Learn the why, when and how behind the short-term rental tax loophole
Investing in a short-term rental (STR)—property rented out less than seven days at a time on average (think VRBO or Airbnb rentals)—can significantly lower your tax burden.
Adding a STR property to your investment mix should not come at the expense of funding other savings vehicles in your financial plan.
- You legally have to prove that you materially participated in your STR business to earn that non-passive tax characterization.
As we roll into year-end and start getting our tax deductions in order, questions around the short-term rental (STR) tax loophole are regularly popping up on CWA client calls and emails. The questions are, can investing in a property really lower my taxes, and if so, how do I take advantage of it?
The answer to the first question is fairly straightforward. Yes. Investing in a short-term rental—property rented out less than seven days at a time on average (think VRBO or Airbnb rentals)—can significantly lower your tax burden.
But before you pull the trigger on that cute vacation rental investment, CPA Brittany Frazier says it’s wise to educate yourself on the somewhat complicated rules around the STR tax loophole to ensure it’s a suitable investment for you and your portfolio.
“Short-term rentals can be a good investment and can also help generate cash flow if done properly. And yes, they can lower your tax burden considerably,” says Brittany. “That said, buying real estate should never be a decision based solely on the potential for tax deductions.”
Before her clients make a real estate investment, Brittany takes them through an exercise to hone in on why they want to buy. She then looks at when a real estate investment makes sense and, finally, how to maximize the tax advantages.
Know Your Why
She starts by laying out the three reasons why people typically choose to invest in real estate:
- Capital appreciation – the expectation that the property’s value will go up over time
- Income generation – enjoying a positive cash flow from renting the property
- Sentimentality – the property means something to the investor
“Today, we are seeing a fourth reason make its way into the mix with the tax advantages of short-term rentals,” says Brittany. “But if lowering taxes is my client’s only ‘why,’ then the tax tail is wagging the dog.”
In that case, Brittany says a STR might not be the right investment due to the complexities and time commitment it takes to reap the tax savings.
“A short-term rental is not a set-it-and-forget-it investment,” says Brittany. “With the time you will invest, you really need to be in it for more than lowering your tax burden. That should just be a nice added benefit.”
Make Sure Your Portfolio is Real Estate-Ready
The next order of business is to determine when the time is right to add a real estate investment to your portfolio. According to Brittany, adding a STR property to your investment mix should not come at the expense of funding other savings vehicles in your financial plan that are building long-term financial security.
“Once the boxes are checked on maxing out 401(k)’s, IRA’s and other tax-advantaged accounts, and you’ve established financial liquidity, a real estate investment is a perfectly fine place to put some extra funds,” says Brittany.
Understand How the Short-Term Rental Tax Loophole Works
This brings us to how to qualify for the STR loophole.
According to Brittany, STR investors should first understand the difference between passive and non-passive income (or loss).
Any business activity where you do not materially participate in generating income or loss is considered passive. For example, owning a rental property you lease to long-term tenants is considered passive, as owners do not spend enough time running the business to be considered non-passive.
Conversely, if you regularly and consistently participate in the day-to-day duties typical of an owner, then the income generated is considered non-passive.
“Classifying your losses as non-passive is key because you can apply the loss to your active income,” says Brittany. “Examples of active income would be income from a W-2 or self-employed business. The important part is, you have to prove that you materially participated in your STR business to earn that non-passive tax characterization.”
There are two ways you can prove material participation.
One, you can qualify as a real estate professional by spending more than half your time (at least 750 hours a year) materially participating in real property business.
“Most investors aren’t looking to spend more time running their real property business than working in their current jobs, so this option typically isn’t ideal,” adds Brittany.
Option two is to prove that you materially participated in running your STR business by fulfilling any one of the 7 Material Participation Tests.
7 Material Participation Tests
#1. You participated for more than 500 hours in your STR business during a year.
#2. Your participation in your STR business constituted a substantial part of all work done.
#3. Your participation was more than 100 hours and at least as much as any other individual.
#4. You significantly participated in multiple STR activities for more than 100 hours each, and your combined significant participation activities exceeded 500 hours.
#5. You materially participated in your STR business for five of the last 10 years.
#6. You materially participated in your STR business for any three of the last 10 years, and it was a Personal Service activity (non-income-producing).
#7. You participated for more than 100 hours on a regular, continuous and substantial basis during the year.
If you’re running your STR business yourself, the second test may be the easiest criterion to meet. Tasks might include time spent managing your rental, cleaning, providing meals or giving transportation.
Take Advantage of Accelerated Depreciation
Once you’ve established a non-passive tax characterization, you can generate losses from your STR through depreciation. Conducting a cost segregation study performed by a qualified engineer and/or CPA will identify and reclassify personal property assets as eligible for accelerated depreciation.
“A cost segregation study essentially breaks out the parts of your property that can be depreciated more quickly,” says Brittany. “So rather than assets depreciating over 39 years, you can depreciate certain assets from five to seven to 15 years.”
Therein lies the STR tax loophole. By purchasing a short-term rental property, proving material participation in its operation and taking advantage of accelerated depreciation, investors can typically save between 20-30% of their real estate investment in the first year.
The takeaway from all this is, according to Brittany: “Make sure you’re ready for the time commitment of running an STR, your current savings goals will not take a back seat to this investment, and you have a trusted team of real estate and financial advisors helping lead the way.”
For more on the pros and cons of investing in a Short-Term Rental property, or for any other tax or financial question you may have, CWA is always here to help.