Short-Term Rental Tax Strategy For High-Income Earners

If you’re a high-income earner, then it’s safe to say that taxes are your biggest expense. As a periodontist, I’m constantly on the lookout for ways to lower taxes for my Investor Group. (If you’re an accredited investor and want access to my personal deal flow, which provides tax benefits, join the GROUP today.

One of the main reasons most doctors and other full-time professionals invest in real estate is the tax advantages.

The United States government incentivizes real estate owners as they’re essentially creating a business. And guess what businesses create? They hire employees who not only stimulate the economy but also pay taxes. You’re also providing an essential service: housing.  

You’ve probably heard that becoming a Real Estate Professional can result in extensive tax breaks, but for many working full-time, this option is not possible.

If you fall into this category, then good news. There’s another potential option for you: short-term rental properties. Your BIGGEST wealth building tool is your income as you’ve spent a lot of time, money, and energy to obtain it.

For many, cutting back part-time at work isn’t an option, which is why many high-income professionals utilize the short-term rental tax loophole.

Before we discuss this strategy, a quick disclaimer…

[Disclaimer: I’m NOT a CPA, tax advisor, attorney, or financial advisor. It’s always best to consult your team of professionals about the topics covered in this article.]

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Real Estate Tax Benefits

One of the major reasons people invest in real estate is the AMAZING tax benefits they offer.

#1. Depreciation deduction

Depreciation is one of the most powerful wealth-building tools in real estate, as it’s a way to write off the value of an asset over time.

Even though real estate usually appreciates in value, the IRS allows you to depreciate its value, called a paper or phantom loss.

They allow you to subtract the losses against the income, increasing your tax burden.

Examples of deductions/expenses you can expect to deduct from the operating income:

• Mortgage and mortgage interest
• Costs from property managers
• Repairs and upkeep
• Insurance
• Legal and professional services
• State and local property taxes

#2. Accelerated depreciation

This is where the real tax savings occur as the IRS allows you to front load the depreciation via a cost segregation study.

A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for tax purposes, which reduces current income tax obligations.

A cost segregation study is typically performed by qualified engineers and/or CPAs.

The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter amount of time (typically 5, 7, and 15 years) than the building (39 years for non-residential real property).

Example:

• 5-year tax-life components: tangible, personal property assets (carpeting, secondary lighting, process related systems, cabinetry, ceiling fans, etc.)
• 7-year tax-life components: all telecommunication-related systems (cabling, telephone, etc.)
• 15-year tax-life components: land improvements (parking lots, driveways, sidewalks, curbs, landscaping, site features like a flagpole or a pond, etc.)

If you’d rather watch a video to learn about this tax strategy, check out this video:

#3. 1031 exchange

Another tax advantage used by real estate investors is by using a 1031 exchange.

The deferred taxes are the capital gains taxes upon selling the property. The IRS is ALWAYS going to want a piece of your newfound wealth. It always seems like they don’t want anyone to succeed, doesn’t it?

Anyway, these so called “windfalls” are what’s considered capital gains, and most are taxed at 15-20%.

As far as how long they’re deferred for….it could be indefinitely, or at least until you die. As long as you follow the IRS rules, you can defer those taxes forever and ever.

The 1031 exchange timeline looks like this:

• Timeline #1 – You have 45 days after you sell your property to identify up to 3 new properties. This can be done in writing, but you must purchase one or more of them.
• Timeline #2 – You have 180 days to close on one or more of the three properties that were identified.

Now that we’ve discussed some of the tax benefits real estate provides, let’s shift gears to tax strategies available for short term rentals.

What is a Short Term Rental (STR)?

A property is considered to be a short-term rental (STR) if it’s rented out for less than seven days at a time on average.

These are very popular in tourist destinations.

Plus, with the advent of online platforms such as Airbnb, it’s never been easier for virtually anyone with a vacation/second home or rental property to use it as a short-term rental.

Short-Term Rental Advantages

The older I get, the smarter (NOT harder) I want to work. You may feel the same way, too. As mentioned earlier, one way to work smarter is buy qualifying as a real estate professional. 

