@Michael Baum You are right in saying that if guests break $2000 worth of stuff in a year, we have the wrong kind of guests. I didn’t make myself clear in my earlier message. My $2000 also covers stuff that inevitably break under normal use - I had to replace a washer $700, a stove $600, a microwave $100, and a grill $400, all within last 2 years, and paid close to $1000 for various service calls by electricians and HVAC techs and pest control. The owner also needs to save for big ticket items that may need to be replaced every 10 or 20 years such as AC, hot water heater, furnace, roof.
Overall i am pretty sure that you and I are in agreement - people usually underestimate the expenses, so it is always good to err on the side of having more reserve.
@Eric Coats, to answer your specific questions, estimating expenses are pretty simple. You should have a good idea of every expense you have in your primary home, then add the STR specific: (These are rough estimate numbers, depending on various factors)
STR insurance - a special insurance that covers both the property and your liability, could be $2~4k in areas without natural disasters, could be more than $10k in some other areas.
cleaning fee - approx. $50 per bedroom, so a 4-bedroom house will cost you about $150~200
consumables - bathroom supplies, kitchen supplies, beverage supplies: $20~30 per week, depending on how much you provide
wear and tear - towels, linen, kitchen utensils, some furniture: $1000~2000 per year
Repairs/replacement for things that guests break or steal: $1000~2000 per year
Also, if your personal use is less than 14 days a year, the entire property's expense is deductible against STR income, but if you use more than 14 days, then you will have to calculate the proportion of how many days it's rented out vs how many days you or your family uses. Don't quote me on that, but it's easy to look up the IRS regulations.
I recently had a conversation with somebody else who is planning to start an STR business. Below is what I told her. I think the main points would apply to you as well.
STR is great, as long as you go into it with eyes wide open and reasonable expectations. The first thing I want to point out is that it may be wise, in your thinking, to separate the property itself from the STR business that's being run from the property.
In the old days (as recent as 10 years ago), people buy a vacation home to enjoy, and they leave it empty when not in use. You only do that if you are rich enough to afford it. Thanks to technology and Airbnb, we can now rent it out when the property is not being used. Thanks to COVID, for a couple of years, you can actually make enough money to be cash flow positive even if you hire a property manager AND have mortgage payments. Alas, this scenario didn't last very long, as you would expect in a free market capitalist society -- new money flood in, more STRs in supply, property prices increase, STR incomes decrease, until a new equilibrium is achieved.
Nowadays, the word STR is being used to describe both the property and the business. I think that could be dangerous if people are not careful in their evaluation. I would recommend that you analyze the operating side of the business and the capital side of the business separately.
On the operating side, you can use AirDNA to predict the potential income which is gross revenue. If you hire a PM, they typically charge 15~25% of the gross. If you self manage, you save that money, but you are basically taking on a side hustle. Then you subtract your expenses: (1) Fixed cost: property tax, STR insurance, utilities, landscaping, etc. (2) Variable cost: platform fees from Airbnb and VRBO, lodging/hotel/transit or whatever pass-through tax your local AHJ requires, cleaning fee, cost of replacement for consumables, repair and maintenance, etc. What's left after subtracting the expenses is your Net Income. In a very loose rule-of-thumb estimate, your Net Income (revenue minus expense) may be about 50~60% of the gross revenue. If you lose 20% to the PM, then you still have 30~40% profit.
Now let's look at how you acquire the property, which is a question of capital. You can get a mortgage, or you can pay cash. If you have a mortgage, you will have a monthly payment. If you pay cash, you don't have a payment, but effectively you are giving up an income stream if the cash had been in a bond or ETF and earning you either interest or appreciation. A lot of people tend to mingle these things when they talk about "break even" or "cap rate", but that leads to a lot of confusion.
Let's use some real numbers which may be easier to understand. Typically, the STR property tends to be priced at 10x of the annual gross revenue, so let's assume you buy a house for $500k and you can get $50k a year in gross revenue. (Some people buy a run-down place and renovate it before starting the STR. In that case, your $500k house may get you $75k or even $100k revenue, because you actually turned it into a $750k house. You are basically doing a flip first, which requires a whole different set of skills.)
So, with $50k revenue, if you hire a PM, they charge 20%, so you give up $10k right away. Your fixed costs could be something like the following: $5k property tax, $2k insurance, $3k utility (including internet and TV), $2k landscaping (mowing, weeding), $2k or $3k maintenance (if you have a pool or hot tub). That's $15k you have to pay even if nobody stays at your place. Variable costs depend on how many guests you have and a lot of other things, but it could cost another $10~15k. So now you are down to about $10~15k net income from the STR business. (Your income will be $10k higher if you self manage, but as I mentioned before, you earn that $10k by acting as your own PM. Some people think it's easy and claim it only takes them a couple of hours a week, some people wouldn't touch it with a 6-ft pole.)
