Short-Term Rental Tax Strategy:

Are you tired of the large tax bills, year after year, and your tax deductions just are not making a dent in what you owe the IRS? Are you looking for legal ways to reduce your tax bill? The Short-Term Rental (STR) Tax Strategy may be a financial strategy that can potentially help. 

Simply put, the Short-Term Rental (STR) Tax Strategy utilizes short-term rental properties, that have an average stay of seven days or less (think Airbnb or Vrbo), that generate income while creating tax deductible expenses and depreciation (non-cash expense) to reduce taxable income. Consider supercharging your depreciation by completing a cost segregation study, combined with bonus depreciation, to allow you to depreciate parts of the property at a faster rate. There is a cost to completing a cost segregation study and you need to understand your long-range plans for the property to properly manage any tax upon exit.

 

Cost Segregation & Bonus Depreciation:

 

All rental real estate is by default “passive” so deductions or expenses can only be used to offset passive income and not create offsets to “non-passive” income, or active income such as your W2 or K1’s in a partnership where you materially participate. The STR approach is unique because it avoids the “passive loss limitation rules” that typically apply to rental properties. If the property qualifies, and you meet the material participation requirements, this is where STR may have significant advantages to offset active income, without the need to have Real Estate Professional Status (REPS -requiring 750 hours or more and no more hours in any other occupation). 

If you qualify, the Short-Term Rental Tax Strategy can potentially result in considerable tax savings.

 

What is a Short-Term Rental?

A short-term rental (STR) is a property with an average stay of 7 days or less. The emergence of properties such as Airbnb’s has made it possible for almost anyone owning a second home, vacation home, or rental property to use it as a short-term rental. 

What is Active Income? 

You stop working, you stop earning 

  • Employee: Work for others 
  • Self-Employed: Work for yourself

What is Passive Income?

Earnings are not dependent on your presence 

  • Money you bring in without actively and regularly working for it. 
  • Limited Partner

Understanding the Short-Term Rental Tax Strategy: 

The Short-Term Rental Strategy allows property owners to classify their rental income as active income as a business. This was originally designed for hotels and the hospitality sector under Treasury Regulation Sec. 1.469–1T(e)(3)(ii)(A). This classification can provide tax advantages. This section defines exceptions that can allow income from rental activities to be treated as non-passive income. According to Section 469, rental activities are generally considered passive, meaning losses cannot offset active income like wages or business earnings. However, there are exceptions, especially for short-term rentals. 

Section 469 was introduced as part of the Tax Reform Act of 1986. Its primary purpose was to limit the ability of high-income taxpayers to use passive losses to offset active income. The section created a clear distinction between passive and active income. For rental properties, this usually meant categorizing them as passive activities. However, certain conditions allow short-term rentals to bypass this rule. 

There Are a Few Ways to Include Income/Expenses From Rental Properties as Active: 

  1. The average stay of a customer is less than 7 days at a time. 
  2. The average stay is 30 days or less, provided substantial services are offered to guests during their stay. Examples may include daily cleaning, linen services, transportation, meals, or entertainment. 
  3. Grouping Election.  The election allows you to group certain activities together and treat them as one activity, but you must meet the definition of a qualifying real estate professional. 
  4. Disposition of Interest in Passive Activity- suspended and current passive ordinary losses from a property would be deductible against nonpassive income in the year of disposition. 
  5. Special $25,000 allowance.  For individuals who “actively participate” in the rental activity and whose adjusted gross income (AGI) is less than $150,000 ($75,000 for married taxpayers filing separately), up to $25,000 of net passive losses from rental real estate are allowed to offset other taxable income each year (Sec. 469(i)) 
  6. Rental income from Real Estate owned by an S Corp is non-passive. Closely held C Corporations may apply passive activity deductions against passive activity income and net active income.  (There are a number of drawbacks of owning investment real estate in an S or C corp so caution should be taken before using this ownership structure). 
  7. Self-rental rule – under IRC Section 469 applies when you rent property to a business in which you or your spouse materially participates. Under this rule, rental losses are classified as passive, but rental income is considered non-passive. 

There Are 7 Material Participation of the Short-Term Rental Strategy (and you only need to meet one of them): 

While the Short-Term Rental Strategy provides a pathway to classify rental income as active, investors must also meet material participation requirements. Material participation is essential for ensuring the activity is not passive. There are seven tests to determine material participation, and investors only need to meet one! Keep good records: 

  1. You participated in the activity for more than 500 hours. 
  2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity. 
  3. Spend more than 100 hours on the activity and more than any other individual: This ensures your involvement is substantial. Arguably, this is the easiest criterion to meet.  
  4. Significant participation for over 100 hours, with combined activities 500+ hours: This can include multiple properties. 
  5. Participated in the business for five of the previous ten years: Shows a long-term commitment. 
  6. Personal service activity for any three of the previous taxable years: Applies to certain service-based roles. 
  7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year. 

 

For Example
Bob owns and actively manages a short-term rental property, putting in over 600 hours per year on tasks such as property maintenance and guest interactions.
By meeting the “+500 hours” test, Bob can exclude his earnings from the definition of rental income. 

 

 

Strategic Tax Planning for Short-Term Rentals:

Investing in short-term rentals requires strategic tax planning. Beyond the initial investment, understanding the tax code and leveraging the Short-Term Rental (STR) Strategy can significantly enhance your tax planning. Here are some steps to consider: 

  • Consult an Asset Strategy Advisor: Expertise in this niche area can provide invaluable insights and strategies. 
  • Perform a Cost Segregation Study: Accelerate depreciation and potentially maximize tax deductions. 
  • Ensure Material Participation: Meet the criteria to classify your rental activity as non-passive. Keep specific records….document your hours and associated tasks. 
  • Understand your in-service date and depreciation changes: Do the math as bonus depreciation is being phased out. 

 

Conclusion:

The Short-Term Rental (STR) Strategy offers a powerful opportunity for real estate investors to potentially reduce their tax burden and enhance their returns. By understanding the provisions within the tax code, such as the material participation tests and bonus depreciation, investors can turn their short-term rental properties into tax-advantaged wealth-building tools. Consult with an expert at Asset Strategy to learn more!


Want to talk about it?

If you have any questions on The Short-Term Rental Strategy or other tax-advantaged wealth strategies, call us at 781-235-4426.

Or schedule a meeting with one of our Advisors by clicking HEREfor a 15-minute discovery call! 

 

www.assetstrategy.com/contact

 


 

Because investor situations and objectives vary this information is not intended to indicate suitability for any individual investor. 

This is for informational purposes only, does not represent legal or tax advice does not indicate suitability for any particular investor, and does not constitute an offer to purchase or sell investments.  

Please consult the appropriate professional regarding your individual circumstance. 

Advisory services are offered through Asset Strategy Advisors, LLC (ASA). Securities are offered through representatives licensed with either Concorde Investment Services, LLC (CIS), member FINRA/SIPC. 

 

This blog was written in reference to the following sources: 

https://www.irs.gov/pub/irs-drop/rp-11-34.pdf 

https://www.law.cornell.edu/uscode/text/26/469 

https://www.irs.gov/newsroom/additional-first-year-depreciation-deduction-bonus-faq 

https://www.irs.gov/pub/irs-pdf/p5653.pdf 

 

Share This Post With A Friend Or Family Member!