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Short term rental properties are a great investment for high earners. They deliver strong cash-on-cash returns and the underlying asset often appreciates. In addition to that, they also offer those with high W-2 income a massive opportunity to reduce their tax burden.
Doing this successfully requires the use of sophisticated tax planning strategies. Whether you’re considering purchasing your first short term rental property or already own a few, the right short term rental tax strategies could save you tens of thousands of dollars for years to come.
Successfully using short term rental properties to reduce the taxes on your W-2 income requires a specialized approach driven by a real estate tax advisor. Our firm specializes in this service area and has a proud track record of helping short term rental property investors minimize their tax burden and build wealth. To learn more, contact our advisory team today.
Key Strategies to Use Short Term Rentals to Reduce Your Tax Burden
Investing in short term rental properties offers several ways to save on taxes and build wealth. A comprehensive tax planning strategy will include all of these. In this guide, we’re going to focus on the two strategies that are most impactful by far: using your short term rental for non-passive losses and depreciating your short term rental property.
Perhaps counterintuitively, you want your short term rental investment to show a loss. These losses can then be used to offset your W-2 income. Now, these losses don’t mean you’ll be actively losing money from your bank account every month; instead, you’ll be depreciating your investment over time.
How to Use My Short Term Rental Property for Non-Passive Losses
Before we explore how to use this strategy, it’s important you understand the distinction between passive and non-passive losses. To unlock many of the most impactful tax benefits, your involvement in your short term rental property must be classified as non-passive.
What are Passive Losses?
Passive losses are defined as losses arising from an investment where you are not a material participant. Losses from long-term rental properties are usually considered passive losses. You can deduct passive losses against your W-2 income, but there are limitations that hinder the effectiveness of this strategy for high earners who aren’t real estate professionals.
What are Non-Passive Losses?
Non-passive losses are defined as losses from an investment (like a short term rental property business) where you are a material participant. They offer greater tax benefits than passive losses.
This begs the question: how do you ensure you are classified as a material participant in the business?
The IRS specifies seven tests for material participation. Provided you satisfy at least one, it’s possible to ensure your short term rental losses are classed as non-passive losses.
Classifying yourself as a material participant in the business is the first step to ensuring that income and losses stemming from your short term rental properties are treated as non-passive.
For the second step, you have two options: renting your property for average stays of seven days or less, or renting your property for an average stay of 30 days or less while providing substantial services.
How Long Should I Rent My Short Term Rental Property For?
Of these two options, it’s usually easier to rent your property for average stays of seven days or less. Platforms like Airbnb and VRBO allow you to cap the length of your stays at seven days.
You can rent out your property for longer than seven days, but just be aware you’ll have to make up the difference later with shorter rental periods. This requires careful management: if your average stay over the course of the year is over seven days, you risk losing non-passive status, which could cost you thousands of dollars.
If you choose to rent your property out for an average duration of more than seven days but less than 30, things become more complicated.
You’re required to provide substantial services, which as the name suggests, requires a lot of work on your part. You must provide guests with additional services such as meals, daily maid service, and no-cost extras like vehicles, tools, or sports equipment. In addition to that, you’ll also have to report this income on your Schedule C and pay self-employment taxes.
For all these reasons, many STR investors choose to rent their property for seven days or less. Once the test for non-passive status has been met, investors can then leverage depreciation to deduce expenses associated with their short term rental properties.
How to Depreciate My Short Term Rental Property to Reduce Taxes on W-2 Income
Depreciation is a powerful tool to realize tax savings on your short term rental property. It allows investors to spread the cost of an asset over a period of many years.
The standard depreciation period for a short term rental property is 39 years. However, by having a cost segregation study completed on their property, investors can pull forward many elements of this depreciation into a shorter timeline, which maximizes the tax benefits.
A cost segregation study splits your property into individual components that can be depreciated over a shorter five, seven, or fifteen year timeline. Typically, these components make up around 20-30% of the property's purchase price and often enable you to show significant losses. These non-passive losses are used to offset your W-2 income, minimizing your overall tax burden.
Paired with bonus depreciation, a cost segregation study enables STR investors to realize huge deductions. In 2024, bonus depreciation is 60%, which enables investors to expense most of the components specified in the cost segregation study in the year of purchase. Bonus depreciation is scheduled to reduce by 20% each year before eventually phasing out in 2027, so to realize maximum benefits, it’s important to act now.
Work With Experienced Real Estate Tax Strategists
Ensuring you meet the criteria as a material participant in your short term rental property and leveraging advanced depreciation strategies are not straightforward issues, and there are often huge amounts of money at stake.
To ensure success, engage the services of experienced real estate tax planning professionals. If you’re in the process of purchasing a short term rental, or already own short term rentals, our advisory team can help.
Contact our advisors today to learn more about how you can use short term rentals to reduce taxes on your W-2 income.