amount of depreciation that you can deduct for a short-term rental property based on the number of days that the property is rented out each year.

[Zachary Jensen]

In the realm of real estate investments, the short-term rental loophole offers a unique opportunity, subject, however, to certain rules and regulations. According to passive activity loss rules, every business is obligated to adhere to specific criteria, especially when it comes to short-term rentals. One crucial stipulation is that the property must be rented for 7 days or less on average. While this may exempt it from being classified as a rental activity, active participation remains a requirement, necessitating compliance with three tests: spending 500 hours on the property, dedicating at least 100 hours (and more than any other participant), and performing all the necessary work needed.

Additionally, long-term viability and consideration of depreciation recapture are important concerns. Excess business losses are capped for single individuals at $250,000 and for married individuals at $500,000, with any surplus being suspended and carried forward. Notably, short-term rentals are categorized as non-residential properties. If over 50% of guests stay on a transient basis, the property is subject to depreciation over 39 years. Bonus depreciation and Section 179 allowances for improvements can be utilized, with the latter, however, capped at zero to prevent negative losses. Determining whether the venture falls under a service or rental business hinges on the provision of substantial services; for instance, if a bed and breakfast service is offered, it must be reported on Schedule C, triggering a 15.3% self-employment tax.

Moreover, personal use plays a crucial role in the classification of the property. If used for 15 days or more or 10% of the rental days at fair market value, it becomes a residence, subject to specific regulations. The REPS-9 election prohibits grouping short-term and long-term rentals, emphasizing the need for careful strategic planning. Notably, personal visits for maintenance purposes do not contribute to personal use calculations. The involvement of onsite management, often seen as a potential red flag, can lead to the property failing crucial qualification tests. Understanding these rules is essential for investors seeking to capitalize on the short-term rental loophole while maintaining compliance with tax regulations.

[Bill Brandt]

Don’t forget. You aren’t creating tax deductions you are only moving them forward. So you’ll have lower deductions in the future and owe all the taxes back if you ever sell without a 1031 exchange. 

I assume the property hasn't gone up in value very much since you bought it. Otherwise I'd suggest you sell and take the tax free gain. Tax free is better than tax deferred. If you wouldn't buy your current home at its current value and make it a STR then don't do it just because you already own it. You would literally be better off selling and buying an identical home in the neighborhood raising your cost basis. (Raising your deductions and lowering your capital gains.)

[Larry King]

@Michael Plaks @Randy Rodenhouse @Zachary Jensen @Bill Brandt 

This is all really good info and exactly what I was looking for, thank you. We believe we can meet REPS material participation requirements using the short term loophole, so long as we keep very detailed records. Regarding personal use, there would be none so thats a non issue. 

You have all brought up some great concerns regarding depreciation recapture and tax free gains vs tax deferrals, I think I need to zoom out and look at the bigger picture when comparing all options.

@Bill Brandt actually the house has gone up in value significantly since we bought it, we have a ton of equity that could be pulled tax free via sale, however we also have a 3.25% mortgage on the house and it could work well as a MTR or LTR as well. We are in a really good position on this property and have multiple options, this is why I'm trying to get a better understanding of which strategy is going to be the most beneficial.

[Zachary Jensen]

Quote from @Larry King:

@Michael Plaks @Randy Rodenhouse @Zachary Jensen @Bill Brandt 

This is all really good info and exactly what I was looking for, thank you. We believe we can meet REPS material participation requirements using the short term loophole, so long as we keep very detailed records. Regarding personal use, there would be none so thats a non issue. 

You have all brought up some great concerns regarding depreciation recapture and tax free gains vs tax deferrals, I think I need to zoom out and look at the bigger picture when comparing all options.

@Bill Brandt actually the house has gone up in value significantly since we bought it, we have a ton of equity that could be pulled tax free via sale, however we also have a 3.25% mortgage on the house and it could work well as a MTR or LTR as well. We are in a really good position on this property and have multiple options, this is why I'm trying to get a better understanding of which strategy is going to be the most beneficial.

 Happy to help! This is an area of the tax code where there is a lot of confusion because of "influencers" pushing a lot of bad ideas out there.

[Bill Brandt]

That was my point. You would only consider your plan if the house HASN’T gone up in value. The fact that it has makes it a bad plan. 
. 
imagine you have $500k in appreciation. If you sell you save $125k MINIMUM in taxes by selling. How long will it take for your STR to make $125k profit after taxes on top of the return your $500k could make?

IE. you take $500k tax free and put it in a Cd. You make about $25k/yr. So how long will it take for your STR to make $165k so you can pay taxes and have the $125k you could have saved by just selling.(And then you'll just have to make $25k for every year it took you to "catch up" to make up for the lost CD income.) That's how long you have to work the STR job for free to be "even" with just selling.

I swear if you'll find even with optimistic numbers it could be 2030 or 2035 by the time you break even. This is if you do all the management yourself, (basically buying yourself a part time job), ar good at marketing and interior design, and if your local government doesn't flip the switch and ban STR or limit the ways you can use it.

There are probably many STR owners that would be happy with just the $25k CD return you could earn risk free.

[Basit Siddiqi]

The depreciable basis will be based on the original puchase price of the proprety plus improvements made to the house.