EP 56 - What is the Short Term Rental Loophole?

Let's dive into the what the Short Term Rental really is, and how the IRS's unique treatment of short-term rentals can work to your advantage, the stark differences between passive and active income, and how savvy application of IRS Code Section 469 and cost segregation can maximize your real estate investment returns.

We'll clear up what you need to know about material participation criteria, the 7 days or less rule, and how you may be able to see major tax benefits from STR's. Grasping just one of the seven tests laid out by the IRS could be your golden ticket to mitigating tax liabilities across various income streams. We discuss how the 'substantially all' provision, the 100-hour rule, and first-year strategies can be game-changers in your investment portfolio. 

Finally, we tackle the myths clouding the short-term rental tax space, bringing clarity to this high-reward sector. While the allure of tax benefits is strong, the commitment required to manage these properties is substantial. We discuss the realities of short-term rental investments, balancing warnings with the undeniable opportunities that await hands-on investors. For those ready to embrace the challenge, this episode is your guidepost to a more prosperous investment journey. 

Transcript

Speaker 1: 0:00

I used to say that short-term rentals were the easiest way in the world to get rich and eliminate your taxes, and for some, that may still be true, but I also think that there's a lot of misperceptions out there. There's a lot of Instagram and TikTok gurus miseducating the public, and I think that there's a lot of confusion on what short-term rentals, how they're treated by the IRS and what you can do to help you out with your taxes, and also what do you have to do to take advantage of the unique tax treatment of short-term rentals. So welcome to the Mark Perlberg CPA Podcast if this isn't your first time listening, and what we're going to dive into today is we're going to talk about what this short-term rental loophole is and what does this mean for you and how you can use it. We're going to go into the basic foundational elements and you're going to understand at the end of this. What is everybody talking about? How can I maybe this does, does this work for me, and what actions do I need? What kind of features, what kind of things do we need in place here? So this could potentially work to create some tax savings. We're going to do a couple of episodes, so I hope you enjoy this and if you do and you're interested in short-term rentals, stay tuned because we're going to do another, following episodes, diving deeper into this short-term rental loophole and additional considerations and also maybe talking about some of the misperceptions out there on short-term rentals and some of the things to just be mindful of, because there is a lot of misinformation.

Speaker 1: 1:42

So let's talk first about actually. Let me introduce myself first. This is the first time. My name is Mark Probert. Welcome to the Mark Probert CPA podcast. Make sure you subscribe and also, if you or anyone else you know is interested in being a client, just go to markprobertcpacom and we're always also always hiring. Send us some good people. One more thing if you like this podcast, I want you to give me some feedback. If you want to know more information, send us some more questions, give us a review. We really appreciate any interaction we get from our audience.

Speaker 1: 2:18

So let's dive into this here. What is the short-term rental that some of you guys may have heard of here? Well, the best way I can explain this is to explain to you how the tax code works with rentals, short-term rentals at a high level. Here it's going to allow us to take losses from our rentals against our W-2s or our business income, rentals against our W-2s or our business income. But let's dive a little more specifically into, to help me understand this. Let's talk about how rentals are normally treated and why short-term rentals have this unique and beneficial tax treatment for a lot of our clients.

Speaker 1: 3:00

So real estate almost always operates at a loss. When you have rental activities, it's even if you're cash flow positive. You're often going to have negative income statements on your tax returns, and that's just the way it works, because we have this wonderful thing called depreciation, and so if you want to learn more about that, you can watch one of my very first episodes called how Does Depreciation Create Millions of Tax Savings Through Real Estate Investing. I also have episode 14 you can check out Sorry, episode 16, maximizing the Benefits of Cost Segregation with Yonah Weiss, where we talk about cost segregation and if you want to learn more about that topic. So cost segregation now allows us to maximize our depreciation write-offs by front-loading them and accelerating. So whenever we have a business activity like rental real estate, we have our revenue minus our expenses, and the depreciation is a huge non-cash tax deduction that real estate investors often rely on to create major tax savings and so if we can create these losses, here's some opportunities to maybe reduce our taxes. Right, we have income from other sources. We have positive income here, but we have losses from the real estate to net against that positive income. It can offset that positive income and reduce our overall taxes when it all rolls up towards 1040, right?

