Amazing Tax Deductions from Your Short Term Rental

Today I’ll review in detail the amazing tax deductions you can get from operating a short term rental business, no real estate professional status needed!

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If you’re an employed physician like me, you pay some of the highest marginal tax rates in the US. We have little ability to shelter income from federal and state income taxes. This is especially true when you live in a high tax state like California.

This is one of the main reasons why I invest in real estate. As a real estate investor, you’re creating a business. The US government likes to encourage businesses, because you’re generating employment and stimulating the economy. In the business of real estate, you’re also providing an essential service: housing.  

General tax deductions of real estate investing

To review, these are some of the deductions/expenses of real estate investing that everyone can expect to deduct from your operating income.

  • Depreciation
  • Mortgage and mortgage interest
  • Property management costs
  • Repairs and upkeep
  • Insurance
  • Legal and professional services
  • State and local real estate taxes

Read more: Tax benefits | Why I’m investing in real estate over stocks – Part 2

But even though I can deduct expenses and depreciation, there’s a limit to these deductions. The IRS usually classifies real estate investing as a passive business. If expenses exceed my rental income, deductions just stack up to be deducted against future gains in later years.  Unfortunately, I can’t deduct against the income from my job as a physician.

The exception to this rule is if you’re a “real estate professional.”

I discussed this special status before in this post: Real estate professional status: a tax shelter for your day job.

If I were a real estate professional, I’d pay very little income tax at all. With the amount of real estate I’ve purchased and renovated over the last year, the associated deductions could easily eclipse my income. 

But I work full time as a physician. Therefore, I am by definition not a real estate professional. 

The exception to the rule

Even if you have a day job, there’s one exception that you should know about. It’s a specific type of real estate investing that mimics the deductions you can get as a real estate professional.

It’s short term rental (also known as vacation rentals).

This strategy is fully legal, supported by the tax code, and can lead to massive deductions come tax time.

It’s also a little complicated, so here’s the basic strategy in bullet points:

  • Buy a short term rental
  • Meet the criteria to classify it as an active business
  • Perform a cost segregation study
  • Accelerate depreciation into the first year
  • Legally claim paper losses from your business
  • Use the tax deductions from your short term rental and apply it to your active income

How it works: Time limits

First, you should buy a short-term rental property, and ensure that the average guest stay is 7 days or less. (See IRS Section 469.) You also have to limit your “personal use days.” Specifically, you have to abide by the 14-day rule, which limits you to 14 days of personal use a year.

If you exceed 14 days of personal use a year, the IRS will reclassify the property as a personal property, not a business.

How it works: Material participation

Secondly, you have to “materially participate” in the short term rental business to ensure you can apply the tax deductions against your ordinary income.

There are a number of ways that you can show material participation. Take your pick, as you only need to fulfil one of these criteria to show material participation for the tax year (paraphrased from IRS Publication 925).

  1. You participated in the activity for more than 500 hours
  2. Your participation was substantially all the participation in the activity
  3. Your participation was greater than 100 hours and no one else participated in the business more than you
  4. Your participation was significant participation and more than 500 hours, and you don’t qualify via the other tests
  5. You materially participated in the activity for 5 of the last 10 years
  6. The activity is a personal service activity, and you materially participated in it for any 3 preceding tax years
  7. You participated for more than 100 hours in a regular, continuous, and substantial basis during the year.

Some of these rules are clear as mud, and also depend on definitions of words like significant participation. The definitions can change based on recent case law, so please consult your tax advisor to check if you’re materially participating or not in the business.

The most common ways to show material participation are via the hours rules (criteria 1 or 3). If you go this route, make sure you are keeping contemporaneous (real-time) detailed records in case you get audited.

Why would I want to do this?

At this point, you might be saying, “This is complicated. Is this worth the hassle?”

The short answer is absolutely! For an employed professional, a short term rental can lead to massive tax deductions. Especially if you have a high income and usually pay a lot of taxes, you should definitely look into this.