Real estate professional status

To qualify, the IRS states you must meet a few conditions:

#1. Must spend the majority of his or her time (more than 50%) in real property businesses in which you materially participate.

#2. Must spend 750 hours or more in the real property business and rentals in which he or she materially participates (roughly 15 hours per week).

In other words, you’ve got to work on real estate more than you do any other job. So, being a real estate professional is your primary profession, which means you spend more hours in real estate than you do at your 9-5.

You also must work at least 750 hours on real estate activities with most of this coming from the day-to-day management of your rentals.

If you want more information on how to qualify, watch this video:

Because the time requirements make it difficult to qualify working full time, many high-income professionals are turning to a different option: short-term rentals.

Join the Passive Investors Circle

What is the Short Term Rental Tax Loophole?

This loophole 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”.

From The Real Estate CPA site, here are the six ways in which income for a rental property can be excluded from the definition of rental activity and thus not automatically passive:

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 that 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.

6 Steps to shelter income

Let’s break this down in layman’s terms for you:

#1. Buy a short-term rental.

#2. Materially participate in the rental.

#3. Obtain a cost segregation study.

#4. Use accelerated depreciation the first year.

#5. Claim paper losses from your business.

#6. Hire a real estate CPA who understands how to use the tax deductions from your short-term rental and apply it to your ordinary income. 

Material Participation Tests for the Short-Term Rental Tax Loophole

It may be difficult for a dentist, physician, or other professional to become a real estate professional as they can’t spend half of their working hours in a real estate business.

This is where the short-term rental tax loophole can help. But remember that you must “materially participate” to ensure you can apply the tax deductions against ordinary/active income.

Are you a high-income W2 earner paying too much in taxes?

Click HERE to find out how the Short-Term Rental Tax Loophole can help.

Here’s a video for a Done-For-You STR Tax Loophole service exclusively for Debt Free Doctors members:

How do you do this? 

There are seven ways to accomplish this, but you must only fulfill one of these criteria to show material participation for the tax year. (Paraphrased from IRS Publication 925).

According to Investopedia, “the material participation tests are a set of Internal Revenue Services (IRS) criteria that evaluate whether a taxpayer has materially participated in a trade, business, rental, or other income-producing activity. A taxpayer materially participates if they pass one of the seven material participation tests. However, passive activity rules limit the deductibility of losses when taxpayer participation fails to meet at least one of the seven material participation tests.”

Related article: Material Participation: A Game Changer for Your Business

7 Material Participation Tests

#1. You participated for more than 500 hours in the short-term rental business.

#2. Your activity substantially constituted participation for the STR business.

#3. Your participation was more than 100 hours and no less than the participation of any other individual.

#4. You must have a significant participation activity for more than 100 hours, and your combined activity in all significant participation activities exceeds 500 hours.

#5. You materially participated in the activity for 5 of the last 10 years.

#6. Personal service activity (non-income-producing) for three of the previous taxable years.

#7. You participated for more than 100 hours in a regular, continuous, and substantial basis during the year.

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. Remember that the goal is to use a STR for non-passive losses.

These losses can be used to offset non-passive income. 

Depreciation for Your Short Term Rental Tax Strategy

If you’re able to pass one of the seven material participation tests, you’re now ready to begin generating losses from your STR with depreciation using a cost segregation study previously discussed. 

Remember that the goal of the study is to identify all construction-related costs that can be depreciated over a 5, 7 and 15 year tax life vs a 39 year life.

This is such a powerful strategy as a 5- and 15-year property can generally represent anywhere from 20-30% of a property’s purchase price.

STR example:

Dr. Z purchases a $1.2m vacation rental in Destin, FL.

His real estate savvy CPA informed him that he could utilize bonus depreciation to shelter around $250k – $300k of his oral surgery income.

Because he makes roughly $300,000 of W2 income, he may be able to pay little to no taxes because of just one rental.

For instance, if you had a cost segregation study performed on a $1m property, anywhere from 20-30% could fully depreciated giving you a $250,000 deduction. 