Speaker 1: 4:33

Well, that was the case for quite some time and a lot of wealthy individuals were using the real estate to reduce their taxes estate to reduce their taxes. But then in 1986, they issued IRS Code Section 469 that redefined the way that we treat rental real estate and basically they said at a high level here that rental real estate is passive per se. So if we have let's say, we're a doctor making a million dollars a year and we invest into a multifamily rental property and we create a lot of losses through depreciation and cost segregation let's say, a half a million dollar loss we would not be able to use any of that half a million dollar loss because that is a passive loss and your job or your business as a physician is active income, which is different from passive income, and therefore you couldn't use any losses. And this was to prevent or minimize the amount of tax savings that highly paid and affluent individuals were generating from real estate. So, even though that's the case, there are some exceptions to rule. One of them is a real estate professional tax status. We have a whole episode on that, in case you ever want to check it out.

Speaker 1: 5:57

And there's another exception that was not really so, I would say people haven't really picked up on it very much which is if the average length of stay is seven days or less. It is not rental activity in the eyes of the IRS. It is not real estate rental activity. All these restrictions that hinder our ability to create these rental real estate losses to offset our other income. If the average length of stay is seven days or less, we no longer have to consider that restriction, sort of. So if the average length of stay is seven days or less, we may be able to create some non-passive losses and now, instead of having these passive losses that are suspended and only offset our passive rental income, we can move it potentially into this bucket of active income with active losses, where we can potentially create negative income from the real estate that can now offset our positive active income, which is typically going to be our job income or our business income, and it could also offset potentially, when we have non-pass losses, potentially offset capital gains income as well that interest income. So if the average length of stay is seven days or less, we're no longer restricted, is no longer stuck in this passive income bucket.

Speaker 1: 7:29

And now this has become a really amazing factor with the rise of Airbnb and VRBO. It's very common now for people to have these short-term rentals. So that factor needs to be in place. And now there's another factor here, because when we have to determine whether income is active or passive, we also have to look at what is called material participation. So the first step is we need the average length of stay to be seven days or less and we might be able to use the losses with depreciation to offset our other sources of income. But there's another thing that is extremely important and most people miss or miscommunicate or don't understand is we need material participation.

Speaker 1: 8:12

Okay, I'm going to say this again, you might want to write this down we need the average length of stay to be seven days or less and we need material participation to fully take advantage of this real estate professional tax status sorry, the short-term rental loophole and to use the income to offset our other sources of income. Now there are other exceptions to the rule and I kind of just said rep status, real estate professional tax status. That's a lot harder to get and we do see some affluent folks where one of the spouse makes a ton of money and then the other one gets the real estate professional tax status, where they work full-time in real estate and now they do all the cost eggs, create massive losses and then they offset their income. Now that's fantastic. But the reason why we're not going to talk about real estate professional tax status today, the reason why short-term rentals are so beneficial, is to have real estate professional tax status. You pretty much need at least one person to be full-time in real estate. So if you have two people with highly paid W-2 jobs, it's almost impossible to get that real estate professional tax status. And that's why the short-term rental is so powerful and popular among affluent individuals is you don't need real estate professional tax status, you don't need to work 750 hours, you don't need to say that you're full-time in real estate. You could just have a side hustle of managing your short-term rentals and now you can create those non-passive losses that are going to be so powerful and create such a massive refund on your tax return.

Speaker 1: 9:46

So now let's dive in here on what is real estate professional tax, sorry. What is material participation? Sorry, it's been a long day Material participation that has to be in place. Hey, sorry to interrupt, but real quick. If you or anyone you know is interested in using our services or joining our team, email info at markperlbergcpacom. That's info at markperlbergcpacom. All right, let's get back to the show.

