If you’re a high-income earner, then it’s safe to say that taxes are your BIGGEST expense. As a periodontist, I’m constantly on the lookout for ways to lower taxes for my Investor Group (if you’re an accredited investor and want access to my personal deal flow providing tax benefits, join the GROUP today.)
One of the main reasons most doctors and other full-time professionals invest in real estate is for the tax advantages.
The United States government incentivizes real estate owners as they’re essentially creating a business. And guess what businesses create? They hire employees that not only stimulate the economy, but also pay taxes. You’re also providing an essential service: housing.
You’ve probably heard that becoming a Real Estate Professional is a way to obtain extensive tax breaks but for many working full-time, this option is not possible.
If you fall into this category then good news. There’s another potential option for you: short-term rental properties. Your BIGGEST wealth building tool is your income as you’ve spent a lot of time, money, and energy to obtain it.
For many, cutting back part time at work isn’t an option which is why many high-income professionals are utilizing the short-term rental tax loophole.
Before we discuss this strategy, a quick disclaimer…
[Disclaimer: I’m NOT a CPA, tax advisor, attorney, or financial advisor. It’s always best to consult your own team of professionals about the topics covered in this article.]
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Real Estate Tax Benefits
One of the major reasons people invest in real estate is the AMAZING tax benefits they offer.
#1. Depreciation deduction
Depreciation is one of the most powerful wealth building tools in real estate as it’s a way to write off the value of an asset over time.
Even though real estate usually appreciates in value, the IRS allows you to depreciate its value called a paper or phantom loss.
They allow you to subtract the losses against the income which will REDUCE your tax burden.
Examples of deductions/expenses you can expect to deduct from the operating income:
- Mortgage and mortgage interest
- Costs from property managers
- Repairs and upkeep
- Legal and professional services
- State and local property taxes
#2. Accelerated depreciation
This is where the real tax savings occur as the IRS allows you to front load the depreciation via a cost segregation study.
A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for tax purposes, which reduces current income tax obligations.
A cost segregation study is typically performed by qualified engineers and/or CPAs.
The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter amount of time (typically 5, 7 and 15 years) than the building (39 years for non-residential real property).
- 5-year tax-life components: tangible, personal property assets (carpeting, secondary lighting, process related systems, cabinetry, ceiling fans, etc.)
- 7-year tax-life components: all telecommunication related systems (cabling, telephone, etc.)
- 15-year tax-life components: land improvements (parking lots, driveways, sidewalk, curbs, landscaping, site features like a flagpole or a pond, etc.)
If you want to learn more about using this strategy, check out this video:
#3. 1031 exchange
Another tax advantage used by real estate investors is by using a 1031 exchange.
Here’s the definition from IRS.gov regarding 1031 exchanges which is also known as “Like-Kind Exchanges“:
Like-kind exchanges — when you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or “like-kind” — have long been permitted under the Internal Revenue Code.
Generally, if you make a like-kind exchange, you are not required to recognize a gain or loss under Internal Revenue Code Section 1031.
In essence, this section allows taxpayers a way to defer taxes by exchanging one property and replace it with a like-kind property. Basically, you’re able to take all of the proceeds from the sale of one property and buy another and the taxes on the transaction are deferred.
The deferred taxes are the capital gains taxes upon selling the property. The IRS is ALWAYS going to want a piece of your newfound wealth. It always seems like they don’t want anyone to succeed, doesn’t it? Anyway, these so called “windfalls” are what’s considered capital gains, and most are taxed at 15-20%.
As far as how long they’re deferred for….it could be indefinitely, or at least until you die. As long as you follow the IRS rules, you can defer those taxes forever and ever.
The 1031 exchange timeline looks like this:
- Timeline #1 – You have 45 days after you sell your property to identify up to 3 new properties. This can be done in writing, but you must purchase one or more of them.
- Timeline #2 – You have 180 days to close on one or more of the three properties that were identified.
Now that we’ve discussed some of the tax benefits real estate provides, let’s shift gears to tax strategies available for short term rentals.
What is a Short Term Rental (STR)?
A property is considered to be a short-term rental (STR) if it’s rented out for less than seven days at a time on average.
These are very popular in tourist destinations.
Plus with the advent of online platforms such as Airbnb, it’s never been easier for virtually anyone with a vacation/second home or rental property to use it as a short term rental.
Short Term Rental Advantages
The older I get, the smarter (NOT harder) I want to work. You may feel the same way too. As mentioned earlier, one way to work smarter is buy qualifying as a real estate professional.
Real estate professional status
In order to qualify, the IRS states you must meet a few conditions:
#1. Must spend the majority of his or her time (more than 50%) in real property businesses in which you materially participate.
#2. Must spend 750 hours or more in the real property business and rentals in which he or she materially participates (roughly 15 hours per week).
In other words, you’ve got to work on real estate more than you do any other job. So being a real estate professional is your primary profession which means you spend more hours in real estate than you do at your 9-5.
