153. A Tax Advisor’s Guide to Building & Self-Managing a Rental Portfolio & More w/ Justin Shore, EA
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154. Debating Whether or Not Are Landlords Extortionists & The Economics of Being a Landlord
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May 23, 2024 | read

STR 04: How a Short-Term Rental Investment Can Result in BIG Tax Savings

Thomas Castelli

In this episode, Brandon gives a detailed explanation of how you can get big tax savings from short-term rental investments.

This episode is sponsored by Landlord Studio and Tax Smart Investors.

Full Transcript:
This podcast has been transcribed using AI, please excuse spelling, grammatical, and other errors.

Thomas Castelli 0:00
You’re now listening to the real estate CPA podcast, your source for all things real estate,

Brandon Hall 0:05
accounting and tax. Here we reveal our secrets that can save you 1000s in taxes, streamline your accounting process and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors and current clients on what strategies they use to grow their business, and how they steer clear of Uncle Sam.

Thomas Castelli 0:29
Hi, everybody. Thanks for tuning in to the fourth episode of the short term rental series. Today’s episode is one of the tech smart daily episodes that Brandon released on YouTube where he walks through how short term rentals can yield massive tax savings. If you’re not familiar with tax Mark daily, it’s a daily YouTube series where Brandon shares all kinds of tax saving strategies and tips for real estate investors. If you’re interested in following along with Brandon on the whiteboard, you can go ahead and check out the video on YouTube. But do be sure to wait until you get home if you’re driving. I’ll go ahead and drop the link to the video in the show notes below. But you can also search for tax smart investors on YouTube. While you’re there. Don’t forget to subscribe to receive more tax smart daily videos. We’ll catch you there but for now we’ll dive right into today’s episode.

