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If you own several rental real estate properties, you’re probably at least somewhat familiar with the various real estate tax opportunities available to you.
Owning rental real estate is a fantastic path toward building significant wealth for your family. The opportunities the tax code provides to real estate investors are a large part of this. Capitalize on them effectively and you can significantly accelerate your wealth building journey.
Two of the most popular tax strategies available to real estate investors are operating short term rentals (like Airbnb) or qualifying as a real estate professional. Both offer significant tax benefits, unlocking the ability for real estate investors to have the losses on their rental properties characterized as non-passive.
This is so valuable because it enables investors to use losses from their properties (usually achieved through depreciation) to offset their non-passive income, such as income from a W-2 job or a business that they own.
There’s no shortage of information online when it comes to both the short term rental loophole and qualifying as a real estate professional, including on this site. But it can still be difficult for real estate investors to understand which path represents the best fit for them.
Do you need qualified advice on the optimal tax strategy for your real estate portfolio? Hall CPA is a specialized real estate accounting firm and has expertise in designing and executing real estate tax strategies for investors all over the country. Contact us today to learn more.
Short Term Rental Tax Strategy with Airbnb
Short term rental properties have been around for years, but have seen a huge spike in popularity in recent years thanks to the emergence of platforms like Airbnb and VRBO.
For real estate investors, the short term rental loophole offers an attractive opportunity to have income and losses from rental properties treated as non-passive. But this approach isn’t a great fit for every investor, and before you decide whether it’s the best path for you, it’s important to consider the benefits and drawbacks.
What is the Short Term Rental Tax Strategy?
Income from rental properties is considered ‘per se’ passive income by the IRS, with some exceptions. One of those exceptions? Operating your rental real estate as short term rental properties.
There are two main ways that property owners can do this: renting their properties out for periods of 7 days or less, or renting their properties out for less than 30 days while also providing substantial services to guests.
For most investors, it’s preferable to aim for average stays of 7 days or less. Providing substantial services can be a significant commitment, effectively meaning your short term rental must function like a hotel. Besides, taxpayers who provide substantial services may also be subject to the 15.3% self-employment tax.
Who is the Short Term Rental Tax Loophole a Good Fit For?
The short term rental tax loophole is a great fit for real estate investors who don’t meet the criteria to qualify as a real estate professional. That includes W-2 employees with high incomes as well as business owners: both of whom often lack the time to satisfy the requirements to qualify for real estate professional status.
For these taxpayers, investing in short term rental properties can produce significant tax savings. In fact, one of our clients at Hall CPA, a successful dentist, reduced his federal income tax liability by around $130,000 by acquiring two short term rental properties.
Advantages and Disadvantages of Operating Short Term Rental Properties
As with any tax strategy, there are trade-offs investors must consider before making any commitments. Here are some of the key advantages and disadvantages of operating short term rental properties.
Advantages of Operating Short Term Rental Properties
- Non-Passive Characterization: operating properties as short term rentals enables investors to have the income and losses from these properties be characterized as non-passive, provided they meet several criteria.
- Increased Profits: short term rentals are typically more profitable than long term rentals, since the nightly rates you can charge on platforms like Airbnb significantly outstrip the income you’d achieve from a long term tenant.
- Deductible Expenses: short term rental properties allow investors to deduct many expenses, including advertising, mortgage interest, repairs, and more.
Disadvantages of Operating Short Term Rental Properties
- Time Demands: managing a short term rental property takes up much more of your time than a long-term property rental: you have to manage inquiries from guests, market your property, ensure cleaning between stays, and more.
- Unpredictability: the income from your short term rental can be entirely unpredictable. Unlike a long term rental where you know you’ll receive a check from your tenant every month, short term rental owners may experience seasonal changes or quiet periods.
- Not a Fit For Every Property: the best performing short term rental properties are in popular travel and vacation destinations. If your properties are in a quiet town with few attractions, there may not be sufficient interest to justify operating the property as a short term rental.
Real Estate Professional Status
Real Estate Professional Status, or REPS, also allows real estate investors to have the income and losses from their long-term rental properties be taxed as non-passive income. However, this designation is more difficult to qualify for than using the short-term rental tax loophole and is not a great fit for many investors.
What is Real Estate Professional Status?
REPS is a tax designation that allows taxpayers that satisfy certain requirements to have the income from their rental properties be treated as non-passive income. To qualify for REPS, there are a couple of main criteria investors must meet:
- Over half of all personal service hours a taxpayer performs in a year must be performed in a real property trade or business in which the taxpayer materially participates
- The taxpayer must spend over 750 hours working in real property trade or business
While it might sound like satisfying these conditions is relatively straightforward, the reality is much more complex. That’s why we wrote a 12,000+ word guide on qualifying as a real estate professional: download it now for a truly comprehensive guide to real estate professional status.
Who is the Real Estate Professional Status a Good Fit For?
The real estate professional status is designed for individuals who work in real property trades or businesses as their primary occupation.
To qualify for REPS, investors have to manage most elements of their portfolio independently and without the support of a third-party property management. That means communicating with tenants, working on routine maintenance tasks, and more.
Because of the qualifications, REPS is not a good fit for real estate investors who have full-time jobs or business that is not a real property trade or business - tax court precedent shows that substantiating this position is next to impossible.
Advantages and Disadvantages of Real Estate Professional Status
Similar to the short term rental loophole, there are several tax benefits and drawbacks to pursuing real estate professional status. Here is a quick overview.
Advantages of Real Estate Professional Status
- Non-Passive Characterization: qualifying as a real estate professional enables investors to have the income and losses from their rental real estate activities be characterized as non-passive.
- Lower Tax Burdens: REPS is especially powerful when used in parallel with other real estate tax strategies, including cost segregation and depreciation.
- Stable Income: taxpayers with REPS typically have long-term tenants in their properties, providing predictable income throughout the year with less risk of vacancies.
Disadvantages of Real Estate Professional Status
- Harder to Substantiate: in the event of an audit, the burden of proof is on the taxpayer to demonstrate that they met all the requirements for REPS. That demands individuals keep time logs, ideally backed by proof including receipts and calendar appointments.
- Requires Hands-On Approach: securing REPS demands that investors actively manage their real estate properties, rather than delegate this to a property manager.
- Not a Fit for All Investors: REPS isn’t a great fit for many real estate investors, and those who have a full-time job elsewhere will find it near impossible to qualify.
Get Specialized Real Estate Tax Advice from Hall CPA
Whether you’re leaning towards turning your portfolio into short term rental properties or think that securing real estate professional status might be a better fit, it’s imperative that you consult with a specialized real estate accountant.
Both of these tax strategies are complex and there are many mistakes that can trip investors up. Partnering with a real estate tax professional ensures you avoid these common pitfalls and execute your strategy using a proven methodology that doesn’t leave you exposed in the event of an audit.
At Hall CPA, we specialize in providing real estate tax advisory services to investors around the country. Our team has a proud track record of helping countless individuals either take advantage of the short term rental loophole or qualify as a real estate professional.
To learn more about our real estate tax planning services, contact us today.