The YouTube algorithm recommended an interesting playlist: The American "Wealth" System. I can't recommend it because it's not very good, but it exposed me to some ideas that I thought were interesting, which I thought I'd scare in this post.

The playlist outlines a strategy for reducing tax burden using short-term rentals, cost segregation studies, and bonus depreciation rules that have come online in the 2025 "One Big Beautiful Bill Act".

At a high level, the strategy works like this:

1. Make your STR a non-passive business (so losses can offset W-2 income).
2. Do a cost segregation study to carve your purchase price into various depreciation timeline buckets, then
3. Take bonus depreciation on the ≤20-year timeline buckets, creating a big “paper loss” and offsetting W-2 taxes immediately.

The concept is to treat these deferred taxes as an interest-free loan from the government, and reinvest those deferred taxes into more assets. So far so good.

The next parts of the strategy are more degenerate and risky:

• Use the deferred taxes as a down-payment for another house
• Instead, use refinancing to access equity without triggering capital gains ("borrow until you die"), and
• Rinse and repeat forever to get leveraged wealth generation
• Never sell your homes, just keep snowballing one investment into another. This avoids capital gains taxes. Plan around the step-up in basis at death that can reduce or eliminate taxable gain for heirs.

I don't actually recommend the playlist for a variety of reasons: they have a conflict of interest selling their product, they make a ton of technical oversimplifications, uses sensationalist language, it has a lot of hand-wavy macro claims, and it neglects to discuss some of the risks. Still, I found it useful as an introduction to some concepts.

I extracted the full transcripts from the playlist using my Youtube transcript extractor script, then discussed it at length with Gemini 3. I then used it to organize the ideas, which I'm pasting below. It covers a lot more of the risks, tightens up some inaccuracies, and adds California-resident-specific info.

The STR Snowball

Step 1) Making the STR non-passive

Think of income as belonging in two buckets: Active income and Passive income (ignoring investment income). Normally, passive losses can only cancel it passive income; you can't use it to offset your W2 income.

Under the passive loss rules (Sec. 469), rentals are passive unless you were a "Real Estate Professional" (750 hours/year + >50% of your working time).

However, short-term rentals can escape that if under certain conditions:

• If average stay is 7 days or less
• you provide substantial services (hotel-like) or amenities (coffee, linens, cleaning).

You can keep your full-time W-2 job and still qualify by meeting the lighter STR material participation tests. The most common for STR owners is:

• 100 hours of participation in the year, AND
• More hours than anyone else (including cleaners, handy-workers, etc.).

You cannot hand off management to a property manager if you want to meet the material participation test.

Step 2) Cost segregation study

Usually you depreciate your home gradually over 27.5 years (or 39-years in some STRs).

A cost segregation study is splits a property into different components that depreciate over different schedules. Usually, roughly 25% of a property’s purchase price often qualifies for this accelerated depreciation.

Under the new One Big Beautiful Bill Act (OBBBA) signed into law on July 4, 2025, you are now allowed to claim 100% of the components that depreciate in less than 20 years immediately.

To maximize this accelerated depreciation fraction, you want to prefer:

• Homes with many bonus amenities, like hot tubs, pools, furniture, specialized electrical. These depreciate faster.
• High improvement value (e.g., Midwest home) vs. high land value (e.g., Malibu cliff house), because land is not depreciable.
• Instead of paying 20% down for an investment property, use it as you primary residence for 1 year and pay 3-5% down. This maximizes the ratio of tax deduction to cash invested.

This step is most beneficial to people at a high tax bracket

Example Math:

• W-2 Income: $100,000 (Tax liability ≈ $20k).
• Buy STR: $500,000 purchase price.
• Cost Seg: Identifies $125,000 (25%) as bonus-eligible 5/7/15-year property.
• Result: $125,000 paper loss.
• Tax Impact: $100,000 offsets W-2 income to $0. Remaining $25,000 carries forward indefinitely to future years.
• Cash Flow: keep the $20k that would have paid in taxes and uses it for the next down payment.
• Repeat

Refinancing, inflation, and step-up in basis

The Over time, three forces work together:

1. Appreciation: The property value grows (historically 3-4%). This appreciation counts as equity, which you can use in refinances.
2. Tenants/guests pay the mortgage principal, building equity. Note however that at the start of the loan they are mostly paying off interest.
3. You pay back fixed-rate debt with future, inflated dollars (effectively "shorting" the dollar).

As equity builds, you can access it via a cash-out refinance (typically up to 75% LTV). Loan proceeds are not taxable income ("Debt is not tax"). This liquidity can fund the next acquisition without selling the asset.

