The last few years have seen a relative boom in the housing market, particularly in the short-term rental space (STR), otherwise known as AirBnb and VRBO homes. This vacation rental space has generated both passive and non-passive income for real estate veterans and side hustlers alike. As we all know, this newfound revenue stream has created massive tax bills for property owners, leaving many in search of various tax savings methods.
Many real-estate professionals and commercial property owners are aware of Cost Segregation and its ability to dramatically reduce taxable income. In brief, cost segregation is a strategy that allows short term rentals to increase tax deductions by accelerating the depreciable life of certain components of a building, thereby reducing taxes owed. However, due to passive activity limitations, some real-estate owners never realize the benefit of these large deductions.
This article focuses on a little-known tax strategy that allows STR investors to maximize their depreciation deduction from cost segregation and use it against W2 or other income.
No Loss Limitations for STRs
Typically, rental real estate owners are not able to take real estate losses against their W2 or other business income due to passive activity loss rules surrounding rental activities. With the explosion of Airbnb, however, short term rental owners are more prevalent than ever and are uniquely positioned, since their property(s) are not subject to the traditional loss limitation rules. This is due to the fact that their units are typically rented for a period of 7 days or less, allowing STRs to skirt around loss limitations, resulting in lower taxable income. Now, instead of needing to qualify as a Real Estate Professional (which is the case for long term rental owners), STRs only need to materially participate in the property to obtain this benefit. Here’s how:
For a STR owner to materially participate in his or her property(s) they must:
- Manage or assist in managing a property for 500 hours or more
- Manage or assist in managing a property more than any other individual, and for a minimal of 100 hours or more
This means that if you have someone clean your properties in between tenants you must track their time and ensure that you’re putting in more hours than they are, these hours must also add up to 100 or more. This same rule applies to anyone servicing your STR.
Why is this Important?
This is important because now STR investors can use losses created from a cost segregation study against rental income AND other income. For Example:
John has a short-term rental that generates $50,000 in rental income and a job that earns him $50,000 in salary. Without any tax strategies or an understanding of the STR tax rules, John’s typical depreciation deduction is $10,000 per year, which gives him a total taxable income of $90,000. If John were to use a cost segregation study and a savvy tax advisor, his depreciation deduction, in this example, would increase to $110,000. Since his property is a short-term rental and he used a cost segregation study, he can now use the full depreciation deduction towards his rental and W2 income, giving him a loss of -$10,000 (instead of a gain of $90,000). John can carry forward that loss into next year and use $10,000 against next year’s income.
Learn more about Cost Segregation
This tax provision, which is referred to as the “transient basis rules,” is not new. It has only become popular and better understood due to the explosion of Short-Term Rentals in the wake of Airbnb and VRBO platforms. Many real estate investors may think – why do I want my rental operation to run a loss? Keep in mind that this is only a paper loss due to a dramatic increase in deductions, which in this case is depreciation.
This loophole, matched with cost segregation studies, is what makes STRs more appetizing from a tax perspective. If you have questions about your short-term rental and the tax breaks associated with this type or real estate, please contact the ATS team below.