Brandon Hall 1:14
Thanks for tuning in to today’s episode of the tax Mart daily. I’m Brandon Hall, a CPA managing partner at the real estate CPA. And you can see this lovely background behind me. I’m actually using a new video program today. And you’ll see why here in a second. But regardless, I invite you to join the tax smart real estate investors Facebook group, a link to join is below in the description of this video. We’re having a lot of fun tax accounting and real estate conversations in that group. And I invite you to come be part of the conversation. Now today’s video, what I want to do is something a little bit different. I want to actually rehash a recent conversation that I had. So with one of my friends, they’re facing this really large tax bill. And they’re not a real estate investor, they don’t even know they don’t know the first thing about real estate investing, they know that I invest in real estate and my wife invest in real estate and that I run this real estate firm and that I have a lot of real estate investor clients. And so they’re always kind of interested in talking about it, you know, financial freedom and all that type of stuff. But they haven’t really like gone further than that. So the conversation got kicked off over a couple IPAs. And if you’re local to Raleigh, North Carolina, there’s a brewing company called R and D brewing, they make Saturdays which I truly believe are the best IPAs that exist on the planet. And I am an IPA fan. So I feel like I can say that confidently. So we’re sitting here talking about some finance stuff over our Saturday IPAs, and the topic of this big tax bill in 2021 comes up. And so my friends, my friends asking me Hey, is there anything that I can do? Do you know anything off top your head? I’m like, No, unless you invest in real estate, and you could invest in short term rentals and, you know, wipe your tax bill out. And then all of a sudden, you know, they’re paying attention like, wait a second, what do you mean, I could wipe my tax bill out, because we’re talking about this guy’s tax bill, it’s gonna be relatively large this year. So got really interested really fast. So explain the whole concept of investing in short term rentals and, and why they give you preferential tax treatment over long term rentals, I was explaining the passive activity rules how you have the passive bucket and the non passive bucket. And I was explaining some numbers and kind of just given him a sense for what he could expect if you were able to pick up a short term rental, and rent it out a couple times by the end of the year. So I want to kind of rehash that conversation with you today. And to do so I feel like I need a trusty whiteboard. There we go. So this is the new program that I’m using, I hope that you like it. Okay, so we started off with the passive activity rules. And if you haven’t watched any of our tax Mark daily content, I’m gonna give you a quick primer on how the passive activity rules work. If you have watched the taxpayer daily content, or you’re pretty used to our content, you’ve heard this bill before, you can just probably skip the next 30 to 60 seconds. So every dollar that you earn is either going to be passive, or non passive. So it’s going to be in one of these two buckets. And this is true, even if you’re not a real estate investor. So that’s that’s what’s so interesting to me about this is that literally every person that files a tax return is subject to these rules, and very few of them even know that they are you really find out that you’re subject to these rules once you start investing in real estate because you start hearing this term passive activity and in that it’s got some tax things that go along with it. So the important thing to know is that every single dollar that you earn goes into the passive bucket or the non passive bucket, my w two income is in the non passive bucket. My business income is in the non passive bucket, my stock income is in the non passive bucket, my rental income is in the passive bucket also in the passive bucket is going to be business income that I don’t materially participate in. So I’m going to put no MP business income where I don’t materially participate that is also in the passive bucket. Even though business income I just sit over here is in the non passive bucket. This is only when I materially participate. So in the past bucket I have real estate and I have business income where I don’t materially participate. Now, it’s important to know because real estate typically generates tax losses after depreciation. If you don’t know what depreciation is, go check out our prior tax Mark videos where we talk all about it. But real estate’s depreciation is typically going to generate a tax loss. Even when you have net operating income or cash flow positive, you’re still going to be able to report to the IRS that you had a tax loss, in most cases sometimes doesn’t work out like that if you have a really crazy cash flowing deal, but most rental real estate’s gonna generate a tax loss. And because we’re in the passive bucket by default, the tax loss is trapped in this passive bucket, you cannot move the tax loss to the non passive bucket unless you qualify as a real estate professional and materially participate in your rental portfolio. So if I can’t move the passive losses out of the passive bucket into the non passive bucket, then I can’t use my rental losses to offset my w two income, my business income and my stock income. So instead, my passive losses just get suspended and carried forward. And that is the downside of investing in rental real estate while you have a full time job, because you’re not gonna be able to qualify as a real estate professional, you’re not gonna be able to materially participate in your rental portfolio. So it’s going to generate passive losses, and those passive losses are going to get trapped and suspended and carried forward. But there’s a little carve out for short term rentals. Short term rentals are not considered rental activities. As long as the average period of customer use is seven days or less, I’m going to put down here seven days. So if you rent your short term rental seven days or less, on average across all of your customers, you do not have a rental activity under these passive activity rules. And what that means is, you don’t have to qualify as a real estate professional. In order to move it from the passive bucket into the non passive bucket, all you have to do is materially participate. And there are seven rules for material participation, there’s seven tests, you’ll need to meet one of them, the two that we see most often, with short term rental owners are substantially all in 100 hours, and more than anyone else. So if your participation in your short term rental activity is substantially all of the participation among everybody that participated, meaning that you did most of the work, you didn’t really have many helping hands, you didn’t hire out property management, you didn’t have a whole lot of cleaning activity, you did the majority of the work. If your participation is substantially all the participation, you will be materially participating. Put an MP here for material participation. Or another test is if you spend 100 hours and more than anyone else, then you are materially participating. I’m not going to dive deep into the material participation test today. But the important thing to know is that you have to meet one of these tests substantially all or 100 hours or more than anyone else to be materially participating in. If you are materially participating. Your rental losses are going to be non passive from this short term rental activity, which means that you can do a cost segregation study. And most of these cost segregation studies are coming in anywhere between 20 to 25% of the purchase price being allocated 257 and 15 year property, which means that you can immediately expense anywhere between 20 to 25% of the purchase price, thanks to 100% bonus depreciation. So to sum this up, we got seven days or less. Excuse my bad handwriting, I’m trying to do this with a mouse seven days or less, we also have to materially participate. We also have to get a cost segregation, study done cost segue. Again, bad handwriting, but that’s okay, you get it plus, plus, so seven days, plus material participation, plus a cost segregation study. And if we can get that if we can get all this going, then we can generally immediately expense anywhere between 20 to 25%.

