Does a cost seg apply to only the STR portion of a multi family?

Question

Here’s our situation: My partner and I bought a rundown two-family and put about $150K into it (electrical, HVAC, and a full cosmetic refresh on one of the two units). Both units are now rented, but the property is still operating at a loss.

We’re considering finishing the basement and converting it into a two-bedroom short-term rental. We’re close to Harvard Square, so the STR demand is potentially strong. The basement renovation will cost around $300K.

My understanding is that it doesn’t make sense to do a cost segregation study now because we don’t have rental income to offset yet (we’re operating at a loss). But if we finish the basement, launch it as an STR, and materially participate, then we could use a cost segregation study to offset our high W-2 incomes.

Someone mentioned that you can’t cost-seg the whole property if only one-third of it is being used as an STR, but I’m not sure that’s accurate. My understanding is that the rule isn’t about STR vs. LTR—it’s about whether you have non-passive income to offset and whether you materially participate. So when question is, do you cost seg the whole property, or only the 1/3 basement ($300k)?

Michael Plaks · Answer

You have a problem, Alicia, but not quite what you're focused on.

Yes, you can cost-segregate a part of the property. It's highly uncommon but it is possible. The real question should be - what's next?

You plan to claim one of the 3 units as an STR for tax purposes while the two current units remain LTRs. Some tax professionals believe that this is not allowed.

Since there is no consensus. I advise that you seek opinions of two or three competent tax experts specializing in real estate.

Bill B. · Answer

It’s an 8% return IF it adds $300k of value to the building. You need your realtor to “guess” what it does to resale value and take that in to account. If it adds $200k it’s a horrible idea. It will take 12 years just to “break even”. If it adds $400k it’s a great idea and you should start tomorrow.

Bill B. · Answer

1) Obviously talk to your CPA but I BELIEVE it only applies to the STR for the exact reason your are stating. The materially participating rule is about STR, your LTR deductions are not affected by how much you participate.

2) Remember, you aren’t creating new deductions, you are simply pulling them forward. That means you’ll have lower deduction in future years when they might be worth more.

3) Lastly, unlike any deductions you can write off as expenses, these deductions have to be paid back if you ever sell without doing a 1031.

TLDR: don’t do this work unless it makes financial sense as a standalone decision. Figure out how much more you’ll spend, how much more you’ll make and what the return is. Also if you will add more or less value than you’re spending. (Many people add an ADU for the high return on money spent only to find out their $400k ADU only added $250k in value to the property. That’s a big hole to dig out of.)

good luck. let me know what you decide and how it worked out with an @ tag.

Alicia Palleschi · Answer

@Bill B. Thanks Bill!! Solid advice. Lets say we do it for the sole purpose of $300k invested brings in $2k of positive cash flow.. that's an 8% cash on cash return, so cost seg aside, that's not bad right? Or am I missing something?

Stanoj Kocev · Answer

The whole property you can cost seg but the portion they live in will have to be subtracted from the benefit as you cannot cost seg your primary residence.

Like if I owned a 3 flat and lived on the top floor, I’d cost seg the entire building, but 1/3 of the benefit would not be able to be used to offset my income because I lived in the top floor.

Jason Malabute · Answer

For the STR were the average stays 7 days or less?

Aaron Zimmerman · Answer

@Michael Plaks agreed with this. Personally, I'd be airing on the side of caution on this one if this were my client given the different uses (LTRs and STRs. The tax benefits in my opinion don't outweigh the risk with doing the STR loophole

Does a cost seg apply to only the STR portion of a multi family?

Most Popular Reply