The Benefits Of Short Term Rentals

Short term rentals have become really popular over the last 5 years with the creation of AirBNB, VRBO, etc. Besides the benefits of cash flow and holding an asset that hopefully grows over the long term, short term rentals have massive tax benefits.

In this blog post we are going to focus on what those main tax benefits are.

For most real estate investors, they hope to generate losses yearly. You may be wondering how they can generate losses when they charge rent. Well… losses mostly come from depreciation. Depreciation basically means the house loses value yearly and you get to deduct that value. You also can speed up this depreciation through cost segregation studies and bonus depreciation.

So now that you understand that, you need to learn about the difference between active and passive.

For most real estate investing, the losses you generate are considered passive. Because they are passive, they only can be used to offset other passive gains. This is a huge issue. Passive losses will not offset your active business income, your w2 wages, etc.

Most who buy rentals, want to find ways to turn those losses active so they can offset other active income. With long term rentals, to do this you need to become a Real Estate Professional which is really hard to do. But… if you become a a Real Estate professional, than you can use those active losses to offset your business income, w2 income, etc. The problem is that it is really hard to qualify for. You must work 750 hours or more per year in real property trades or businesses. Most people will not qualify as they have a main job that results in them not being able to get this status. I see so many doctors, business owners, etc. who want to qualify, but it does not work that way. The only real way is if their spouse gets the Real Estate Professional Status.

Now here’s where short term rentals become attractive.

There is a short term rental loophole out there. How’s it a loophole? Well… with short term rentals you do not need to become a real estate professional to get these benefits. The requirements are actually way less. Copied straight from the tax code, here are 6 ways to qualify to make the rental activity active with short term rentals:

The average period of customer use for such property is seven days or less.
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 like a hotel would provide, such as daily cleaning or meals.
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).
The rental of such property is treated as incidental to a non rental activity of the taxpayer.
The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers.
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.

Now we also need to look at the material participation tests. These tests will determine whether you qualify based on your use of and involvement in your short term rental property. Here they are:

Spend more than 500 hours on the short term rental business
Do substantially everything for the STR business
Spend more than 100 hours on the activity and no one other individual spends more time than you do
Significant participation activity for more than 100 hours, and your combined activity in all significant participation activities exceeds 500 hours
Participating in the business for five of the 10 previous taxable years
Personal service activity (non income-producing) for three of the previous taxable years
Regular, continuous, provable participation in the business for more than 100 hours

The first 3, especially #3, is how most end up being able to qualify. If you meet one of these tests, then your short term rental is excluded from being a rental activity and considered non-passive.

Why is this so important?

The goal is that you can then generate losses and then use those losses to offset your high income.

Many people choose this strategy, they hire a team, they do Cost Segregation Studies and then they pay little tax.

Here’s the math on how a cost seg study can work.

Let’s say you bought a $1.5 million dollar home and did a cost segregation study. Somewhere between 20-30% would be resegregated and then depreciated (but the land cannot be). If the land is $200,000 then you could get anywhere from $260,000-$390,000. But then you can only bonus depreciate 80% of that in 2023 and that will go down to 60% in 2024. This means the math would be around $208,000 – $312,000 that could be depreciated. This is a super powerful strategy that can be used to offset taxes on w2 income.

Note: It was 100% bonus depreciation before 2023, now it is 80%, then in 2024 down to 60%, 2025 down to 40%, and so on till it hits 0% in 2027. Who knows if this will change or be extended but that is the plan for now.

Even if/when bonus depreciation phases out, you can depreciate portions of your property at 5 or 15 years instead of 39 years, which still represents an opportunity for savings.

As you can see, this is a really powerful strategy when done correctly. But, you need a great team around you to help make this work and get it done correctly.

And you still need to find rentals that are good investments. I have seen way too many people buy bad properties just to do this, and in the long run it does not work out great.

The last thing you need to know is that this depreciation gets recaptured later on down the line by paying more tax upon the sale. Instead of long term capital gains, it is taxed at 25%.

Thanks for reading, hopefully you found this helpful.