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of the purchase price, okay, so again, seven days or less, on average per customer, you have to materially participate substantially all 100 hours more than anyone else. So those are those the two main tests that we’re going to see as a short term rental owner. And we then do a cost segregation study in a cost segregation study simply takes my purchase price and reallocates it between five seven and 15 year property as well as 39 year property. So it’s just saying, you know, you bought this building, but not everything in the building is going to last as long as the building’s gonna last, it’s gonna deteriorate faster. So we’re going to allocate costs to those faster timelines. That’s what a cost segregation study does. But then you get to immediately expense any component with a useful life of less than 20 years. And typically 20 to 25% of the purchase price is going to be allocated to components with a useful have less than 20 years. That’s why you get to immediately expense 20 to 25% of the purchase price. So what does this mean? Let’s walk through the example that I walked through with my friend the other night. I said, Okay, how much money could you put down on a property, and my friend was like, I could probably put down about $100,000. So that means that we’re looking at a $500,000 property right? 20% down $500,000. Now, on this $500,000 property, if if we short term if we have a short term rental seven days or less if he can materially participate. And if we run a cost segregation study, let’s just assume that we’re able to take 25% of the purchase price as first year bonus depreciation, which means that our first year bonus depreciation is going to be $125,000. So what does this mean here? Well, this means that we have a $125,000 deduction. And let’s just assume for the purposes of this conversation, that that is also our tax loss that we’re going to claim against our income this year. And now my friend is in the 32% tax bracket. So now we’re going to multiply this by 32%. That’s supposed to be a point. So that’s what’s to come down here. But 32% Alright, so 125 multiplied by 32%. Alright, so 125 multiplied by 32%. Let’s see what that is 125 times point three, two, that’s $40,000. Alright, so I’m going to put a 40. Okay. This is my friends tax savings. So we buy a $500,000 home, we short term rental, seven days or less, on average, we materially participate. So either substantially all my participation is substantially all the participation, or I spend 100 hours or more than anyone else. So I do materially participate, which means that I have a non passive activity. Okay, very key, I’m moving it out of the passive bucket, and into the non passive bucket via material participation. And remember, this only works for the short term rental, I can’t do this with a long term rental, because I have to qualify as a real estate professional and then materially participate. And I can’t qualify as a real estate professional with a full time job. So it’s not going to happen. So there’s only works for short term rentals, because I don’t have to qualify as a real estate professional, I don’t have to meet that first threshold, all I have to do is materially participate substantially all or 100 hours and more than anyone else. So I materially participate, I get cost segregation study performed, 25% of the value is identified as five, seven and 15 year components, meaning that I can immediately expense it via bonus depreciation, and that bonus depreciation just turns out to be right around my taxable income or my taxable loss. So I have $125,000 tax loss from this rental property, I then multiply my tax rate because I want to know, it’s great that I get this tax loss, this deduction, but what’s my actual tax savings? So I multiply it by my tax rate, and I get a $40,000 tax savings. So what did we just do here? Well, we bought a $500,000 property, we put $100,000, down on this $500,000 property, but then I immediately got $40,000 back. So I really put $60,000 down on this $500,000 property. But it’s like I put 20% down anyway, so I am using the tax code to buy real estate, and to keep money in my pocket at the same time, because now I can take this 40k And now I can go buy a $200,000 property, I can go put 20% down now on a $200,000 property. So this one $100,000 investment acquiring this 500k property has given me enough cash to go and add another $200,000 of real estate. And again, I know that there’s creative financing. I’m not going to get into all that right now, but I’m just assuming 20% down on everything. But the point is, is that the tax refund allows me to acquire more and more real estate in over time I build this large portfolio of cash flowing assets, you pay down all that debt you write off into the sunset, baby. That’s what it’s all about. Thanks for listening to today’s show.

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