Summary

Utilizing the short-term rental tax loophole is an effective way for high-income earners to reduce their overall tax burden.

Getting help from a real estate CPA/attorney to guide you through the process is one of the keys to make this strategy a success.

The Short-Term Rental Tax Course

Want more information about reducing taxes AND building wealth?

Investing in short-term rental (STR) properties and using the STR Loophole is one of the few tax strategies that can save you 5-6 figures in taxes without working full-time in real estate.

Because certain aspects of this strategy will phase out over the next few years, the time to act is NOW.

Which is exactly why the guys at TheRealEstateCPA.com created this course.

After working one-on-one with hundreds of real estate investors, they want to help as many investors as possible use the STR Loophole to reduce their tax bills.

If you want to save thousands in taxes and build your wealth faster than you ever thought possible, don’t wait, enroll in this course today and take advantage of this strategy while you still can.

Join the Passive Investors Circle

FAQs

What is the Short-Term Rental Loophole, and How Does It Affect Taxable Income?

The short-term rental loophole refers to a provision in tax laws that allows property owners to potentially avoid classifying rental income from short-term rental properties as taxable income under certain conditions. This can significantly impact how income taxes are calculated for individuals engaging in rental activities, especially for those who rent their properties for less than 14 days a year, known as the 14-day rule.

Can Real Estate Professionals Use Short-Term Rental Properties to Offset Rental Losses?

Yes, real estate professionals often use short-term rental properties as a strategy to offset rental losses. This is because the income and expenses from these properties can be actively managed as part of their overall real estate investment portfolio. Unlike passive activities, real estate professionals can classify losses from rental activities as non-passive, which can be used to offset other types of income, potentially reducing overall taxable income.

How Does Personal Use of a Short-Term Rental Property Affect Tax Implications for Property Owners?

Personal use of a short-term rental property can significantly affect the tax implications for property owners. If a property is used for personal purposes for more than 14 days or 10% of the total days it’s rented, it can limit the ability to deduct rental losses on a tax return. Property owners need to carefully track personal use to ensure compliance with IRS rules regarding rental income and personal use.

Are Property Owners Subject to Self-Employment Taxes for Income from Short-Term Rentals?

Generally, property owners are not subject to self-employment taxes for income generated from short-term rentals, as this income is typically considered rental income, not business activity. However, if substantial services (like regular cleaning, changing linens, or concierge services) are provided, the IRS may classify it as a business activity, potentially subjecting it to self-employment taxes.

How Did the Tax Reform Act Impact Short-Term Rentals for High-Income Earners with W-2 Income?

The Tax Reform Act brought several changes that impact high-income earners with W-2 income who invest in short-term rentals. One significant change is the limitation on deducting business losses against other types of income, which can affect those with substantial income from other sources, like a full-time job. Additionally, the Act has altered the way rental income is taxed, which could affect the cash flow and profitability of short-term vacation rentals and long-term rental properties.

How can depreciation deductions serve as a powerful tool for property owners in the short-term rental business?

Depreciation is a method used to allocate the cost of tangible property over its useful life, reflecting wear and tear, decay, or justifiable obsolescence. For short-term rental owners, depreciation deductions can be a powerful tool, enabling them to deduct part of the cost of the real estate investment each year from their taxable income. This results in lower annual tax liabilities and can contribute to a substantial tax savings over the useful life of the property. Property managers and owners should consult with tax professionals to ensure they maximize these deductions while complying with IRS regulations.

What are the key considerations for short-term rental owners to avoid a tax loss while switching between short-term and long-term rental uses?

Owners must be mindful of the number of days the property is rented at fair market value. For a property to qualify for short-term rental tax benefits, it should be rented out for less than 30 days at a time over the course of the year. Switching between short-term and long-term rental uses can affect the property’s tax status and the deductions allowable. To maintain eligibility for STR tax benefits and avoid potential tax losses, owners should meet the material participation criteria and plan their rental schedules carefully. This includes balancing the average stay to prevent classification as a long-term rental, which can significantly alter the tax implications and available benefits.