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.
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.
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:
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.
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:
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.
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.
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:
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.
Since 2018, bonus depreciation for short term rentals and other business activities has been 100%. 2022 was 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:
For illustrative purposes, that would mean, if you were going to get a $250k deduction, you’d get $200k in 2023.
The $250k deduction would become $150k. Still sizable, but the power of the strategy will decrease.
The $250k deduction would become $100k.
The $250k deduction would become $50k.
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.
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: