Using the short term rental tax strategy can be a powerful way to reduce your income taxes. This strategy is a big incentive for many short term real estate investors. But here’s the question: can this strategy work for non real estate investors too, such as W-2 employees?
Tax advisors have been recommending this strategy to W-2 employees who want to lower their tax liability. But does it really work? What are the risks involved? And what should you watch out for before diving in?
This article dives deep into how W-2 employees can make the most of the short term rental loophole. It’s all about maximizing tax benefits and we’re ready to start. But with every tax strategy there are risk you should know before investing. Let’s dive in!
Exploring the Evolution of Short Term Rental Tax Strategies
During the 1980s, the Tax Reform Act of 1986 was enacted as a pivotal measure in President Reagan’s second term. This legislation not only aimed to simply the federal income tax system. It is also aimed at eliminating tax loopholes and tax shelters.
One of the most common tax-shelters utilized were rental partnerships. High earning professionals looking to reduce their tax liability would invest in these tax shelters to receive large paper losses while receiving tax free distributions.
Before the Act, W-2 employees were able to offset losses from rental properties against all types of income including their wages. A frequently employed tax strategy, especially prevalent among highly compensated professionals such as doctors and attorneys, involved investing in rental properties, depreciating them, and subsequently offsetting the resulting losses against their income.
The introduction of Section 469, commonly referred to as the Passive Activity Loss Limitation (PAL) Rules, under the Tax Reform Act, had a profound impact. These rules deemed all rental properties as passive by default, leaving no avenue to classify them as non-passive. Undeniably, this restriction brought about its fair share of frustration.
The Act carved out some exceptions for real estate professionals but this tax loophole was effectively closed for most taxpayers.
The Unintended Loophole
Although the Section 469 closed the rental loophole for most W-2 employees, the IRS left an unintended loophole when drafting the rules. You can locate it in the tax code, specifically under Reg. Section 1.469-1T(e)(3)(ii)(A). This section outlines exceptions to the definition of a “rental activity”.
One such exception is for short term rentals. Specifically, a rental activity is not technically a rental activity for the purposes of applying the PAL rules if the average period of customer use for such property is 7 days or less.
This rules carves out exceptions for rental properties that are more akin to a bed and breakfast or a vacation rental. However, the IRS couldn’t have predicted the rise of short term rental websites like Airbnb and Vrbo which would give access to short term rental investing to a broader range of taxpayers.
Couple this with the changes under The Tax Cuts and Jobs Act (TCJA) and you have a grand slam tax strategy. Notably, the TCJA introduced a provision for 100% bonus depreciation. This enables real estate investors to immediately deduct the full cost of eligible improvements made between Sept. 27, 2017, and Jan. 1, 2023.
Short Term Rental Tax Strategy For W-2 Employees
So, what is the actual tax strategy? As I mentioned before, rental losses are considered passive and therefore cannot offset other types of income like W-2 wages. They can only offset passive income like income from another rental property.
However, short term rentals are not considered passive activities and therefore losses generated from your short term rental can offset your wages. On top of that, accelerated depreciation allows you to front load those losses to get the biggest bang for your buck in the first year. you could even potentially offset your entire income and pay zero in tax.
Let’s look at an example.
Let’s say you’re an executive making $500,000 a year. To benefit from this strategy you can purchase a property with the intent of turning it into a short term rental. You put 20% down on a $300,000 property and finance the rest. Additionally, you make major improvements to the interior of the property and get a cost segregation study to see what portion is eligible for accelerated depreciation.
Your property is now worth $400,000, you are ready to list it on AirBnB and your accountant has informed you you’re eligible for $100,000 in a depreciation deduction. Not only do you have a $100,000 offset on your return but you now have a property that is going to cashflow.
Ok, this sounds great, but what’s the catch? Although this strategy might seem like a no-brainer, there are several factors to consider.
Let’s explore some reasons why you might not want to use this strategy.
As a highly paid professional you probably don’t have time to manage a short term rental. From client calls to business trips, you can’t expect to manage an Airbnb listing on the side.
This might be a big hurdle considering you need to meet the material participation test. The exception to the definition of rental activities in the tax code listed above only works if you meet one of the 7 material participation test. Most of the test are not relevant for our purposes so let’s look at the easiest hurdles to cross.
- Work more than 500 hours on your rental business
- Be the only person managing the property
- Work more than 100 hours, hire others to help but no one person can work as much as you
If you intend on hiring a property manager number 2 and 3 are out. That means you need to show you worked roughly 9 to 10 hours per week managing the property in some way. That’s equivalent to every Saturday of the year.
Another strategy would be to have your spouse manage the properties. If you are married, the participation of your spouse counts as your participation. This works great for a couple with a stay at home spouse looking to make some side income. However, if you’re single or if your spouse is just as busy as you are then this might not work for you.
Bonus Depreciation is Going Away
2022 was the last year to benefit from 100% bonus depreciation. Right now, 100% bonus depreciation will gradually decrease each year for the next five years until it phases out.
- 2023 – 80%
- 2024 – 60%.
- 2025 – 40%.
- 2026 – 20%
- 2027 – 0%
There is no current plan in Congress to extend this provision so expect it to go away. With the growing national debt and increase in inflation I wouldn’t bet on any additional tax cuts anytime soon.
Let me clarify: The short term rental loophole itself is not phasing out, just the access to the 100% bonus depreciation. However, you won’t get as much bang for your buck especially if you are paying a tax advisor major fees to help you with this strategy.
Being a landlord carries a unique set of risks and responsibilities. You’re essentially running a business and that means being liable for any legal issues, tenant disputes, repairs, evictions, and other problems that come up.
You must be aware of all applicable laws in your area and make sure you abide by them. You’ll also need to screen all potential tenants, collect rental payments, and manage any necessary repairs and maintenance. It’s a lot of work and can be a financial burden if you’re not prepared.
Airbnb nightmares can become a reality for landlords. One of the risks of offering your property as a short term rental is that you could end up with tenants who are careless and disrespectful of the space they’re staying in. This could mean anything from leaving a property in a state of disarray to extensive damage that requires costly repairs.
Unless you are interested in investing in real estate you shouldn’t get a short term rental just to get a short term tax break. Without doing proper research you could put yourself at risk of loosing your initial investment.
With raising interest rates and a slowdown in the economy, it is becoming harder to predict the short term rental. The potential for economic headwinds or a recession are increasing and could result in you sitting on a property with no listings.
Therefore, before investing in a short term rental you should get advice from an expert and understand the risks involved. Do your research, seek consultation, and make sure you understand the full implications of your investment.
Unlocking the Door to Success: Short-Term Rental Strategies for W-2 Employees
Investing in short term rentals can be a great way to save on taxes, but it’s important to remember that there are risks and responsibilities involved. Make sure you understand the risk and requirements before investing in a short term rental and consult an expert. Lastly, don’t forget to check your local laws and regulations as they may vary from state to state.