The short-term rental tax strategy is an advanced tax strategy that allows short-term rental investors to offset their earned income (i.e. W-2 income) with losses generated from short-term rental activities.
This strategy is attractive when compared to long-term rentals which are classified as “passive” activities for income tax purposes, because passive activity losses can generally only offset passive income.
As a result, taxpayers typically don’t benefit much (if any) from losses related to long-term rental properties until the property is ultimately sold, due to IRS limitations based on adjusted gross income. One exception to this is when the taxpayer is a real estate professional, but many investors with existing careers are unable to meet the requirements.
This article breaks down the basics of how to take advantage of the short-term rental tax strategy, and outlines the necessary steps to do so.
What is the short-term rental tax strategy?
According to Internal Revenue Code Section 469; when the average stay of a guest is seven days or less, the activity is no longer classified as a passive rental activity, it’s treated as a business, treating all income and expenses from the property as non-passive. Think about it as if you operated a hotel which would be considered a business.
Although, most investors perceive the average stay of seven days or less the easiest path to qualify, this classification also extends to properties with average stays of 30 days or less, provided substantial services are offered to guests during their stay, such as linen changes, cleaning, vehicles, or vouchers for local attractions.
Material Participation Tests for Short-Term Rentals
As previously discussed, obtaining real estate professional status is an avenue to being able to offset losses on rental properties against active income. However, this avenue is often unavailable to high-earning professionals, who may not be able to dedicate half of their working hours to a real estate venture. Fortunately, the short-term rental tax strategy provides an alternative solution.
The exceptions to the rental activities definition in the tax code, as mentioned earlier, can render losses non-passive for short-term real estate investors who meet one of the seven material participation criteria. These tests assess your level of engagement and involvement in your short-term rental property, determining your eligibility for this tax strategy.
Here are the material participation criteria:
Spend more than 500 hours on the short-term rental business.
Do substantially everything for the short-term rental business.
Spend more than 100 hours on the activity, with no other individual surpassing your time commitment.
Engage in a significant participation activity for more than 100 hours, with your combined activity in all significant participation activities exceeding 500 hours.
Participate in the business for five of the previous 10 taxable years.
Engage in a personal service activity (non income-producing) for three of the previous taxable years.
Demonstrate regular, continuous, and provable participation in the business for more than 100 hours.
The first three criteria are the most commonly met by the majority of short-term real estate investors. Once you satisfy one of these tests and your short-term rental is no longer categorized as a rental activity, it is considered non-passive for tax purposes.
Depreciation Strategy for Short-Term Rentals
Engaging a knowledgeable real estate tax advisor will include a strategic approach to maximizing depreciation for your short-term rental which will include conducting a cost segregation study on your property.
The purpose of a cost segregation study is to reclassify specific components of your property, transitioning many of them from a 39-year depreciable life (the standard depreciation life for a short-term rental property) to 5 and 15 years. This applies to tangible personal property, land improvement property, and qualified improvement property.
Here’s why this matters - The power of this strategy lies in the fact that 5 and 15-year property components typically make up 20-30% of a property's purchase price and are available for bonus depreciation.
Example: For instance, if you own a $1 million property and undergo a cost segregation study, approximately 20-30% of the property's value could be re-segregated and fully depreciated. This could translate to a substantial deduction of approximately $250,000.
This is powerful because your losses are classified as non-passive, and the losses can be used to offset active income such as W-2 income.
What’s Changing About Depreciation for Short-Term Rentals?
In 2018, the bonus depreciation rate for short-term rentals and other business activities has stood at 100%. However, 2022 marked the final year of this 100% bonus depreciation, as a planned phased approach is set to gradually reduce the percentage over the next five years. Here's what to anticipate:
In 2023, the bonus depreciation decreased to 80%. As an example, a $250,000 deduction in 2023 would now be $200,000.
In 2024, the rate further reduces to 60%, resulting in a $250,000 deduction becoming $150,000.
By 2025, the bonus depreciation drops to 40%, making the $250,000 deduction now $100,000.
In 2026, the rate diminishes to 20%, reducing the $250,000 deduction to $50,000.
In 2027, the bonus depreciation is slated to disappear entirely, adhering to the current plan.
While changes and extensions are possible given the recent presidential election, this is the current trajectory. It's important to clarify that the short-term rental depreciation strategy itself is not under threat and is likely to remain intact. However, the 100% bonus depreciation is phasing out under current tax law, but many believe it will be reinstated.
Even as bonus depreciation diminishes, there remains an opportunity to depreciate portions of your property at 5 or 15 years instead of the standard 39 years, presenting a continued avenue for savings. Embracing a comprehensive short-term rental tax strategy remains the most effective approach for maximizing benefits from short-term rental investments.
Utilizing Like-Kind Exchanges When Selling Short-Term Rentals
This is where the strategy gets interesting and has the potential to turn short-term tax savings into permanent tax savings!
By obtaining a cost segregation study and accelerating depreciation by means of bonus depreciation, as mentioned above, the cost-basis of the property will rapidly decline as you enjoy the losses year over year for tax purposes. This means that when you eventually sale the property, you will likely have a sizeable gain for tax purposes.
However, you can leverage Internal Revenue Code Section 1031 to “defer” taxable gains if you abide by the formalities. We’ll outline the criteria for 1031 exchanges in a separate article. What’s important to note is that this code section allows for the deferral of taxable gains, it does not eliminate them. So, if you 1031 a property and ultimately sale it, you would be responsible for the tax when you file your tax returns for that tax year.
However, what if you never sold the property? What if you kept “kicking the can down the road”, meaning that you continue utilizing 1031 exchanges to acquire more properties, eventually leaving your accumulation of wealth and legacy to the beneficiaries of your estate?
This is where the tax strategy turns into permanent tax savings. See, when someone inherits something, they enjoy something called “stepped-up-basis”. Stepped-up-basis means that their cost-basis is equal to the fair-market-value of the item they inherited, on the day they inherited it. What the original owner paid for it doesn’t matter. So, if a person inherited something and immediately sold it, they wouldn’t owe any tax.
Therefore, accumulated gains from 1031 exchanges are essentially eliminated when they are inherited by one’s beneficiaries. That’s right, during their lifetime the taxpayer never paid tax on gains related to the sale of properties while they enjoyed non-passive losses which offset other income, and their beneficiaries benefit from their stepped-up-basis. Essentially, wiping the slate clean of capital gains tax.
Final Words: Tax Strategies for Short-Term Rentals
In conclusion, short-term rentals present a compelling avenue for substantial tax savings while building wealth.
However, this venture demands a strategic component and thorough grasp of the tax code that you will likely only achieve by consulting with a qualified tax advisor that specializes in real estate. Contact us at info@fleming-advisors.com.
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