Question: What would you say is the latest craze in real estate investing? The thing that everyone is talking about and wanting to learn more about?
If you ask me, the term “short-term rentals” comes to mind. At the most recent BPCon, the short-term rental breakout session was not just a full house. It was standing room only. People were packed wall to wall, even with investors standing outside the conference room listening in.
So why are so many people interested in short-term rentals? Well, odds are that even if you do not own a short-term rental, you have likely stayed at one before. Whether listed through Airbnb, VRBO, or other similar sites, many investors see significantly higher cash flow by turning a traditional property into a short-term rental. Also, there can be an added perk if the investor can get some personal enjoyment out of the short-term rental property as well.
It is not uncommon for us to see a property make two to three times the cash flow when changing from a long-term rental to a short-term rental. With the higher cash flow comes the need for good tax planning. Why? Because how much of it you get to keep is more important than how much money you make! So let’s go over how to minimize taxes from your short-term rental investments.
Short-term rentals and taxes
To start, we need to first define what a short-term rental is when it comes to taxes. Many investors are under the impression that just because they list their properties on a platform like VRBO or Airbnb, they are considered short-term rentals. That is a mistake.
For tax purposes, a rental is not defined by where it is listed but by the number of days that a property is available for rent, as well as what type of services are offered alongside the rental. Generally speaking, if the average number of rental days per guest is seven days or less for the year, then the property is considered a short-term rental for tax purposes.
If the average guest stay is longer than seven days, that property will still likely be treated the same way as a long-term rental even though it might be advertised as a short-term property. Rentals, where hotel-type services are offered (like a bed & breakfast), are generally treated as short-term rentals.
One important thing to remember is that short-term rentals, like long-term rentals, are typically taxed at the investor’s highest ordinary income tax rate. So if you are an investor who is in the 35% tax bracket for your W-2 and other income, any taxable rental income is added on top and also subject to this tax rate.
Strategies for reducing taxes on short term rentals
Since short-term rentals often create high cash flow, it is essential to make sure that you are using the appropriate short-term rental strategies throughout the year to reduce taxes on this source of income.
Maximize your tax deductions
Maximizing your tax deductions is the first step in reducing your taxes on your short-term rentals. As an investor, you may have frequent trips to your short-term rental to set up, stage, or even manage the properties. Make sure to document your trips so that you can write those off against your rental income at tax time. Travel to short-term rentals is tax deductible against rental income, just like travel for any other type of real estate investing. The key is to make sure you have documentation to prove the reason for those trips. Let’s go over an example of just how powerful this can be.
Let’s say James owns a few short-term rentals in a lakefront community just two hours away from his home. He purchased a large truck that he used primarily to rehab, stage, and manage the short-term rentals.
Since the car was primarily for business use and weighed more than 6, 000 lbs, James was able to deduct the entire purchase price of the truck. By writing off close to $30k on that truck, James was able to lower the taxes on his short-term rentals and save close to $10k in taxes. Depreciation is based on the truck’s purchase price, so James was able to create a significant write-off even though he financed part of that truck purchase.
Shift your income
Income shifting is another way to maximize tax savings on short-term rental income. Consider paying family or friends who are helping you out with your short-term rentals to shift income and save on taxes.
James had a nephew who was still in college that was interested in getting into real estate. James hired his nephew to help with the rehab and repairs to get the short-term rentals ready. The $8,000 James paid his nephew was tax deductible and saved James another $2,400 in taxes. Most of the tax-saving short-term rental strategies traditionally used for long-term rentals are the same ones available to short-term rental investors.
Take advantage of depreciation
An investor may often have higher start-up costs with short-term rentals. Sometimes you may need to purchase furniture, fixtures, and appliances. Whether buying these as brand-new items or buying used items, most of these items may currently be eligible for bonus depreciation. This means that instead of depreciating the cost of these items over multiple years, you may be able to take the full depreciation in the first year.
For example, if James spent $6,000 on appliances, furniture, and a kayak for his short-term rental on the lake, that can result in a $6,000 deduction immediately in the first year. It is important to keep itemized listings of the items you spend money on. Supplies like towels, bedding, and toilet paper are all tax-deductible expenses. Those small amounts can add up to some substantial tax savings.
Track your expenses
Tracking expenses for short-term rentals is just like any other rental property. If you have multiple short-term rentals, track the income and expenses by property. We have already touched on travel, furnishings, and income shifting.