You also must work at least 750 hours on real estate activities with most of this coming from the day-to-day management of your rentals.
If you want more information on how to qualify, watch this video:
Because the time requirements make it difficult to qualify working full time, many high-income professionals are turning to a different option: short-term rentalsJoin the Passive Investors Circle
What is the Short Term Rental Tax Loophole?
This loophole can be found in the tax code under Reg. Section 1.469-1T(e)(3)(ii)(A), and defines exceptions to the definition of “rental activity”.
From TheRealEstateCPA.com site, here’s the six ways in which income for a rental property can be excluded from the definition of a rental activity, and thus not automatically passive:
- The average period of customer use for such property is seven days or less.
- The average period of customer use for such property is 30 days or less, and significant personal services are providedby or on behalf of the owner of the property in connection with making the property available for use by customers. This could include services like a hotel would provide, such as daily cleaning or meals.
- Extraordinary personal services (same as above) are provided by or on behalf of the owner of the property in connection with making such property available for use by customers (without regard to the average period of customer use).
- The rental of such property is treated as incidental to a non-rental activity of the taxpayer.
- The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers.
- The provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not a rental activity.
Steps to take in order to shelter income
Let’s break this down in laymen’s terms for you:
#1. Buy a short-term rental.
#2. Materially participate in the rental.
#3. Obtain a cost segregation study.
#4. Use accelerated depreciation the first year.
#5. Claim paper losses from your business.
#6. Hire a real estate CPA who understands how to use the tax deductions from your short-term rental and apply it to your ordinary income.
Material Participation Tests for the Short-Term Rental Tax Loophole
It may be difficult for a dentist, physician, or other professional to become a real estate professional as they can’t spend half of their working hours in a real estate business.
This is where the short-term rental tax loophole can help. But remember that you must “materially participate” to ensure you can apply the tax deductions against ordinary/active income.
How do you do this?
There’s seven ways to accomplish this but you only need to fulfil one of these criteria to show material participation for the tax year. (Paraphrased from IRS Publication 925).
According to Investopedia, “the material participation tests are a set of Internal Revenue Services (IRS) criteria that evaluate whether a taxpayer has materially participated in a trade, business, rental, or other income-producing activity. A taxpayer materially participates if they pass one of the seven material participation tests. However, passive activity rules limit the deductibility of losses when taxpayer participation fails to meet at least one of the seven material participation tests.”
7 Material Participation Tests
#1. You participated for more than 500 hours on the short term rental business.
#2. Your activity constituted all participation substantially for the STR business.
#3. Your participation was more than 100 hours and no less than the participation of any other individual.
#4. You must have a significant participation activity for more than 100 hours, and your combined activity in all significant participation activities exceeds 500 hours.
#5. You materially participated in the activity for 5 of the last 10 years.
#6. Personal service activity (non-income-producing) for three of the previous taxable years.
#7. You participated for more than 100 hours in a regular, continuous, and substantial basis during the year.
Once you meet one of these tests, and your short-term rental is excluded from the definition of a rental activity, then it is considered non-passive. Remember that the goal is to use a STR for non-passive losses.
These losses can be used to offset non-passive income.
Depreciation for Your Short Term Rental Tax Strategy
If you’re able to pass one of the seven material participation tests, you’re now ready to begin generating losses from your STR with depreciation using a cost segregation study previously discussed.
Remember that the goal of the study is to identify all construction-related costs that can be depreciated over a 5, 7 and 15 year tax life vs a 39 year life.
This is such a powerful strategy as a 5- and 15-year property can generally represent anywhere from 20-30% of a property’s purchase price.
Dr. Z purchases a $1.2m vacation rental in Destin, FL.
His real estate savvy CPA informed him that he could utilize bonus depreciation to shelter around $250k – $300k of his oral surgery income.
Because he makes roughly $300,000 of W2 income, he may be able to pay little to no taxes because of just one rental.
For instance, if you had a cost segregation study performed on a $1m property, anywhere from 20-30% could fully depreciated giving you a $250,000 deduction.
Utilizing the short-term rental tax loophole is an effective way high-income earners can reduce their overall tax burden.
Getting help from a real estate CPA/attorney to guide you through the process is one of the keys to make this strategy a success.
The Short-Term Rental Tax Course
Want more information about reducing taxes AND building wealth?
Investing in short-term rental (STR) properties and using the STR Loophole is one of the few tax strategies that can save you 5-6 figures in taxes without working full-time in real estate.
And because certain aspects of this strategy will phase-out over the next few years, the time to act is NOW.
Which is exactly why the guys at TheRealEstateCPA.com created this course.
After working with one-on-one with hundreds of real estate investors, they want to help as many investors as possible use the STR Loophole to reduce their tax bills.
If you want to save thousands in taxes and build your wealth faster than you ever thought possible, don’t wait, enroll in this course today and take advantage of this strategy while you still can.Join the Passive Investors Circle