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The short term rental tax strategy is a powerful way to reduce taxes on your income, and is a key incentive for a lot of short term real estate investors. This article breaks down the basics of how to take advantage of the short term rental loophole, and what a strategic approach to short term rental taxes looks like.
If you’re buying a short term rental, or already own a couple or more, the best step you can take is to connect with a real estate tax advisor. Our firm specializes in this, and we know that even small changes can make a huge difference in what you save on taxes. When you get someone who knows this field, it can give you a strategic advantage that supports your personal wealth and business growth. Contact our advisory department today to learn more.
Let’s dive into STR tax strategy.
The History of Short Term Rental Tax Strategy
Back in the 1980s, the Tax Reform Act of 1986 was passed. It was a top priority during President Reagan’s second term, and served to decrease federal income tax rates in certain tax brackets. It also changed the way taxes worked for short term rental properties.
Prior to this Act, individuals could take losses for rental properties against active income without any caveats. There was no such thing as passive activities, only business activities. Controversy existed around this as it applied to highly paid professionals, specifically doctors and attorneys, but the allowance applied across the board.
Here’s why people cared:
These highly paid professionals would buy a rental property, depreciate that property, then take the losses against their high income. Through lobbying and various initiatives, The Tax Reform Act introduced Section 469 of the tax code, which is the Passive Activity Rules. These rules made all rental properties passive by default. At that point, there was no way to make rental properties non-passive.
Through additional rounds of lobbying, especially from the real estate industry, a new law was passed in the mid-1990s called the Real Estate Professional Status (REPS) exception. Real property trades or business owners were then allowed to use losses from rental properties, classified as non-passive.
We’ll talk more in a minute about REPS as part of a short term rental tax strategy, but essentially you have to qualify as a real estate professional. To do that, you must work 750 hours and more than your total working time in real property trades or businesses.
What is the Short Term Rental Tax Loophole?
The short term rental loophole has saved people thousands of dollars a year in taxes because it doesn’t require you to be a real estate professional. It can be found in the tax code under Reg. Section 1.469-1T(e)(3)(ii)(A), and defines exceptions to the definition of “rental activity”.
Straight from the tax code, here are the six ways in which income for a rental property to be excluded from the definition of a rental activity, and thus not automatically passive:
- The average period of customer use for such property is seven days or less.
- The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers. This could include services like a hotel would provide, such as daily cleaning or meals.
- Extraordinary personal services (same as above) are provided by or on behalf of the owner of the property in connection with making such property available for use by customers (without regard to the average period of customer use).
- The rental of such property is treated as incidental to a non rental activity of the taxpayer.
- The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers.
- The provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not a rental activity.
At this point, do you feel like you need a comprehensive Guide to Short Term Rentals? We have one. This is what you need to open next.
Material Participation Tests for the Short Term Rental Tax Loophole
We mentioned before that earning a real estate professional status is one way to turn losses on rental properties. However, this isn’t typically an option for highly paid professionals like doctors or lawyers, because they don’t have half of their working time to work in a real estate business. The good news is that the short term rental tax loophole can help.
The exceptions to the definition of rental activities in the tax code listed above can also turn losses non-passive if you, the short term real estate investor, meet one of seven material participation criteria. These tests will determine whether you qualify based on your use of and involvement in your short term rental property.
Here they are:
- Spend more than 500 hours on the short term rental business
- Do substantially everything for the STR business
- Spend more than 100 hours on the activity and no one other individual spends more time than you do
- Significant participation activity for more than 100 hours, and your combined activity in all significant participation activities exceeds 500 hours
- Participating in the business for five of the 10 previous taxable years
- Personal service activity (non income-producing) for three of the previous taxable years
- Regular, continuous, provable participation in the business for more than 100 hours
The first three are the ones the majority of short term real estate investors qualify for.
Once you meet one of these tests, and your short-term rental is excluded from the definition of a rental activity, then it is considered non-passive.
STR Income and Non-Passive Losses
The goal of ticking these boxes is to use your short term rental for non-passive losses. This is what you want because non-passive losses can offset non-passive income. If you can meet the criteria, your short-term rental will save you money on taxes.
That’s the first big component of a short term rental tax strategy. The second is depreciation.
Depreciation for Your Short Term Rental Tax Strategy
If you get a savvy real estate CPA, they’re going to lead you through leveraging depreciation for your short term rental.
Here’s what they will help guide you on:
- Having a cost segregation study on your property
- That cost segregation will reclassify certain components of your property from 39 year life (depreciation life for an STR property) into 5 and 15 year life. This is for tangible personal property, land improvement property, and qualified improvement property.
Here’s why this is powerful:
5 and 15 year property can generally represent anywhere from 20-30% of a property’s purchase price.
Example: if you had a $1 million dollar property and did a cost segregation structure, anywhere from 20-30% could be resegregated and fully depreciated. This would give you a $250,000 deduction.
This is powerful because your losses are non-passive, and that tax loss can be used to offset taxes on your W-2 income.
What’s Changing About Depreciation for Short Term Rentals?
Since 2018, bonus depreciation for short term rentals and other business activities has been 100%. 2022 is the last year of 100% bonus depreciation. It is currently slated for a phased approach to decrease the percentage every year for the next five years.
This is what to expect:
- In 2023, it will drop down to 80% bonus depreciation.
For illustrative purposes, that would mean, if you were going to get a $250k deduction, you’d get $200k in 2023.
- In 2024, it will drop down to 60%.
The $250k deduction would become $150k. Still sizable, but the power of the strategy will decrease.
- In 2025, it will drop down to 40%.
The $250k deduction would become $100k.
- In 2026, it will drop down to 20%.
The $250k deduction would become $50k.
- In 2027, it will disappear completely.
It may be changed and extended, but this is the current plan.
To be clear: The short term rental depreciation loophole itself is not on the chopping block and may never be on the chopping block. However, the 100% bonus depreciation is naturally phasing out as part of the current law, which will reduce the impact of the strategy.
Even when bonus depreciation phases out, you can depreciate portions of your property at 5 or 15 years instead of 39 years, which still represents an opportunity for savings.
A comprehensive short term rental tax strategy is still the best way to get maximum benefits from short term rental investments.
Tax Strategies for Short Term Rentals
As you can see, investing in short term rentals can be an incredibly effective way to save money on your taxes. Getting into the game with Airbnb or similar platforms, and expanding your earning potential by accumulating additional properties, is a tactic used by high net worth individuals nationwide.
It does require tactical know-how and an understanding of the tax code. It also requires the help of a team, specifically a real estate CPA, a lawyer, and some administrative assistance, cleaners, and more.
While there is a learning curve and a few steps to get started, if you really want to, you can be looking at major savings on your tax bill by investing in short term rentals.
We’re the ones to call on for help:
- If you already own a short term rental or are in the act of acquiring a short term rental, you want to talk to our advisors.
- If you want to see what other people are doing and learn more about how it may apply to your situation, join the Tax Smart Insiders group through a Tax Smart Investors™ subscription plan with our risk free trial.