Short-Term Rental Tax Loophole For Physicians and Dentists

[Editor’s Note: Today’s article is a guest post from my personal accountant Thomas Castelli, CPA. Thomas is a Partner at Hall CPA, PLLC, an accounting firm that helps real estate investors keep more of their hard earned dollars in their pockets and out of the government’s with proactive tax strategy and planning.}

As a dentist or physician, using The Short-Term Rental Loophole can be a powerful way to reduce taxes without working full-time in real estate.

This article will explain how to use The Short Term Rental Loophole to reduce taxable income.

Join the Passive Investors Circle

Understanding the History of Short-Term Rental Tax Strategy

To grasp the significance of the short term rental tax strategy, let’s explore its historical context.

The Tax Reform Act of 1986, a top priority during President Reagan’s second term, introduced the Passive Activity Rules under Internal Revenue Code Section 469 of the tax code.

Before this act, individuals, including highly paid professionals like dentists and physicians, could use losses from rental properties to offset their non-passive income (i.e., ordinary income) without limitations.

However, the Passive Activity Rules made all rental properties passive by default, disallowing the use of rental losses to offset active income, including income from a W-2 job or active trade or business.

If you’re a high income earner wanting to learn how to use real estate to reduce your tax burden, check out this video:

Later the real estate professional status (REPS) was passed in the mid-1990s. This allowed real estate investors to utilize real estate losses from properties to offset non-passive income if they spent more than 750 hours and more than half their total working time in real property trades or businesses.

The problem is that REPS is great for investors who work primarily in the real estate industry but does little for full time high-income earners in other professions, such as dentistry or medicine.

Related article: Top Advantages Of Real Estate Professional Tax Status

The Short Term Rental Tax Loophole: A Powerful REPS Alternative for Everyone Else

The good news is that you don’t have to be a real estate professional to use the STR loophole, which has saved many high-income earners, including dentists, thousands of dollars on their tax return.

According to Reg. Section 1.469-1T(e)(3)(ii)(A), short-term rental properties can be excluded from the definition of rental activity, and thus not automatically classified as passive if certain conditions are met:

• The average stay of customer use for the property is seven days or less; or
• The average period of customer use for the property is 30 days or less, and significant personal services, such as daily cleaning or meals, are provided by or on behalf of the property owner.

Once one of these conditions is met, your rental property is no longer passive by default, and you don’t need to qualify as a real estate professional to turn losses non-passive. All you need to do is materially participate.

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.

Meeting the Material Participation Tests

While real estate professional status is one way to turn losses on rental properties non-passive, it may not be feasible for highly paid professionals like dentists or physicians due to time constraints.

By meeting one of the seven material participation tests outlined in the tax code, you can turn losses from your short-term rental property non-passive. These tests assess your involvement and use of the rental property. The three most common tests for short-term real estate investors are:

• Spending more than 500 hours on the short-term rental business.
• Performing substantially all the activities for the STR business.
• Spending more than 100 hours on the activity, with no other individual spending more time than you.

Once you meet one of these tests, and your short-term rental is excluded from the definition of rental activity as outlined in the previous section, it is considered non-passive.

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

---

---

Leveraging Non-Passive Losses and Depreciation

The goal of fulfilling the aforementioned requirements is to utilize your short-term rental for non-passive losses. This is advantageous because non-passive losses can offset non-passive income, including W-2 or active business income, potentially resulting in tax benefits for you.

If you’re new to the world of real estate taxes, you might be wondering why you would want to have a loss on your short-term rentals to begin with.

That’s because these losses are typically generated from the non-cash expense called a depreciation deduction. Depreciation tracks the deterioration of a building over a period of many years. It can create tax deductions despite the fact that you may have generated positive cash flow.

Thanks to a process known as cost segregation and a tax incentive called bonus depreciation, it’s possible to significantly increase this depreciation expense in the first year of operation.

To illustrate, if you had a property where the house was worth $1 million and did a cost segregation study, anywhere from 20-30% could be eligible for bonus depreciation. Assuming 25% was eligible, with bonus depreciation at 80% in 2023, this would give you a $200,000 deduction.

If you’re a higher-income earner in the upper tax bracket, this $200,000 deduction could be worth up to $74,000 in tax savings.

Powerful right?

The Bottom Line

As you can see, investing in short-term rentals offers a highly effective means of maximizing tax savings for high-income earners.

However, succeeding in this endeavor necessitates strategic knowledge of the tax code and the assistance of a competent team. This team typically includes a real estate CPA, real estate agent, cleaners, and more.

While there may be a learning curve and initial steps to overcome, committing to short-term rentals can lead to substantial tax reductions for those genuinely interested in pursuing this opportunity.

Written by Thomas Castelli, CPA. Thomas is a Partner at Hall CPA, PLLC, an accounting firm that helps real estate investors keep more of their hard earned dollars in their pockets and out of the governments with proactive tax strategy and planning.

Join the Passive Investors Circle