Probably the most common question we get surrounding tax reduction strategy is “what if I bought a rental property?” As with most things in the tax code, our response is “it depends”.
By default, rental properties are deemed passive activities rather than active. As such, limitations on losses are in place and oftentimes rental property owners do not get the current benefit of rental property losses.
There are exceptions, notably, if the taxpayer is a so-called Qualified “Real Estate Professional”. But the reality is any taxpayer that holds a full time job is highly unlikely to meet the criteria for that status qualification. It’s just a very difficult hurdle to clear while also holding down a 9-5 W2 job.
So are you out of luck entirely? Well not necessarily. There is a specific carve out for Short Term Rental Properties (STR) where the threshold for active status is lower. And active status often means current tax benefits not available to passive status.
How Does a Property Qualify for STR Treatment?
As the name implies, these are properties where the rental terms are short in nature. In this case, the most commonly met requirement is that the average guest stay length lasts no more than 7 days. There are a few other qualifying methodologies but this is the most frequent.
Obviously, given the short term nature of these properties we are thinking about vacation properties. Month to month commercial or residential properties wouldn’t meet this criteria and, thus, can’t qualify for this tax treatment.
Active or Passive?
So the property meets the STR requirement…so what? Well, in order to receive the benefit of the active designation one of 7 tests must be met. The most commonly met tests are one of the following:
- Taxpayer spends more than 500 hours working in their short-term rental business
- Taxpayer carries out ALL the necessary tasks to run the business themselves
- If working with someone else (property manager for example), taxpayer’s participation must be greater than 100 hours and equal to the number of hours the other party puts in
If the taxpayer meets one of the above criteria the STR can be deemed active and is no longer limited by the passive loss rules. Important to note that if the taxpayer hires a property manager or similar agent the active tests will be more difficult to meet.
Well if a property meets the short term criteria and the taxpayer can claim active designation we can now use rental property losses to offset other income sources such as wages, investment income and the like.
This is helpful in any year but is particularly important in the year a property is placed in service as a rental. Why?
Depreciation is a non-cash tax deduction used to offset rental income each year. Taxpayers often get confused because real estate often rises in its fair market value. That is generally true, of course. But for your tax filings the IRS requires depreciation as something of a cost recovery method and, as mentioned, is a deduction against income.
While the structural part of a building is depreciated over long time horizons and land value isn’t depreciated at all, other items like furniture, appliances and similar non-structural assets can be depreciated over short periods of time.
And to add fuel to the depreciation fire, so-called Bonus Depreciation allows these non-structural items to be written off entirely or in large part in the year it is placed in service. For example, if a rental owner purchased $15,000 in appliances and furniture in a year where 100% bonus depreciation was allowable, that full $15,000 would be eligible for a depreciation write off. That can be a massive value in many cases.
First Year Placed in Service
So you might ask, putting all of this together, what is a good use case to potentially see large tax write offs? And the answer is the first year a new STR is placed in service.
In fact, we can get quite granular and pull out a lot of assets in a purchased property and qualify them for bonus depreciation through a process called COST SEGREGATION. Cost segregation is a process whereby we identify items in a home that might be eligible for bonus depreciation.
An example might be helpful:
- Say you purchase a qualifying STR for $500k
- We decide to do a cost segregation study and determine that there is $50k of property in that STR eligible for Bonus Depreciation
- In addition, you purchase $25k in furniture and appliances to outfit the property
- Assuming you meet all the criteria, you would be eligible for $75k of bonus depreciation in Year One!
- If that depreciation, along with other write offs, creates a tax loss AND you meet the criteria above, you could offset wage and investment income with that loss
Obviously, I don’t like the idea of letting the tail wag the tax dog. In other words, purchasing an expensive rental property simply to obtain these tax benefits isn’t a great idea. There are risks in investing in real estate just like there are risks in any investment.
But if you are already inclined to purchase a rental property, particularly in a vacation destination, this STR tax methodology might tip the scales in favor of such a property.
If you are considering something like this, please let us know so we can assist you in the process. With proper planning a Short Term Rental can generate considerable tax losses and tax savings.