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For real estate investors, both securing real estate professional status and investing in short term rentals (STRs) can result in significant tax savings. Successfully leveraging both of these strategies enables real estate investors to have their income and losses treated as non-passive.
By default, income and losses (achieved through depreciation) from rental real estate is considered passive income. From a tax perspective, that means it can only be used to offset other passive income––not the non-passive income you earn through your W-2 job or business ownership.
That adds up to a huge benefit, that depending on the size of your portfolio, might save you tens or even hundreds of thousands of dollars each tax season. To have your STRs be treated as non-passive, or to secure real estate professional tax status, there are several criteria that you must satisfy.
These real estate tax strategies aren’t the perfect match for every investor, but when executed correctly with the support of an experienced real estate accounting firm, they can add up to significant tax benefits that allow you to grow your wealth faster.
In this quick guide, we’ll share an overview of both tax strategies: qualifying as a real estate professional and operating short term rentals in a tax-advantaged manner. Read on to discover if either of these strategies makes sense for your portfolio.
What is Real Estate Professional Status?
Real Estate Professional Status, sometimes referred to as REPS, is a tax designation that individuals can elect on their tax filings that allows income and losses from rental real estate activities to be characterized as non-passive.
To qualify as a real estate professional, you must satisfy two key tests:
- Over 50% of all the personal services you performed in all businesses during the year must be performed in real property trades or businesses in which you materially participate
- You must spend over 750 hours working in a real property trade or business
This might seem simple, but the reality is that this is an extremely complex area of the tax code. In fact, it’s so complex we put together a 12,000+ word guide on qualifying as a real estate professional – download it now for a truly comprehensive overview of all the rules and benefits.
REPS is a carve-out designed specifically for full-time rental real estate investors who actively manage their properties. That means taking a hands-on approach to tasks like dealing with tenants and performing routine maintenance work, not delegating everything to a property management company.
What Are Short Term Rentals? A Tax Definition
The name short term rental is pretty descriptive: they’re simply rentals that guests stay in for short periods of time. Ever stayed in an Airbnb or VRBO on vacation? There’s a pretty good chance you might have stayed in an STR.
The income or losses from qualified STRs may be eligible for the same non-passive characterization as that enjoyed by a real estate professional, provided your short term rental properties meet the criteria specified by the IRS.
There are two main options available:
- Average rental periods of 7 days or less.
- Average rental periods of between 7 and 30 days, provided substantial services are offered to guests.
It’s usually preferable for short term rental operators to aim for their guests to stay for 7 days or less.
If the average rental period is over 7 days, owners are required to provide substantial services to their guests. What constitutes substantial services? The easiest way to break this down is to think about the services commonly provided by a hotel. For STRs, substantial services might include providing meals, daily cleaning, the use of a vehicle, and more. In practice, this essentially means you, or someone employed by you acts as a professional host whenever you have guests.
The other issue for short term rental operators with average rental periods between 7 and 30 days is that they have to report this income on Schedule C, which exposes them to 15.3% self-employment taxes.
These distinctions make it extremely important for STR operators to track average stay duration throughout the year. It’s best for investors to proactively manage their properties to ensure the average stay duration remains under 7 days, and there are software platforms to help you with this.
Short Term Rentals or Real Estate Professional Status: What’s The Best Fit For You?
Determining which approach makes sense for you is entirely situational and we encourage you to seek tax advice personalized to your unique situation. However, there are some general tax scenarios where either operating STRs or securing real estate professional status typically make more sense.
If you don’t meet the criteria to qualify as a real estate professional, operating STRs might be an attractive alternative. That applies to individuals who have a full-time job or ownership role in an unrelated business, or who lack the time to commit the hours necessary to qualify as a real estate professional. Provided you operate your STRs according to best practices and materially participate in them, you can enjoy similar tax benefits to real estate professionals.
For investors with larger portfolios, it’s possible to adopt a blended approach that leverages both STRs and real estate professional status. However, if you have a portfolio of properties, you cannot count the hours spent on your STR properties toward securing real estate professional status on your other, non-STR properties. This is backed up by Tax Court precedent.
If you have a portfolio of existing long-term rentals, you might be considering converting them to STRs. That can be attractive from a tax perspective if done properly and might even boost your income.
However, you should bear in mind that if you take this approach, you’re essentially signing up to run a new business with none of the predictability and stability offered by long-term rental properties. You might have to invest in furniture, decorations, and other amenities to make your property an attractive option for vacationers. In some instances, the juice just isn’t worth the squeeze.
Partner with a Specialized Real Estate Accounting Firm: Hall CPA
Successfully adopting a short term rental strategy or qualifying as a real estate professional can both unlock significant tax benefits for real estate investors. But neither of these strategies are approaches you should take lightly: both require significant amounts of work and the support of an experienced real estate accounting firm.
If you’re considering either approach or want to learn more about other real estate tax strategies that might represent a better fit for your portfolio, Hall CPA can help. Our tax advisors and CPAs specialize in the real estate industry and are experienced partners to real estate investors across the nation.