How to Maximize Tax Savings for Short-Term Rentals With Cost Segregation

The true value of short-term rentals is determined by how they are taxed, even though they can produce significant cash flow. For short-term rentals, cost segregation enables real estate owners or investors to improve first-year returns, reduce taxable income, and speed up depreciation.

In addition to conducting fully IRS-compliant studies and matching the analysis to your property and income profile, an experienced cost segregation provider is familiar with the particular tax regulations that apply to short-term rentals.

Here is a useful summary of how cost segregation relates to short-term rentals and what factors to take into account when choosing a cost segregation company that complements your investment plan.

Detailed Site Inspection and Asset Evaluation

Experienced engineers and tax experts conduct a thorough site visit as part of a cost segregation study. The team meticulously records and photographs all pertinent building elements during this inspection, including interior finishes, HVAC systems, electrical and plumbing systems, and qualifying external improvements.

After that, each asset is assessed according to its present state or the reasonable amount of time it is anticipated to fulfill its intended purpose. For instance, HVAC systems follow the building’s depreciation schedule, 27.5 years for residential and 39 years for commercial, while land improvements such as driveways, landscaping, and sidewalks are depreciated over 15 years.

Accurate asset classification and a justifiable cost segregation strategy that optimizes depreciation benefits depend on this thorough on-site analysis.

Strategic Cost Allocation and Depreciation Classification

When properly structured, short-term rentals can be an effective tool for tax planning as well as a source of income. According to IRS regulations under Treas. Reg. § 1.469-1T treats a rental activity as not passive if the average period of customer use is 7 days or less, which means short-term properties can be classified as an active trade or business for tax purposes rather than a traditional rental.

After identifying assets, the team allocates costs to each qualifying property component through a thorough cost segregation analysis. Costs are distributed according to how each component is used and how fast it depreciates, as opposed to treating the building as a single asset. Based on IRS guidelines, assets are categorized into appropriate recovery periods of 5-year, 7-year, 15-year.

Residential rental property with average guest stays of 30 days or longer is depreciated over 27.5 years, while nonresidential rental property with stays under 30 days is depreciated over 39 years, in accordance with IRS guidelines.

What is Material Participation?

Material participation determines whether short-term rental losses can offset non-passive income. To apply cost segregation benefits against wages or business income, the IRS requires owners to be actively involved in the rental activity during the tax year.

The IRS defines material participation as regular, continuous, and substantial involvement. Several tests are commonly used to establish this status, including:

• 500-hour test: You spend more than 500 hours directly participating in the rental activity during the year.

• Substantially all participation test: You perform nearly all of the work required to operate the rental.

• 100-hour and more-than-anyone-else test: You participate for at least 100 hours and exceed the involvement of any other individual.

Material participation includes managing bookings, communicating with guests, coordinating cleaning and maintenance, and overseeing day-to-day operations. When these standards are met, the short-term rental may be treated as an active business, allowing losses such as those generated through cost segregation and accelerated depreciation to potentially offset other non-passive income.

Why Cost Segregation Is Effective for Short-Term Rentals

Cost segregation works well for short-term rental properties compared to traditional rentals. STRs frequently feature upscale finishes, high-end appliances, and guest-focused amenities meant to support higher nightly rates.

The amount of accelerated depreciation available through a cost segregation study increases because many of these components are eligible for shorter depreciation lives.

One other huge benefit for Short-Term Rentals is that, because it is a 39-year asset, any improvements made in the interior generally qualify for accelerated depreciation as well through something called QIP and can be accelerated as a 15-year asset.

In the short-term rental market, where continuous reinvestment is essential, this benefit is particularly significant. By lowering taxable income in prior years, a well-done cost segregation analysis helps short-term rental owners recover capital more quickly.

These tax savings can then be applied to areas that directly affect occupancy and revenue, such as marketing, furnishings, pricing strategy, or property upgrades.

For short-term rental investors managing multiple tax considerations, cost segregation adds a strategic layer to their tax plan. When applied correctly, it turns depreciation into a proactive tool that supports both cash flow and long-term growth.

For a real-world example of how cost segregation benefits short-term rental investors, see this short-term rental case study.

Key Considerations Before Using Cost Segregation for Short-Term Rentals

When it comes to short-term rental cost segregation, timing is crucial. Under tax law, the bonus depreciation rate under the Tax Cuts and Jobs Act phased down gradually after 2022. 100% in 2022, 80% in 2023, 60% in 2024, and 40% for early 2025 under the old schedule. Acting sooner could allow short-term rental owners to claim larger first-year deductions.

However, new legislation enacted in 2025 restores 100% bonus depreciation for qualified property acquired after January 19, 2025, providing an extra incentive to plan asset purchases carefully around that date.

There are different ways short-term rental owners may qualify for tax benefits, but the requirements vary. Real Estate Professional Status (REPS) is the most restrictive option and generally applies only if real estate is your primary occupation. When qualified, REPS can convert rental losses from passive to non-passive.

For most short-term rental owners, material participation is the more realistic and commonly used approach. It allows eligible owners to offset income without meeting the strict REPS requirements.

And lastly, expert advice is crucial. Cost segregation and short-term rental tax regulations are complicated, and mistakes can lower benefits or lead to problems with compliance. Collaborating with a skilled cost segregation provider and an experienced CPA guarantees that the strategy is implemented appropriately, justifiably, and under your tax strategy.

The Bottom Line for Cost Segregation and Short-Term Rentals

Cost segregation for short-term rentals can be a very successful tax strategy if it is set up properly. Owners can accelerate depreciation into earlier years, turn normally passive losses into active losses, and drastically lower taxable income by combining short-term rental status with material participation.

Nevertheless, execution is important. IRS regulations pertaining to cost segregation, material participation, and short-term rentals are complex and require a lot of paperwork. Keeping accurate records of time spent, tasks completed, and supporting documentation is crucial, as is collaborating with a certified CPA and an experienced cost segregation provider.

This approach provides significant tax savings without compromising compliance when used appropriately.