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Investing in short term rental properties is a great way for high earners to minimize tax exposure while building long-term wealth. Whether you’re just starting out on your short term rental property journey, have already purchased a couple of properties, or own multiple successful rentals, the principles to maximize your losses remain the same.
If you have high levels of active income, like W-2 or 1099 income, investing in non-passive assets is a powerful way to reduce your tax liability. With the help of sophisticated tax planners, short term rental properties can produce significant losses. You can then deduct these losses against your actively earned income, reducing the amount of tax you owe and ultimately keeping more money in your pocket.
For a deep dive into the process of finding, purchasing, and operating a short term rental property, read our Guide to Short Term Rentals. If you’re primarily interested in learning how to maximize your losses from your short term rental properties, read on.
Short Term Rentals: Non-Passive Income and Losses
To be able to effectively apply your income and losses from your short term rental properties to your taxes, you must be a material participant in the business and the income must be classed as non-passive.
These distinctions are crucial to securing the optimal tax status for your short term rental income. Let’s take a closer look at exactly what these terms mean and explore the steps you must take to qualify.
What is Material Participation in Short Term Rental Properties?
The first condition you must satisfy is the material participation requirement. In a nutshell, this means you are personally involved in the business activity. The IRS specifies seven tests that determine whether you are materially involved in the business. You only have to satisfy one of the seven.
These tests are outlined in IRS Publication 925: Passive Activity and At-Risk Rules. Most short term rental investors typically qualify for one of these three tests:
- Spend more than 500 hours annually on the short term rental business
- Do substantially everything for the short term rental business
- Spend more than 100 hours on the short term rental business, with no one other individual spending more time than you on the short term rental business.
Additionally, it’s important to make sure your short term rental qualifies for the short term rental loophole. For more information on qualifying for the loophole, read this article: Short Term Rental Tax Strategy.
Provided you qualify as materially participating in the business, and your short term rental is excluded from the traditional definition of a rental, your income and losses will be considered non-passive. This unlocks the ability to maximize your losses from your short term rental properties by leveraging depreciation.
How to Use Depreciation to Maximize My Short Term Rental Losses
Depreciation is perhaps the single most powerful way for investors to maximize the losses they realize from short term rentals. Leveraged correctly, depreciation allows you to spread the cost of a property over multiple years, and recent bonus depreciation laws enable investors to deduct large portions of their expenses in the first year.
What is Depreciation?
Depreciation is a fundamental concept in financial accounting. When you purchase a short term rental property, that property is considered to have a “useful life”. For short term rental properties, this “useful life” is generally 39 years. Over these 39 years, the property is considered to depreciate in value to zero. Each year, the investor is permitted to take a depreciation deduction of one thirty-ninth of the building’s value.
For a more detailed overview of the mechanics of depreciation, read this guide: Basics of Real Estate Depreciation Recapture.
It’s clear that even this basic form of depreciation offers favorable tax advantages, but more advanced strategies, including cost segregation studies and bonus depreciation, offer investors the ability to truly maximize their losses from short term rentals.
Using a Cost Segregation Study to Maximize Short Term Rental Losses
A cost segregation study is one of the most effective ways for investors to maximize their losses from short term rental properties. Performing a cost segregation study allows real estate investors to dramatically shorten depreciation timelines, which both improves cash flow and can enable a significant reduction in the investor’s tax burden.
Cost segregation studies separate and re-classify various elements of your property. These components, such as appliances, carpets, and bathroom fixtures, can then be depreciated over a much faster time period: 5, 7, or 15 years, depending on the element.
On average, these components make up 20-30% of a property’s purchase price. These losses are classified as non-passive and can be used to reduce taxes on your W-2 income. There are costs involved with undertaking a cost segregation study, but they’re typically dramatically outweighed by the tax benefits you can realize.
Using Bonus Depreciation to Further Maximize Short Term Rental Losses
Bonus depreciation can take the losses that you’re able to realize from your short term rental properties even further. Under current laws, investors can deduct 100% of the value of the components identified in the cost segregation study that have a class life of 20 years or less in the first year of ownership. These losses are non-passive and carry forward into future years.
Bonus depreciation is scheduled to be phased out over the next five years. Since 2018, bonus depreciation has stood at 100%, but in 2023, this is scheduled to drop to 80%, then 60% in 2024, 40% in 2025, and 20% in 2026, before being eliminated entirely in 2027. To realize the full benefits of bonus depreciation, it’s important to act now.
Work with Real Estate Tax Professionals
Each of the strategies outlined above is extremely effective in enabling short term rental investors to maximize their losses. However, these are sophisticated tax planning strategies, and it’s advisable to work with a team of real estate tax specialists to ensure every element of your loss-maximizing strategy is executed correctly.
Our advisory team is here to help develop a short term rental tax strategy that’s fully tailored to your needs. To learn more, contact the team today.