Now let's look at the acquisition cost or capital cost: if you buy the $500k house with a mortgage with a 20% down payment, your monthly payment will be about $2700. Annually, it's $32k. You make $10k from STR, you have to come up with $22k out of your pocket, not to mention the upfront $100k down payment and possibly another $20k to furnish the house unless you bought it as an existing STR.
So in summary, in today's market, it's impossible to buy a STR and be a passive owner and still make enough profit to cover your mortgage payment. You either have to earn extra money via sweat equity (working as your own PM or do the renovation work), or you have to be ok with a negative cash flow. Any profit you can make from STR will help with the mortgage, but it's a bad idea to count on the STR to make a certain amount of money if that's the only way you can afford the house.
Bottom line, you have to decide how badly you want to own the place, and how much financial cushion you have, and how much risk you are willing to take.
I don't mean to scare you away from STR. For the right people with the right perspective, it could be a great way to diversify your investment and enhance your quality of life. I wish you best of luck.
@Jacob Lockard I have a somewhat contrarian view on this topic.
If you look at this as a regular business, its revenue is $82k, and its expenses are $41k, so the gross profit is $41k. That's not bad. If somebody tells you "give me $3400 every month, and at the end of the month, I will give you $6800 back", you will of course jump at this deal. Your house is basically giving you this deal, except there is a catch -- in order to make that kind of money, you need to put up $860k cash upfront. So your decision is: do I borrow the money at 6% (subsidized by the tax deduction, which work out to be more like 4.5~5%) to make that investment or do I pass?
In order to make that decision, you have to consider your own financial situation. What's your total income vs expense (outside the house)? Can you find a way to squeeze some cash flow from other areas of your life to fund the loan payment? Do you also have money set aside for major expenditures on the house? If you can manage the cash flow and if you have a reasonably long term perspective, I would recommend that you keep the house and use it for STR. Keep in mind that the mortgage payment covers the principal as well as the interest charge. And, unlike other business like pizzeria or hair salon, the underlying asset of this business is guaranteed to appreciate in value over time.
You were doing the calculation based on the assumption that the income from STR has to cover the expenses AND the mortgage payment. That may be feasible pre-COVID, but it's not realistic now. Almost all the STR properties are priced at around 10x multiple of their gross annual revenue, which puts your house right at average ($859k sale price for $83k annual revenue). In other words, if you are selling this house to another investor, he/she will have the same financial calculation -- their income won't cover the expense + mortgage payment either. But they are willing to do this deal, because they are willing to be cash flow negative for a while in exchange for the future gains.
Having said all that, if you really cannot come up with the extra money to pay the mortgage, you have another possible option -- rental arbitrage. Find an experienced STR operator who is already managing properties in the area. Instead of hiring that person as the PM, propose to rent the house to him as a LTR. Charge him $5500 a month which is the same as your mortgage payment. So you will break even but eventually (after 30 years) will have a fully paid off house. He will have a built-in expense of $81000 ($66k rent payment to you, $25k operating expense). If he does a mediocre job and makes $83k as Air DNA projected, he will barely break even, but if he believes in himself and is willing to put the money where his mouth is, he can improve the performance and maybe make $93k or $103k gross. He gets to keep all the extra profit. That will be a win-win and that's how a real arbitrage is supposed to work.
For STR, the estimate of $6k to furnish the house seems too low and 80% occupancy rate seems too high. $6k may be barely enough for the furniture, such as beds and couches and tables and chairs, but what about the softer stuff like kitchen utensils and dinnerwares, and bedding and linen, and decorations? 80% occupancy rate is very high- that's basically 5-6 days booked for every week for all 52 weeks.
You are also not counting other STR expenses in your calculation- things like replacement cost (everything in the house that could break will break), extra insurance, and other maintenance expenses (lawn care, snow removal, periodic appliance maintenance, etc).
Who gave you this number? If they come from your realtor, take it with a grain of salt.
If your realtor is so experienced and she is so confident about the property, maybe you can offer her a deal: you will rent it to her as a LTR at $1200 a month. She can do all the work and make $1800. (Your $1478 is after her 20% commission, so she is saying that the STR can have a profit of $1800 before subtracting the commission.) This is basically the infamous STR arbitrage. You can make more than LTR, and she can make more than being just a property manager -if she is willing to put her own money on the line.
