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STR 02: The Details on Using Short-Term Rentals Losses to Reduce Active Income & Technical Details
May 20, 2021

May 23, 2024 | read

STR 01: How The Short-Term Rental Loophole Can Save You Thousands in Taxes

Ben Isley

This is the first episode in our series of episodes to unpack and clarify the tax loophole of short-term rentals. There are many important considerations when investing in short-term rentals, and using this strategy should not be taken lightly! One does not simply buy a short-term rental, list it on Airbnb, and reap tax rewards. Brandon Hall and Thomas Castelli will walk through all aspects of investing in short-term rentals to reduce your tax liability.

We don’t take the term “loophole” lightly. Many areas that are touted in the media as such are not actually true loopholes. We are going to actually explain the strategy of using short-term rentals to reduce your tax liability.

With the Biden tax law changes in the pipeline, you definitely want to stay up to date. Do so by joining our Facebook group: www.facebook.com/groups/taxsmartinvestors

Short-term rentals are important because many taxpayers want to offset their W2/active/ordinary/nonpassive income with real estate losses. If done properly, short-term rentals can offset directly against this ordinary income without the real estate professional status.

Losses can be generated by increasing your depreciation expense by using cost segregation studies to offset active business income without qualifying as a real estate professional.

Passive Activity Loss Rules

Every business is subject to passive activity loss rules.

Theoretically, you can passively participate in a business that you own, if you aren’t materially participating. Technically, every business is subject to these rules. For a larger history and full context, please first go listen to this previous episode: REPS 01. If you don’t materially participate, the activity is passive. Passive losses can only offset passive income. Passive losses cannot offset non-passive income (such as W-2 or active business income).

With all of the context on rental real estate and the real estate professional status, there is one type of activity that is treated differently: short-term rentals.

We will go through the citations and code sections next episode.

If you rent a property to customers with an average stay of 7 days or less, on average, this is a short-term rental. If that’s true, you don’t have a “rental” activity under Section 469. This means you don’t have to qualify as a real estate professional to recategorize that activity from passive to active. You do still have to materially participate.

While you still have to materially participate, you don’t have the additional hurdle of needing to spend more than 1/2 of your total working time within the business (like with REPS).

The fact that your average stay is 7 days or less is the portion that means your business is not a “rental” activity. Since your business isn’t technically a rental activity, you aren’t playing by those REPS rules for other true rental real estate activities. We will get into the specifics of this in the next episode.

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Who is a good fit?

For this to be a good fit, we generally see high-income earners. $200-300K+ up to $1MM.

For this strategy to be a good fit you also have to be bullish, in general, on short-term rentals. Airbnb and VRBO business models. You have to want to be a landlord and you have to want to own property long-term in the market/area. There are local laws and ordinances in many areas.

Many high-income earners often let the tax tail wag the dog. A deal may be tax-advantaged, but the tax advantage should not overpower the actual economics of the deal. Tax may be the motivation, but the investment principles must be kept #1. If it’s a bad investment, it’s a bad investment.

If you’re solely doing this for tax benefits, I think you’re going to be disappointed in the long run. You get the immediate gratification of tax savings, and that feels really good, but you are holding a short-term rental, and it must produce. If it doesn’t produce, the tax savings will get eaten up quickly with your net operating loss. You must operate and manage the property – it needs to actually produce a return.

Excess Business Losses – Section 461L

This section caps single individuals at $250K and married couples at $500K at excess business losses. An excess business loss if the dollar amount of your losses vs your dollars earned. If you have more dollars of loss, you have an excess business loss. Excess business losses over those thresholds are capped, suspended, and carried forward. If you’re married, you can only claim $500K in excess of your business income.

Be sure to tune in to episode 2 next, where we walk through the tax code sections and citations. In episode 3, we will go through some court cases and the Do’s and Don’t’s of short-term rentals.

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