As an employed surgeon, I fall into this category. In fact, the desire for more tax deductions is one of the main reasons why I got into real estate investing.

The follow up question might then be, “Why would I want to show a loss ? Isn’t the purpose of business to have income?”

You’re right of course — I want to make money from any business activity. But the more I learn about real estate, the more I realize that the skillful use of tax deductions is a hidden wealth accelerant.  And paper losses are one way to access tax deductions.

An example from my portfolio

Let’s take my most recent real estate acquisition: the Palm Springs home.  

This 1940s classic Spanish home has 5 bedrooms and 3 bathrooms, and I purchased it for $1.08 million earlier this year. It’s pretty rough around the edges and will need some extensive remodeling and a pool to really bring it to life as a great Airbnb or VRBO. In fact, we budgeted up to $300k for the renovation.  

We are also paying holding costs for the home during the renovation, such as the mortgage, property tax, and utilities.

But the biggest deduction is going to be depreciation.

Depreciation

Depreciation is the concept that real estate degrades over time. The roof ages, the HVAC loses function, the cabinets get damaged, and even the toilets have a lifespan. In fact, for a single family home, the IRS will assume you’re deducting 3.6% of the cost of home every year as depreciation. This fixes the “lifespan” of a typical residential property at 27.5 years. 

An important point is that land doesn’t depreciate. So when you depreciate your property, the land is being carved out of the calculations. 

Also, you don’t have a choice when it comes to depreciation. Even if you forget to deduct it on your taxes, the IRS still assumes that you’ve done so. And when you sell the property, the IRS will try to get part of this back in something called “depreciation recapture.” (You can avoid this with a 1031 exchange.)

Accelerated depreciation

Since the 2017 Tax Cuts and Jobs Act, you can also perform “accelerated depreciation.” This is a tax strategy that allows you to take up to 15 years of depreciation and “accelerate” 100% of it into the first year of ownership.  

So you get to take a massive amount of depreciation in year 1. In most cases, this will generate a big paper loss.  

If you fulfil the criteria discussed above and are running an “active” real estate business, you can deduct the full amount of this loss from your active income.  

Of note: the ability to take 100% accelerated bonus depreciation starts to sundown in 2023 when it moves to 80%. It then goes down by 20% every year until it hits 20% total acceleration potential.  

Predicting the loss with a cost segregation study

How much will this equate to for an average short term rental home? You’ll need to do something called a “cost segregation study” to find out exactly.  

A cost segregation study will analyze your property and assign a depreciation schedule to every component of the home. Everything from the cabinets to the roof will be evaluated and put on schedule over its assigned life span. The first 15 years of this life span can then be “accelerated” by your CPA into the first year of your business ownership.

But I’ve seen that a good rule of thumb is that you’ll be able to deduct 20-30% of the purchase price of a home in the first year via accelerated depreciation.

We’ve performed a cost segregation on the Palm Springs house, and it came back more aggressive than expected. With this study, we expect to deduct over 30% of the purchase price via accelerated depreciation.  

That’s right — if we fulfil the criteria, we should be able to deduct over $300,000 from our taxes in April. This should lead to a tax refund of over $100,000.  

I spoke to my tax professional last week and confirmed that my understanding of this is correct.

I use Engineered Tax Services for my cost segregation needs. My personal contact there is Kim Lochridge.

Additional deductions

If we can check all the boxes, there are also many more business expenses for the Palm Springs home that we will be deducting against our active income.

Here’s a short list:

  • Cleaning services
  • Insurance premiums
  • Lodging taxes
  • Security systems
  • Renovation costs
  • Furniture and supplies
  • Various rental expenses

The cost of having a business

This all comes at a cost, of course. We are investing a tremendous amount of money and time into into this property, with a lot of uncertainty in the year(s) to come due to Covid-19. We have to manage the property ourselves to qualify as “active participants” in the business.

