Renting out properties on a short-term basis can be a good way to generate an additional income stream without a significant investment of time. You can also take advantage of the short-term rental tax loophole if you meet certain requirements. This loophole is designed to extend tax benefits to investors who rent out property on a short-term basis. If you’re considering real estate as an investment, it’s important to know how the loophole works. You can also talk to a financial advisor about where real estate might fit into your investment strategy.
Understanding the Short-Term Rental Tax Loophole
The short-term rental tax loophole allows for the favorable tax treatment of income from short-term rental properties when certain conditions are met. The loophole benefits property owners who don’t meet the criteria for Real Estate Professional Status (REPS). It does so by providing an exception to how rental activity is defined and how the income generated from it is taxed.
Specifically, the loophole distinguishes between passive and non-passive activity. If your rental activities are considered to be non-passive, then they’re covered by the loophole. The federal tax code defines the standards for proving that income generated by a rental property is non-passive.
- A guest stay lasts no more than seven days on average.
- The average period that a guest uses the property as a rental is 30 days or less and the owner provides basic services that are on par with what a hotel might offer.
- Owners provide extraordinary personal services to make the property ready for us.
- Property rentals are treated as being incidental to the non-rental activity of the owner.
- Use of the property is available during defined business hours and it’s not exclusive to any one guest.
- Any provision of the property for use in activities conducted by a partnership, S-corp or joint venture the property owner has an interest in is not a rental activity.
So, what does all that mean in simple terms? In a nutshell, the short-term rental tax loophole can add up to significant tax savings if you qualify, without requiring you to be a full-time real estate professional.
How Does the Short-Term Rental Tax Loophole Work?
The tax loophole for short-term rentals works by providing a framework for distinguishing between passive and non-passive activity. Section 469 of the federal tax code, which was introduced by the Tax Reform Act, automatically assigned passive status to all rental properties. In the 1990s, an exception to the rule was created which allowed for certain rental income to be classified as non-passive.
In order to meet the tax standard for a service business, you must be renting out properties on a short-term basis and provide substantial services to guests. For example, if you’re renting out a home on Airbnb or VRBO, that might include offering daily cleaning services, providing meals or offering transportation. Basic services, like garbage collection or internet service, wouldn’t fall under this umbrella.
You also have to pass a material participation test to take advantage of the short-term rental tax loophole. The tax code provides seven ways to do that, but you only need to satisfy one. Here are the requirements.
- You spend more than 500 hours working in your short-term rental business.
- You carry out all the necessary tasks to run the business yourself.
- If working with someone else, your participation must be greater than 100 hours and equal to the number of hours they put in.
- You significantly participate in activities for more than 100 hours, with 500 combined hours of participation in the business.
- You participated in the activities in five of the last 10 years.
- You participated in a personal service activity for three of the previous taxable years.
- You worked more than 100 hours in the business on a regular, continuous basis.
The easiest criteria to meet may be the second one if you’re handling all activities related to your short-term rental business yourself. You could also qualify under the first rule, depending on how many hours you’ve put into renting out properties for the short term.
Tax Benefits of the Short-Term Rental Loophole
The primary goal when taking advantage of the short-term rental loophole is to save money on taxes. When rental income qualifies as non-passive, that opens the door to claiming deductions for business expenses related to the property. Deductions reduce your taxable income for the year, which could substantially lower your tax bill.
You can also benefit from depreciation with short-term rentals. The IRS allows you to treat depreciation—or the loss of value—as a deductible expense. That’s another way to reduce your taxable income and minimize taxes. Bonus depreciation allows you to deduct costs associated with short-lived capital improvements. For example, if you replace the HVAC system at your rental property, you may be able to claim additional depreciation for those improvements.
A cost segregation study can be helpful for maximizing depreciation tax benefits. This type of study breaks the property down into separate elements and costs, then depreciates them over a period of five, seven or 15 years. The purpose is to figure out which parts of the property you may be able to accelerate depreciation for in order to yield a larger tax benefit.
Tips for Reducing Taxes on Short-Term Rental Properties
If you own a short-term rental or are thinking of buying one, it’s helpful to know what you can do to cut down on your tax liability. Here are a few additional tips for minimizing taxes on rental properties.
- Max out deductions: Owning rental properties can allow you to deduct a variety of expenses and none are too small to claim if you’re trying to slash your tax bill. Keeping good records of every expense associated with your rental property can help you make the most of the deductions you’re eligible to claim when it’s time to file your return.
- Depreciate what you can: As mentioned, depreciation can equal tax savings if you’re able to write off the declining value of assets. If you’re just getting into the short-term rental market, for instance, you may be able to depreciate any new appliances, fixtures or furniture you buy to get the property ready to rent.
- Track all of your expenses: If you have expenses related to owning a rental property, other than those that are directly connected to the property itself you may be able to deduct those as well. For example, if you maintain a home office specifically for running your short-term rental business you may be able to claim a deduction using the simplified method or actual expenses.
If you’re new to rental investing, it can help to have a team to call on for support. For example, you might want to work with a certified public accountant to make sure you’re claiming all of the tax benefits you’re eligible for and that you’re meeting the requirements for the short-term rental tax loophole. Working with a financial advisor is an opportunity to create a strategic plan for managing the income your rental property brings in.
The short-term rental tax loophole can provide some valuable benefits to property owners if you know how to claim it. Before wading into the realm of property rentals, it’s important to weigh the pros and cons, as well as the time commitment required to make sure it’s right for you.
Tax Planning Tips
- Real estate investments can help you further your financial goals, but they’re not always right for everyone. Talking over the benefits and potential drawbacks with a financial advisor can help you to decide if it’s right for you. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Interested in real estate investments but don’t want to own property? There are other ways to invest in real estate without direct ownership, including real estate investment trusts (REITs), real estate funds and crowdfunded properties. Exploring the benefits and risks of each one can help you find the right avenue for investing, based on your objectives and goals.
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