Don’t forget the other potential tax deductions such as business meals, eligible home office, or related educational expenses. Since short-term rentals can be very profitable, it is extremely important to make sure you capture all of your expenses to offset the taxes associated with that income.
Know the tax benefits
Investing in short-term rentals can also come with some great tax benefits. Some of those tax benefits may even be better than those from investments in regular long-term rental properties.
For those in the long-term rental space, you probably already know some of the restrictions concerning the passive activity loss rules for higher-income investors. In short, if your adjusted gross income is over $150,000, then any rental losses from long-term rental properties typically can only offset income from other passive activities. When there is an excess loss, those losses are not used to offset taxes from your W-2 income. The losses are instead carried forward into future years to offset future passive income.
However, an investor who can claim real estate professional status would then be able to use the net losses from the long-term rentals to reduce taxes from W-2 and other income. For investors who work full-time, obtaining real estate professional status is often tough to achieve. One of the main hurdles is that the investor must spend more time in real estate than their job.
So for someone working 2,000 hours a year at a job, they would need to spend more than 2,000 hours that year in real estate as well. Real estate professional status is often difficult for investors who are still working full time. This means the excess rental losses are not as helpful to offset taxes from W-2 or other non-passive income. When it comes to short-term rentals, though, the good news is that it is treated differently than long-term rentals for tax purposes.
One of the perks of investing in short-term rentals is that the investor’s ability to use excess rental losses from the short-term rentals to offset taxes from W-2 and other income is a little easier to achieve. This means that if you’re operating in the short-term rental space, you do not need to be a real estate professional to be able to potentially use rental losses from those properties to offset taxes from W-2 and other income.
However, you will still need to show that you are materially participating in your short-term rentals. So what exactly does it mean to materially participate in your short-term rentals? There are seven tests, and you only need to meet one of them.
Tax benefit qualifications to know
Out of the seven possible qualifications, here are the top three that are most commonly used:
- Participate for more than 500 hours during the year on the short-term rentals
- Participate for more than 100 hours in the short-term rentals, and no one else incurred more time than you
- Participate in substantially all of the activities in the short-term rentals where your participation exceeds the combined time of all other individuals
Material participation time can include tasks such as staging and managing the property, dealing with guests, repairing, cleaning, restocking the property, to name a few.
Once you meet one of the material participation tests for your short-term rental, then any net tax losses may be deductible in the current tax year and thus help offset taxes from W-2 income. If you are an investor who owns multiple short-term rentals, you may be able to combine your hours across all of your short-term rentals as well.
Let’s go over a quick example of how this strategy works: Ashley works full-time at a tech company. She decides to buy a property in a nearby ski area and rent it out as a short-term rental. Even though she had to pay a slight premium for the property and incur some start-up costs to get the property ready, it had phenomenal cash flow in the first year.
Ashley loves connecting with her guests and sharing her insights to make their stay a memorable experience. By working proactively with her tax advisor, she decided to be very involved in managing her short-term rentals. She documents her hours during the year to ensure she meets one of the material participation tests. Her tax advisors assisted her with maximizing her tax deductions by writing off the business use of her car, computer, and home office.
The first year she owned the property, she decided to obtain a cost segregation study to accelerate the depreciation deduction for her short-term rental. With proactive tax planning, not only did Ashley not have to pay taxes on all of that cash flow she received from the property, but she also created a significant net loss of $20,000 for tax purposes.
Since she worked during the year to ensure that she met the martial participation hours with respect to this property, Ashley was able to use the $20,000 loss from the short-term rental to reduce some of her taxes from her W-2 income at the tech company. Not only did Ashley receive significant cash flow from the property, but she also paid no current taxes on that cash flow and instead used additional losses to reduce taxes from her W-2 income.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Final thoughts on tax benefits for short-term rental investors
As you can see, there can be some significant tax benefits to investing in short-term rentals. It is important to remember that rules and regulations can change quickly regarding short-term real estate investing.
Before investing in a short-term rental, it can make sense to analyze the deal to see how it would otherwise perform as a long-term or mid-term rental. If the city were to enact new short-term rental restrictions or changes, you want to ensure that you have alternative investment strategies to keep the property performing well.
Once you have decided that short-term rental investing is for you, make sure to work with your tax advisor and plan proactively during the year so that you can keep more of that excellent cash flow!