Example Math:

• Buy for $400k ($80k down, $320k loan).
• Value grows to $500k; Loan paid down to $280k.
• Refinance at 75% LTV of $500k = $375k new loan.
• Pay off old $280k loan = $95k cash out (tax-free).

When you die, under current law, assets receive a step-up in basis. Heirs inherit the property at fair market value, wiping out the deferred tax liability from the depreciation you took.

California state specifics

California disallows bonus depreciation. NY and NJ also don't conform.

So, for your Federal return, you file as expected, but for your CA return, you have to add back the deducted amount and use CA’s slower depreciation schedule (Form 3885A).

The OBBBA raised the State and Local Tax (SALT) deduction cap to $40,000 (for income <$500k) through 2029. This helps offset some of the pain of high CA taxes, though likely not enough to fully counter the lack of bonus depreciation conformity.

If the STR is in another state, you still have to pay CA taxes since California residents are taxed on their worldwide income and CA’s depreciation rules apply even if the STR is in another state.
You may also file a nonresident return in the state where the property is, following their rules. You generally get a credit on your CA return for taxes paid to that other state.

If the STR is inside CA, but you weren't a CA resident, you file a CA nonresident return for that property’s income only, using CA’s slower depreciation rules."only" can weaken meaning"only" can weaken meaning"only" can weaken meaning"only" can weaken meaning

Key Risks and Gotchas

• Local Bans: Cities can ban or cap STRs, forcing you to long-term rental (killing the "7-day average" loophole).
• Law Changes: Bonus depreciation rules, step-up in basis, and passive loss rules are subject to change by Congress.
• Recapture: Selling the property triggers recapture tax on the depreciation you took, often at higher rates (up to 25%). To avoid this, you typically must 1031 exchange into a larger property or hold until death. You are effectively committed to a perpetual cycle of buying/holding to avoid the tax hit.
• Material Participation Scrutiny: The IRS may audit your hours logs. You must prove you did the work and (often) more than anyone else.
  • The "Out-of-State" Trap: If you live in State A and the STR is in State B, it is very hard to prove you spent more hours than the local cleaner or handyman. If a cleaner spends 105 hours/year and you spend 100, you fail the test, and the losses become passive (useless against W-2).
• The "Personal Use" Trap (Sec 280A): You generally cannot use the property personally for more than 14 days per year (or 10% of the total rental days, whichever is greater).
  • If you exceed this limit, the property is considered a "residence," and your deductions are capped at the rental income amount. You cannot create a loss to offset your W-2 income.
• Engineering Quality: IRS expects serious, engineering-based cost seg reports. The video advises against "rule of thumb" estimates and emphasizes using reputable firms that provide audit protection and engineering sign-offs.
• The videos claim deferred taxes are an "interest-free loan." This is true for the tax side, but the Refinance side is expensive.
  • Cash-out refi proceeds are tax-free, but they are debt. You pay mortgage interest (e.g., 6-7%) on that money.
  • If you borrow at 7% to buy a property that yields 5%, you are losing money on the leverage, even if you saved on taxes.
• "Phantom Income" (Taxes on money you don't have): In later years (e.g., Year 7+), your depreciation runs out, and your mortgage payments shift toward mostly Principal (which is not tax-deductible).
  • Scenario: You collect $15,000 in actual cash profit, but you make $10,000 in mortgage payments. But because principal payments aren't deductible, the IRS calculates your profit as $15,000. You might owe $6,000 in taxes despite only having $5,000 cash. You have to pay the IRS out of your own pocket.
• Liquidity Risk & LTV Traps: The strategy assumes you can always refinance to get your money back.
  • Banks typically lend up to 75% Loan-to-Value (LTV).
  • The Trap: If the market dips even 5-10% when you plan to refinance, you might not have enough equity to qualify for a cash-out loan. Your down payment gets "stuck" in the property for years, halting your ability to buy the next one.
• The "LTV Math": You typically buy at 80% LTV (20% down) or 95% LTV (5% down). You can only cash-out refinance up to 75% LTV.
  • The Gap: You have negative access to equity on Day 1. You cannot pull cash out until you pay down the loan significantly, OR the property appreciates significantly.
  • Amortization Drag: In the first few years of a mortgage, your payments are almost entirely interest, not principal. You are not building equity through payments fast enough to bridge this gap quickly. You are effectively relying 100% on market appreciation to make the refinance possible. Further, you typically can't request a re-appraisal of the property until you have owned it for a year, unless you have done major renovations that have increased the value of the property.
• It's a Business: STRs require management (cleaning, guest comms, pricing). It is not passive income.