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Short term rentals (STRs) are a great way to save money on taxes, but you have to understand the strategy to make them work for you. The goal is to make the income you earn from short term rentals non-passive. In case you’re a newbie, non-passive income and losses are those you incur from a business activity in which you (the taxpayer) are a material participant. Non-passive income is deductible against your “active” income and can reduce your taxes. Short term rentals are a powerful real estate investment opportunity because of this dynamic.
For a full primer, read our Guide to Short Term Rentals. Keep reading here for a quick answer on how to make short term rentals non-passive so those investments actively support tax savings.
First, in any arena, you must meet the material participant requirement from a business activity to make it nonpassive. There are seven ways to do that, any of which can be used by the IRS to determine whether you’ve materially participated.
For more insights into short term rental losses, you can check out this podcast episode.
As long as you meet at least one of the material participation tests, and prove your involvement in the business, you then have two options to ensure your short term rental income is non-passive.
Two Ways to Make Short Term Rentals Non-Passive
Here are your two options:
Average Stay of 7 Days or Less
You can rent your property for an average stay of seven days or less. This simply means that the annual average stay of people who rent out your property is seven days or less.
Does this mean you can’t ever have someone stay in your STR for more than a week? Not necessarily. You can rent for more than seven days, but the average has to work out to seven days. The typical software or listing platforms for short term rentals may have built-in mechanisms to help you maintain this average stay.
As you investigate Airbnb, VRBO, HomeAway, etc., you may be able to cap stay length at seven days, which then requires no calculations or ongoing monitoring.
However, there may be times when it benefits you to let people stay a little longer. For instance, if you have a vacation rental and make most of your money seasonally, you could rent out for ten days at a time. Keep in mind you would absolutely have to offset that with shorter stays for the rest of the year. If you go even to eight days for an average stay, you risk losing your non-passive status and could have STR income count as taxable income.
Seven day stay is the more common of the two options, in part because when you take advantage of this option, you don’t have to pay self-employment taxes.
So, what if you generally want to rent your property out for a month at a time or have longer-term stays? There is option number two.
Average Stay of 30 Days or Less PLUS Substantial Services
In the event that the seven days isn’t your preference, a second provision allows you to rent your short term rental for thirty days or less, as long as you also offer substantial services. Now, be prepared, these substantial services aren’t called that in error: they must be substantial and basically require you to run a hospitality business.
It’s helpful to think of “substantial services” for short term rentals as “hotel like.” In other words, what would a hotel offer? Daily cleaning, daily breakfast, tours, the provision of tools (at no extra charge), the provision of a vehicle (at no extra charge), added benefits, etc. These require you, or someone you hire, to essentially play host or hostess on the property. It’s a significant engagement, which is why it’s the less common of the two options for most real estate investors.
There are some downsides to choosing this provision. For instance, if you choose the 30 days or more plus substantial services, you must report it on Schedule C, filing as a business. This means your income will be subject to 15.3% self-employment taxes.
So, you may either meet the seven days or less, or 30 days or less, criteria to make short term rentals non-passive.
Mistakes That Could Put Non-Passive STR Status at Risk
Let’s talk about mistakes people make with short term rentals that could put non-passive status at risk. A first has to do with using the property personally. If you are going to use your short term rental, you can only do that for less than the greater of 14 days or 10% of the total days rented. If you stay longer than that, your short term rental property will be considered a residence. Once the property is considered a residence, losses from the property are limited to the income the property generates, which blows the short term rental loophole.
It’s also important that you don’t make the mistake of misinterpreting what a “stay” is. A “stay” encompasses anytime a person is lodging at the property for less than the fair market value of rent. This includes family members (parents, siblings, children). So, if you want to rent your short term rental out part of the year and let friends and family stay there another part of the year, you absolutely risk losing non-passive status for your taxes.
Should You Just Have a Long Term Rental?
People get into the short term rental game for many reasons, and the ability to make non-passive income is one of them. Because there are complexities to this, you may wonder if just going for a long term rental is an option. Of course, it is, but it carries none of the benefits of STRs.
There are pros and cons to long term rentals. The pros are that you have one lease, less work, can delegate almost everything out, and may have more stability. Tenants of long term leases are likely to think of it as “home” and treat it as such.
There are cons, too. The cons are that all income is automatically passive, which means that you can’t reduce taxes on your active income unless you’re a real estate professional.
Short term rentals are an appealing option because they can be highly profitable and win you a significant tax deduction. On average, you can charge more per day. You will deal with the ins and outs of running a short term rental business, but if you get your strategy right, you can do this successfully.
Find an Accountant for Short Term Rentals
Realize that you need a real estate accountant to weigh in on your options for running a short term rental business? We recommend reaching out to a qualified real estate tax advisor. Our advisory services are unparalleled and can steer you in the right direction to minimize risks and maximize tax savings. Contact us now to learn more.