Cost Segregation Strategy - The One Month Short Term Rental to Long Term Rental Conversion
The short-term rental (STR) to long-term rental (LTR) conversion strategy, often involving a “one month” or minimal operational period (for the short term rental passive to active loss qualification), is a tax optimization approach used by real estate investors to maximize depreciation deductions while transitioning property use.
It’s particularly popular for leveraging cost segregation studies and bonus depreciation to create large upfront tax losses that can offset active income (like W-2 wages and business income), without requiring real estate professional (REP) status.
This strategy exploits differences in tax treatment between Short Term Rentals (STRs)(e.g., Airbnbs with average guest stays of 7 days or less) and LTRs (e.g., traditional year-long leases):
STRs are treated as a trade or business (non-passive) if you materially participate (typically 100+ hours/year) and the average stay is ≤7 days. This allows losses to offset ordinary income.
Cost segregation accelerates depreciation by reclassifying 20-40% of the property’s cost basis (e.g., furniture, appliances, flooring, landscaping) into shorter recovery periods - MACRS (5, 7, or 15 years) instead of the default 39 years for STRs (considered non-residential if average stays ≤30 days). Cost segregation is key to this strategy. If a cost segregation study is not performed, the losses on the first year of the property will be SIGNIFICANTLY less (Think in the hundred of thousands)
100% bonus depreciation (permanently extended under recent legislation like the One Big Beautiful Bill as of 2025) lets you deduct the full value of those shorter-life assets in Year 1, creating a significant “paper loss.” 100% bonus depreciation is also key to this strategy. This allow you to take a majority of the depreciation (based on the asset type and adjusted basis) in the year 1.
After claiming these benefits in the initial year, convert to an Long Term Rental (LTR) for simpler management, passive income, and potentially faster remaining depreciation on the building. Essentially, an investor would begin looking for a property in August/September, close in October/November (if everything goes well) and list and rent the property for short term stays in December.
Note: For bonus depreciation, the entire amount can be taken for the year, regardless of it being placed in service in December. However, the MACRS depreciation received for the asset will be prorated.
The “one month” aspect often refers to minimizing the STR operational period, placing the property in service late in the year (like December) and securing just enough short stays (e.g., one or a few weekends) to establish the ≤7-day average for tax qualification, while still claiming full-year benefits on bonus depreciation.
Strategy:
Acquire and Prepare the Property:
Buy a residential property suitable for rentals (e.g., $500,000 purchase price).
Furnish and improve it (e.g., $50,000+ in appliances, decor, and upgrades) to maximize segregable assets. *Not required
Place it in service as an STR (make it available for rent via platforms like Airbnb). To minimize hassle, do this late in the tax year (November/December) for a one month.
Operate as STR Minimally:
Secure at a few actual short rentals (≤7 days each) to qualify the average customer use period as ≤7 days for the year. (Average = total rented days / number of renters; even 1-2 bookings can suffice if they’re short.)
Document material participation (e.g., logs of time spent on marketing, cleaning, guest communication—aim for 100+ hours).
This establishes the property as non-passive, allowing losses to offset active income. No need for full-year bookings; the goal is qualification, not maximum revenue.
Perform Cost Segregation Study:
Hire an engineer or specialist (cost: $1,500-$3,000) to analyze the property and reallocate costs:
Example: On a $500,000 property, ~$100,000-$200,000 might shift to 5/7/15-year assets (personal property and land improvements).
The remaining ~60-80% (building structure) starts depreciating over 39 years (STR default).
Apply 100% bonus depreciation to the shorter-life assets, deducting their full value in Year 1 (no proration for late-year placement).
Claim Tax Benefits in Year 1:
Generate a large loss: Revenue minus expenses (including the bonus depreciation) creates a deductible loss (e.g., $150,000+ deduction on a mid-sized property).
Offset against ordinary income: If your AGI is high (e.g., $300,000+ from W-2), this could save $50,000+ in taxes at 37% federal rates.
No REP status needed, unlike traditional rentals.
Convert to LTR:
Switch to long-term tenants starting the next tax year (e.g., January after a December STR start).
The conversion changes the property’s classification to residential, allowing you to adjust the remaining building basis from 39-year to 27.5-year depreciation. This accelerates future deductions on the structure (e.g., higher annual depreciation going forward).
Previously claimed bonus depreciation remains intact—no immediate reversal.
Benefits
Upfront Tax Savings: Front-load deductions to offset high-income years, improving cash flow (e.g., defer taxes by $30,000-$100,000+ in Year 1).
Flexibility: Minimize STR headaches (e.g., guest turnover, regulations) by limiting to one month or minimal bookings, then enjoy stable LTR income.
Accelerated Long-Term Depreciation: Switching to 27.5 years on the building boosts ongoing deductions compared to sticking with STR’s 39 years.
No Passive Loss Limits: Unlike LTRs, Year 1 losses aren’t capped at $25,000 (or suspended if no REP status).
Cash Flow Boost: Tax savings can fund more investments; works well for high-earners without full-time real estate involvement.
Major Hurdles/Risks I have seen:
Qualification: Must prove ≤7-day average and material participation; audits are common for aggressive STR claims. If no actual rentals occur, the IRS may reclassify as passive or deny deductions (property must be genuinely available and used for business).
Depreciation Recapture: Upon eventual sale, bonus-depreciated assets are recaptured at ordinary income rates (up to 37%), not capital gains (15-20%). This is a deferral, not elimination—plan for it (e.g., via 1031 exchange).
Bonus Depreciation Phase: While permanent at 100% as of 2025, eligibility requires qualified property (≤20-year recovery period). Building structure doesn’t qualify directly.
Local Regulations: STRs face bans or fees in some areas; conversion might not retroactively help if audited.
Audit Risk: The IRS scrutinizes STR loopholes; poor documentation (e.g., no time logs) can lead to reclassification and penalties.
Not for Everyone: Best for high-income taxpayers ($200,000+ AGI); lower brackets get less benefit. Costs (study, furnishings) must outweigh savings.
Example Calculation
Property cost: $500,000 (building $400,000, land $100,000 non-depreciable).
Cost seg reallocates $150,000 to 5/15-year assets.
Year 1: 100% bonus dep = $150,000 deduction + prorated 39-year dep on $250,000 building ($500/month if late-year start).
Total loss: $150,000+ (assuming minimal revenue/expenses).
Tax savings: $55,500 at 37% rate.
Year 2+: Convert to LTR, depreciate remaining building basis over 27.5 years ($9,000/year vs. $6,400 under 39 years).
