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Greg O'Brien, CPA, CTS

Unlocking the Tax-Free Potential using the Short Term Rental Loophole

The short-term rental loophole is a tax advantage that allows investors to gain tax-free wealth without being a real estate professional. To fully exploit this loophole, it's crucial for a short-term rental investor to fulfill at least one of the seven material participation criteria and employ accelerated depreciation through a cost segregation study. By understanding the tax code, leveraging the short-term rental loophole, and employing the expertise of a tax strategist, investors can maximize their tax savings and pave the way for long-term wealth accumulation.

Unlocking the Tax-Free Potential using the Short Term Rental Loophole

The realm of short-term rentals has become a burgeoning field for investors seeking to augment their income and accrue tax-free wealth. Online platforms such as Airbnb have become crucial in this strategy, playing a significant role in the tax planning approaches of high net worth individuals.

However, understanding and leveraging the short-term rental tax loophole requires a thorough knowledge of the tax code and its implications. Unfortunately, it is our estimation at Anomaly CPA that 95% of accountants do not understand this.  

We have become a leader in the execution of the short term rental tax loophole by carefully studying the tax code, regulations and relevant court cases (yes, there are court cases on short term rentals)!

Decoding the Short-Term Rental Loophole Tax Strategy

The tax advantage referred to as the "short-term rental loophole" has emerged as a valuable alternative to gaining a real estate professional status, especially considering the more flexible requirements.

The whole idea is you can structure the activity in a way that allows you to shift it from a "passive activity" to a "non-passive" activity without being a real estate professional for tax purposes (see our blog on the real estate professional status).

According to the tax code, specifically Reg. Section 1.469-1T(e)(3)(ii)(A), there are six unique situations under which rental income could be classified as non-passive:

  1. The property experiences an average customer use of seven days or less.
  2. The average customer use of the property is 30 days or less, and substantial personal services are rendered in association with the rental.
  3. Regardless of the rental period, extraordinary personal services are provided in connection to the property rental.
  4. The property rental is incidental to a non-rental activity of the taxpayer.
  5. The property is available during defined business hours for nonexclusive use by various customers.
  6. The property is utilized in an activity executed by a partnership, S corporation, or joint venture in which the taxpayer holds an interest, and it is not deemed a rental activity.

Each of these situations paves the way for strategic tax planning, potentially leading to substantial tax savings and set you up for long term tax free wealth.

It is important to note, if you do NOT provide extraordinary services (think daily food, daily maid with guests in the house) then this would be reported on Schedule E of your tax return.  The only case in which a short term rental would be reported on Schedule C is if you provide extraordinary services and run the activity similar to a bed and breakfast.

Meeting Material Participation Criteria: Maximizing the Loophole's Potential

Yet, to fully exploit this loophole, it's crucial for a short-term rental investor to fulfill at least one of the seven material participation criteria.

These benchmarks help ascertain your active engagement with your short-term rental business. Here's a brief overview of the criteria:

  1. Investing more than 500 hours annually into the short-term rental business.
  2. Being the individual who performs virtually all services for the business.
  3. Spending in excess of 100 hours on the activity, with no other individual dedicating more time than you.  In this test, if you have a property manager, you must be extremely carefully!

These are generally the most achievable criteria for most investors, though it is possible to meet the remaining criteria with careful, proactive involvement and strategic planning.

Depreciation: An Essential Component of Your Tax Strategy

Another cornerstone of a robust short-term rental tax strategy involves the use of depreciation, specifically accelerated depreciation.

Collaborating with a skilled real estate CPA can guide you in employing this element to its fullest potential.

A cost segregation study on your property can significantly amplify your depreciation deductions. This method reclassifies components of your property from the standard 39-year depreciation life to shorter 5 and 15-year depreciation schedules.

The strategic benefit of this approach lies in its capacity to offset your taxable income. For example, a property valued at $1 million could potentially provide up to a $250,000 deduction when a cost segregation structure is efficiently implemented.

Navigating the Shifting Sands of Depreciation

While bonus depreciation is currently set at 80%, it is set to start decreasing from 2023 onwards, reducing incrementally over the subsequent four years.

Despite this upcoming shift, the short-term rental depreciation loophole remains intact. As bonus depreciation decreases, the strategic reclassification of parts of your property to shorter depreciation periods still holds significant tax savings potential.

Building Long-Term Wealth with Short-Term Rentals

Crafting a successful tax strategy around short-term rentals is a combination of knowledge, proactive tax planning, and strategic decision-making. While there's undoubtedly a learning curve involved, mastering the intricacies of the tax code, leveraging the short-term rental loophole, and employing the expertise of a tax strategist can lead to substantial tax benefits and long-term wealth growth.

A Deeper Look into the Material Participation Criteria

Understanding and meeting the seven material participation criteria is central to unlocking the full potential of the short-term rental loophole. Let's delve deeper into these benchmarks:

  1. Dedicating over 500 hours per year to your short-term rental business demonstrates significant involvement. This may involve a wide range of activities, from property maintenance and improvements to administrative tasks and customer service.  Focus on the 11 real property trades or businesses as your guide.
  2. If you undertake virtually all the services related to your short-term rental business, you're likely to meet the second criterion. This requires a hands-on approach, where you're actively managing and running the operation.  This test is more "grey" than the others so work with your tax strategist and proceed with caution.
  3. The third criterion involves a balance between your time investment and that of others. If you're contributing over 100 hours annually and no one else is dedicating more time than you, this criterion is met.
  4. The remaining criteria, while perhaps less common, can still be achievable with strategic planning and a proactive approach. They involve various combinations of time commitment and personal service activities spread over several years.

The Role of Depreciation in Your Tax Strategy: Going Beyond the Basics

Depreciation is a powerful tool in your tax strategy toolbox, especially when it comes to short-term rental properties. The process begins with a cost segregation study, performed by a tax strategist or engineer. This study dissects your property into different components, each with its own depreciation schedule.

Rather than adhering to the standard 39-year life for depreciation, certain components of your property - such as personal property, land improvements, and qualified improvement property - can be reclassified into 5 and 15-year lives. This means you can take larger depreciation deductions over a shorter period, thereby lowering your taxable income in those years.

These accelerated depreciation deductions will allow you to strategically create losses which can then offset W2 income up to the excess business loss limits and all business income!

Short-Term Rentals: A Platform for Tax-Free Wealth

Harnessing the power of short-term rentals can provide a significant boost in your quest for tax-free wealth. The short-term rental loophole offers a viable path for individuals who might not qualify for a real estate professional status but are keen to explore real estate as a tax-saving strategy.

While navigating the complexities of the tax code can seem daunting, with the right team - including a tax strategist and a proactive tax planning approach - you can maximize your tax savings and pave the way for long-term wealth accumulation.

Investing in short-term rentals requires strategic planning, an understanding of tax laws, and a proactive approach. However, with the right mindset, resources, and professional help, you can transform this venture into a successful tax strategy, driving wealth accumulation and financial success.

The Short Term Rental Tax Strategy Loophole Checklist!

1) Average customer period of use is seven days or less during the year

2) You materially participate in the short term rental using one of the seven tests

3) You do NOT provide extraordinary services (which would lead to self employment taxes)

4) You execute a cost segregation study to accelerate depreciation and assist in maximizing the short term rental tax loophole

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