@Michael Baum, @Ryan Moyer, @Nancy Bachety, @Arda Bircan and many others, I thank you all for your input. However, based on some of the feedbacks, I have a feeling that some people didn’t read my whole entry or missed some points I tried to make, so I will make some clarification here.
(1) I said this previously and I will repeat it again: "I am not saying it's a bad idea to invest in an STR. I am saying it's a bad idea to invest in an STR purely for the benefit of cost seg to lower your tax bill.”
(2) My husband has a high W2 income and I am a stay-at-home wife. We have a STR property that's worth 7 figures. We are supposedly the perfect demographics. But our research led us to say no to Cost Seg. That's why I wanted to share our analysis and explain why I disagreed with some arguments made by the OP.
(3) My husband did an analysis for a friend who had high W2 income but didn't own an STR yet. The conclusion was that he would be better off investing elsewhere. That's the Excel file I tried to post but was unreadable due to the formatting by BP's website.
(4) If you already have an STR, cost seg or not depends on many other factors. My husband did the number crunching and decided that it would not benefit us as buy-and-hold real estate investors. It may work for somebody who intends to grow their real estate empire, but it's not for us – it feels like a runaway train that you can never jump off.
(5 Having said all that, everybody is entitled to their opinion, but since Bigger Pockets is more of an educational site, I think it's important that we do not confuse opinions from facts. I only comment on things that I have personal first-hand experiences, and I hope others would do the same. In that regards, I admire people like Andrew Steffens or Colin H who are frequent posters on this forum. They are quick to provide input, but always stay within their lanes and temper any opinions with “that’s how I do it” or “that’s what I think”, instead of making sweeping statements like “if you are X, you should do Y”. So, along that line, I would like to know how many people on this thread have actually done cost segs on their properties and how much W2 income tax you saved from that.
After I submitted the previous post, I realized how badly the Excel table was distorted by the BP forum webpage. Sorry.
It doesn't matter. These are made-up numbers. You can argue about some of the specific numbers in the assumptions, but the bottom line is, there is no "free lunch" when it comes to paying tax. You may be able to delay a little, but in order to achieve it, it will still cost you dearly in other departments, and the tax bill catches up eventually and may end up being more expensive in the long run.
Bonus depreciation may sound good -- "oh, I can offset it against my W2 income and not have to pay tax", but in reality, it is just another way for the tax professionals to get more business by charging you for doing the cost seg as well as preparing an ever-increasingly complicated tax return. If you are a corporation or a real estate developer, it may be different, but for the vast majority of the mom and pop investors, it has no value.
First of all, I always find it laughable that any high income professional, doctor or lawyer or corporate executive, would want to trade their most valuable resource (time) for something they already have plenty (money). Second of all, any depreciation, regular or bonus, is a delayed tax. You still have to pay it eventually, possibly at a higher rate. If you are close to retirement age, and think your W2 income will decrease significantly in a couple of years, then cost seg and bonus depreciation can be useful. But I don't think that's the case for most people.
I am just a housewife, but my husband is an engineer and has an MBA. We have a STR beach house and he looked into the bonus depreciation scheme. He even went so far as creating an Excel file (as an engineer would do), and concluded that (1) if you are not already a real estate investor, you are actually better off by taking the money and investing in the stock market; (2) if you already own a STR, cost seg has a small benefit, but the benefit decreases the longer you own the property, also there is the cost of the cost seg itself. To be clear, he is not saying that you should not invest in real estate or STR. He is saying that if you want to invest in STR, do it because you think it's a good way to make money or because you want to diversify your assets, but don't do it just for the cost seg tax savings.
The key point to remember is that yes you can get the bonus depreciation right away, and depending on your W2 income amount, you can skip paying tax for the first 3 or 4 years. But then what? Once the bonus depreciation is over, your tax goes back up. Another key point: how much is your time worth? If you make $200k a year, that's $100/hr your employer is paying you. To use this "tax loophole", you need to spend at least 100 hrs AND more than anybody else. 100 hrs is 8 hrs a month -- if you have 3 or 4 rentals per month, your cleaner will spend more than that. I think realistically, 150 hrs or even 200 hrs is more likely, especially for a new STR owner.
Here is the Excel table my husband did, with some very simplistic assumptions. Assuming you have $1.2M cash, which can be invested in the stock market and reasonably get a 7% return. Or you can buy a $1.2M STR with the building valued at $1M, which is your max bonus depreciation amount. Assuming your W2 income is $250k, and you get a gross income of $100k from your STR. Roughly it translates to about $50k Net after deducting all expenses.
