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Tax Planning for Short Term Rentals

 

Short term rental tax strategy is a great way to lower taxes on your income, and is a main reason for many short term real estate investors. This article explains the basics of how to use the short term rental loophole, and what a smart approach to short term rental taxes looks like.

If you’re purchasing a short term rental, or already have a few or more, the best step you can take is to talk to a real estate tax advisor. Our firm is an expert in this, and we know that even small changes can have a big impact on what you save on taxes. When you work with someone who understands this field, it can give you a strategic advantage that helps your personal wealth and business growth.
Let’s dive into STR tax strategy.

The Evolution of Tax Planning for Short Term Rentals
The Tax Reform Act of 1986 was a major law that passed in the 1980s. It was one of President Reagan’s main goals for his second term, and it reduced federal income tax rates for some tax brackets. It also affected how taxes were calculated for short term rental properties.

Before this Act, individuals could deduct losses from rental properties from active income without any restrictions. There was no distinction between passive and business activities. This caused some disagreement because it benefited highly paid professionals, especially doctors and lawyers, but it applied to everyone. 
Here’s why people cared:
These high-income professionals would purchase a rental property, lower its value for tax purposes, then use the losses to reduce their taxable income. Through influencing and various initiatives, The Tax Reform Act created Section 469 of the tax code, which is the Passive Activity Rules. These rules made all rental properties passive by default. After that, there was no way to make rental properties non-passive.

Through more rounds of influencing, especially from the real estate industry, a new law was enacted in the mid-1990s called the Real Estate Professional Status (REPS) exception. Owners of real property trades or businesses could then use losses from rental properties, classified as non-passive.

We'll discuss more about REPS as part of a short term rental tax strategy, but basically 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. 

How does the Short Term Rental Tax Loophole work?
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”.
Here are the six criteria from the tax code that can make income from a rental property qualify as non-rental activity, and therefore not passive by default:

1. The average period of customer use for such property is seven days or less.
2. 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.
3. 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). 
4. The rental of such property is treated as incidental to a non rental activity of the taxpayer.
5. The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers.
6. 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.

If you want a complete Guide to Short Term Rentals, we have one. Here is what you should read next.

Criteria for Material Involvement to Qualify for the Tax Break on Short Term Rentals
We said earlier that becoming a real estate professional is one way to convert losses on rental properties. However, this is usually not an option for highly paid professionals like doctors or lawyers, because they don't have half of their working time to spend on a real estate business. The short term rental tax loophole can help, though.

The exceptions to the definition of rental activities in the tax code above can also make losses non-passive if you, the short term real estate investor, satisfy 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:

1. Spend more than 500 hours on the short term rental business
2. Do substantially everything for the STR business
3. Spend more than 100 hours on the activity and no one other individual spends more time than you do
4. Significant participation activity for more than 100 hours, and your combined activity in all significant participation activities exceeds 500 hours
5. Participating in the business for five of the 10 previous taxable years
6. Personal service activity (non income-producing) for three of the previous taxable years
7. Regular, continuous, provable participation in the business for more than 100 hours

Most short term real estate investors can qualify for one of these three tests.

If you pass one of these tests, and your short-term rental is not counted as a rental activity, then it is not passive.

STR Income and Non-Passive Losses
You want to check these boxes so that you can use your short term rental for non-passive losses. This is beneficial because non-passive losses can reduce non-passive income. If you can qualify, your short-term rental will lower your tax bill.

This is the first main element of a short term rental tax strategy. The second is depreciation.

How Depreciation Affects Your Taxes as a Short Term Rental Host
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. 

This is how this can benefit you:

5 and 15 year property can usually make up 20-30% of a property’s purchase price.

Example: if you bought a $1 million dollar property and did a cost segregation structure, 20-30% of it could be resegregated and fully depreciated. This would give you a $250,000 deduction.

This is beneficial because your losses are non-passive, and that tax loss can be used to reduce taxes on your W-2 income.

What’s Changing About Depreciation for Short Term Rentals?
Bonus depreciation for short term rentals and other business activities has been at 100% since 2018. This is the final year that bonus depreciation will be fully 100%. After this, the plan is to gradually reduce the percentage each year for the following 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 this article shows, investing in short term rentals can be a very effective way to reduce your tax expenses. By using Airbnb or similar platforms, and increasing your income potential by acquiring more properties, you can follow the strategy of many wealthy people across the country.

However, this also requires strategic knowledge and an understanding of the tax code. You also need the help of a team, including a real estate CPA, a lawyer, and some support staff, cleaners, and more.

Although there are some challenges and steps to get started, you can achieve significant savings on your tax bill by investing in short term rentals if you are determined to do so. 
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.