Bonus Depreciation for Short-Term Rentals in 2021

Bonus depreciation lets a taxpayer deduct a percentage of the cost of qualifying shorter-life property in the year it is placed in service, rather than spreading it across the asset's recovery period. For a short-term rental, the qualifying property is what a cost segregation study reclassifies out of the building: carpet, appliances, decorative lighting, specialty electrical, furnishings, and land improvements such as driveways, landscaping and pools. This is where it stood in 2021, which was the year domestic travel came back faster than anyone had modelled.

What 2021 changed

2021 was the year short-term rental demand came back violently. Domestic leisure travel recovered far faster than international, drive-to markets absorbed the overflow, and guests who would previously have booked a hotel booked a whole house instead. Supply had not caught up, so occupancy and nightly rates rose together, which almost never happens.

Demand outran supply for most of the year. Properties that would have struggled in 2019 filled at rates their owners had not thought possible, which made the market look easier than it was.

Bonus depreciation was still at 100% under the TCJA schedule, and would remain there through 2022 before the phase-down began.

How it works

Bonus depreciation lets a taxpayer deduct a percentage of the cost of qualifying shorter-life property in the year it is placed in service, rather than spreading it across the asset's recovery period. For a short-term rental, the qualifying property is what a cost segregation study reclassifies out of the building: carpet, appliances, decorative lighting, specialty electrical, furnishings, and land improvements such as driveways, landscaping and pools.

1. A cost segregation study separates the purchase into components and assigns each to its correct recovery period, commonly 5, 7 and 15 years for the pieces that come out of the building shell.
2. Bonus depreciation then applies to those shorter-life components at whatever percentage the law allows for the year the property is placed in service.
3. The remaining structure continues over its long recovery period, 39 years for a short-term rental with an average stay of seven days or less, or 27.5 for residential rental property.
4. None of this is usable against wage income unless the activity clears the seven-day average period of customer use and the owner materially participates.

What that meant in 2021 specifically

With bonus depreciation still at 100%, a cost segregation study on a property placed in service that year could accelerate the full eligible amount into year one, which made the strategy unusually powerful for high earners.

The risk nobody priced in 2021 was that the conditions were exceptional rather than normal. Buyers who underwrote on 2021 revenue and 2021 financing costs were building a model on the best year the asset class had ever had.

The right discipline in 2021 was to underwrite on pre-pandemic revenue rather than current revenue, and to buy on a basis that would survive normalisation.

Where it goes wrong

The failure modes are consistent across years, which is itself useful information: they are not caused by the market cycle, so a different year does not protect you from them.

• Treating the deduction as free money. It is a timing shift, and on sale the depreciation taken is recaptured, with Section 1245 recapture on personal property components taxed as ordinary income.
• Commissioning a study before confirming the participation position, which produces a large loss that is passive and generally suspended.
• Assuming the placed-in-service date is the closing date. It is when the property is ready and available for its intended use, which for a rental generally means available for booking.

What a buyer should have done in 2021

The right discipline in 2021 was to underwrite on pre-pandemic revenue rather than current revenue, and to buy on a basis that would survive normalisation.

The underwriting discipline does not change with the year. Twelve individual monthly revenue figures from a comparable set you assembled, a complete expense stack including reserves, and a stress test at 75% of projection that still covers debt service.

We screen roughly a thousand deals a week and eliminate about 98% of them. That ratio has held across every year on this site, through the boom, the correction and the stabilisation, because it is a function of how listings are selected rather than of the market.

What generalises, and what does not

Reading a year in isolation is the most common analytical error in this business. 2021 had its own conditions, and someone who learned the wrong lesson from it carried that lesson into a market that no longer rewarded it.

What generalises is the mechanics above. The definitions, the tests, the sequence and the failure modes are the same in every year on this site, which is why they are worth learning properly once rather than relearning each cycle.

What does not generalise is the environment: the cost of capital, the depth of supply, the bonus depreciation percentage, and the regulatory posture of a given jurisdiction. Those change, sometimes abruptly, and a model that treats them as fixed is a model that was only ever right about one year.

The practical consequence is to build the analysis so the environment is an input rather than an assumption. A property that only works at one interest rate, one occupancy level and one tax treatment is not an investment thesis, it is a bet that nothing moves.

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