Conclusion: you save some money in the first 3 years, but at a cost of spending a lot of time to manage the STR, not to mention any start-up time to buy and furnish and launch the STR. But over a span of 10 years, you actually make less money.
Again, I want to emphasize, I am not saying it's a bad idea to invest in an STR. I am saying it's a bad idea to invest in an STR purely for the benefit of cost seg to lower your tax bill.
| Option 1: invest money | Option 2: STR with Cost Seg | |||||||||||
| Investment income on $1.2 M | W2 income | 25% tax on Income | Money in the bank | Value of my time | Net Income on $1.2M STR | $1M Bonus Depreciation | W2 income | 25% tax on income | Money in the bank | Value of my time ($100*200 hrs) | REAL NET PROFIT | |
| Year 1 | $90,000 | $250,000 | $85,000 | $255,000 | 0 | $50,000 | -$300,000 | $250,000 | $0 | $300,000 | ($20,000) | $280,000 |
| Year 2 | $90,000 | $250,000 | $85,000 | $255,000 | 0 | $50,000 | -$300,000 | $250,000 | $0 | $300,000 | ($20,000) | $280,000 |
| Year 3 | $90,000 | $250,000 | $85,000 | $255,000 | 0 | $50,000 | -$300,000 | $250,000 | $0 | $300,000 | ($20,000) | $280,000 |
| Year 4 | $90,000 | $250,000 | $85,000 | $255,000 | 0 | $50,000 | -$100,000 | $250,000 | $50,000 | $250,000 | ($20,000) | $230,000 |
| Year 5 | $90,000 | $250,000 | $85,000 | $255,000 | 0 | $50,000 | $0 | $250,000 | $75,000 | $225,000 | $225,000 | |
| Year 6 | $90,000 | $250,000 | $85,000 | $255,000 | 0 | $50,000 | $0 | $250,000 | $75,000 | $225,000 | $225,000 | |
| Year 7 | $90,000 | $250,000 | $85,000 | $255,000 | 0 | $50,000 | $0 | $250,000 | $75,000 | $225,000 | $225,000 | |
| Year 8 | $90,000 | $250,000 | $85,000 | $255,000 | 0 | $50,000 | $0 | $250,000 | $75,000 | $225,000 | $225,000 | |
| Year 9 | $90,000 | $250,000 | $85,000 | $255,000 | 0 | $50,000 | $0 | $250,000 | $75,000 | $225,000 | $225,000 | |
| Year 10 | $90,000 | $250,000 | $85,000 | $255,000 | 0 | $50,000 | $0 | $250,000 | $75,000 | $225,000 | $225,000 | |
| TOTAL | $2,550,000 | $2,420,000 |
I have STRs with charcoal grills and I have them with propane grills. The charcoal grill does not impact my rents at all.
I was imagining the scenario that I, as a guest, was surprised to realize the house only had a park grill. So Ken’s comment was fair. If the description clearly indicates what type of grill is at the property, then the guest should have no complaints. But as a property owner, you need to realize that it’s something that could turn away customers, so please make sure it’s explicitly mentioned and maybe include a photo, as most properties listings don’t devote any ink or photo to show the grill. And that comes down to another cost benefit analysis- if 1 in 10 potential guests choose not to book your house because of the lack of a propane grill, is it worth $300 to get one?
@Kyle Smith If I was a guest myself, I would not want to deal with a charcoal grill, especially those ugly bare bone park grill. That’s for people to use for free in public venues. If I am paying thousands of dollars to stay in your property, I want convenience and I want something similar to what I use at home, which most likely is a propane grill. Faced with an unfamiliar grill, I will either burn or undercook my food and then I will blame the cheap property owner for not wanting to spend $300 on a real grill. Not to mention the fact that if I want to cook it again, I will have to clean out the used charcoal. Am I going to carefully scrap it into a garbage can? No. You are lucky if I dump them in the landscape instead of on your lawn. The easiest way for me to express my displeasure? Docking a star on your review.
I have a propane grill at my rental and my insurance company asked me to show them pictures of where it was. They specifically said it needed to be at least 3 horizontal feet and 6 vertical feet away from any building or fence or siding. I had it by the pool but one guest carried it up onto a second floor balcony which was no more than 4-5 ft wide. After that, I moved it back down to the original spot by the pool but used some left over ceramic flooring tiles to build a little platform for the grill. It has stayed put since then.