But since we cannot qualify for Real Estate Professional status, this is the best real estate related deductions we’re ever going to see while the Dr-ess and I still work our day jobs.  The home office deduction pales in comparison to what we expect from this business venture.

In Year 1 of ownership, we expect a huge tax deduction against our tax return. In Year 2 and beyond, we expect the short-term rental income from this one property to rival the rest of our long term rental income combined.

A note about Schedules

Your CPA might ask if you want to file your real estate taxes on Schedule E vs Schedule C. I’m not going to address this topic today. This post is already pretty long!

But let’s just say for now that it depends if you’re providing “substantial services” for your guests or not. It’s my opinion that it’s much better for you to file the taxes on Schedule E.

Conclusion

If you’re a high income professional and want tax deductions, you should consider starting a short term rental business. 

You have to be prepared to manage the property yourself or invest a significant amount of time into the business. You have to be careful to fulfil the IRS criteria as noted above. But if you do, you’ve got until 2023 to take full advantage of the 100% bonus depreciation.

But if you already have a second home or you just love vacation homes, this could be a great fit for you.

Because if you do it right, you might be able to gain a fantastic weekend getaway, a great source of extra income, and a truly amazing tax deduction at the same time. 

–TDD

What do you think about this tax move, pretty amazing, right? Comment below!

And don’t forget — if you want to learn the basics of Short Term Rental, consider the Carpe Diem MD Short Term Rental course! Here’s my review!

Click here to learn more and sign up!


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Will Porter
Will Porter
10 months ago

Why doesn’t this fall under the AGI max out of $150k for active real estate investments?

Merideth
Merideth
10 months ago

I’m sorry if I sound ignorant, I am new at the short term rental and we are approaching our first tax season with a lot of trepidation. Are you saying you can take deductions that will apply to your regular income as well as short term rental income? Thank you for your insightful article and advice!

Matt
Matt
9 months ago

What happens when bonus depreciation gets phased out? Will all this be worth it then? How else can we offset W2 income since we don’t qualify for REPs (REP benefits will be phased out anyway). Currently, if you use up all your depreciation in one year, what happens in year 2 and forward? Sounds like you have to buy a new house every year

Salim Shahsamand
Salim Shahsamand
7 months ago

Can you give a “hypothetical” example of how you will be able to qualify for the 1 of 7? I know you mentioned the Palm Springs home is a big renovation. Will your active involvement in the renovation count? I am just trying to get a better understanding. We are in contract for our first and we live in CA and the property is out of state but I would love to be able to qualify for 1 of the 7 to make this work for us. Thanks! Appreciate the info!

Steve
Steve
6 months ago

Do you manage the bookings and cleaning service for the short-term rental or does another company provide those services? If another company manages the bookings and cleaning can the owner still qualify for material participation status?

Salim Shahsamand
Salim Shahsamand
6 months ago

What type of proof is needed to show that you participated 100 hours and more than any other individual involved? I have a hard time thinking I will be able to prove this against the time my cleaner will be putting in turning the property between guests.

Richard Sherman
Richard Sherman
5 months ago

Will this apply for international short term rental investments?

jason
jason
5 months ago

Great article! I ran this by my accountant and his initial reaction was that substantial services and a schedule c are needed to get around the income limits to claim a loss. I’m curious to know how you are doing this without substantial services on a schedule e?

Newbie
Newbie
4 months ago

Will the bonus depreciation apply to California state tax?

Craig
Craig
1 month ago

Thank you for the great write up! This sounds like a great opportunity. I had a few questions that I hope can help some other readers as well.

1. Can you buy a home as a primary residence, rent out an ADU or other separate unit that you are not using, and still take advantage of this? Or does it have to be a totally separate property?
2. Does this affect how you take title on the property? Can you do a LLC or does it need to be a personal second home?
3. Can you do this with an existing primary or second home that you already own?
a. And what if you have already spent more than 14 days of the year using this home? Is that restriction only applied once you put the unit in service or would you have to get another property to qualify?

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