Speaker 1: 10:22

The case here is we need to say a few things can be true. So it's a seven-pronged test. You only need one attribute to be true, to say that you materially participate in a business activity. Now let's backtrack here. Like I said earlier, you have all these restrictions when you have rental real estate activity because the IRS knows it's so easy to create a loss and those losses go into that passive rental real estate bucket. However, when the average legal estate is seven days or less, it's not rental activity. So now we're going to look at the treatment of this activity just like we would any other business. Now, with any business, whether it's real estate or a car wash or a restaurant, whether it's active or passive we now have to say we have to evaluate if the person materially participates. And again, we want to create non-passive losses. So we want to see material participation so we can use, we can move this income into that non-passive bucket to offset our job income and our business income. So to have material participation, we need to say that we performed.

Speaker 1: 11:49

There's a few things here and only one of them has to be true and I'm going to tell you. These are the ones here that we most often see and will try to accomplish. The most common one is if we can say that you put in a hundred hours and more than any other individual, now you are materially participating. Another way that we could say that you materially participated is if you put in 500 hours Now we don't have to worry about anyone else's activities 500 hours in that year, now we're materially participating. Ignore the 750 rule, that's rep status. We're ignoring this. All we care about now is material participation.

Speaker 1: 12:34

There's another one which is substantially all. If you do substantially all the work in that business and that's not a very clearly defined one and we rarely will try to accomplish this it's good for long-term rentals. But basically, if we do 80% or more of the activities, we can say we did substantially all and we materially participate. But that's really hard to do when you have cleaners and you don't want to be scrubbing toilets between all these guests. I mean, they're coming every seven days. You got to make a living here, so we need one of the two attributes. The most common is we need to say that we put in 100 hours and no one else put in any more time than us and that means you have no property manager and no cleaner putting in more time than you and that's going to allow you to say that you materially participated. So if we have the average length of stay is seven days or less and I've done this hundreds and hundreds of times and almost always it's incredibly rare that this would not be true almost always the average length of stay on these short-term rentals is going to be seven days or less. So if you self-manage and all the time that we're putting in into communicating with guests and vendors, marketing, setting up the place, we're mostly likely going to get to that 100 hours in the first year.

Speaker 1: 14:03

Now here's the tricky part, and I think most of the time we will and we've been audited and we've protected our clients. But there are other people on this short-term rental. So we want to really log all of our hours here and when we have a cleaner, usually there's a team of cleaners and we may find that there's a lot of cleaning to be done between all of these guests, but as long as we can say that there's not a single individual cleaner who put more time in us on this rental property, then we've materially participated. And usually when we get a property, there's a lot of work that gets done in the first year which is going to help us to materially participate. Right, you're going to inspect the whole place, you're going to drive to the place, you're going to be communicating with the cleaners, setting them up, buying equipment, fixing furniture, installing furniture, taking pictures, marketing, writing the material, creating the account. There's so much stuff that you have to do in that first year that's going to allow you to get that 100 hours.

Speaker 1: 15:14

Now the challenge here is what? If we keep on growing and adding new rentals, eventually it's going to be hard to put 100 hours into every other rental. Well, that is true, but we can still continue to have material participation and create these losses, and the way we can do it is well. First thing, remember, in our first year. We're putting a ton of time into setting up this property, so we likely will materially participate. Another thing to consider here is we only really need to materially participate, generally speaking, is in the first year, because that's when we do the cost seg. Generally speaking is in the first year because that's when we do the cost seg and that's where we really see the value of those non-passive losses because we're going to do a cost segregation study create massive losses and as long as and that's really the year that first year we really utilize these losses to offset our other sources of income. Now, in addition to that, we can do what is called a grouping election.

Speaker 1: 16:09

Keeping it simple here, and if we can look at our collection of properties let's say we now have so many rentals we don't have enough time to run around and put 100 hours into every new rental say that we put in at least 100 hours and more time than any single individual in our collection of short-term rentals. We can also say that we materially participated. And if that's also, let's say there's other people, we have full-time property managers on staff as long as we, we may want to say that we put in at least 500 hours in our collection of short-term rentals to achieve material participation. So I hope I didn't lose you so far diving into some of the jargon here and we're just let me just say this again to simplify this for some of you folks we need the average length of stay to be seven days or less, as established in IRS Code Section 469. And that when the average length of stay is seven days or less, the rules that determine whether it's active or passive are going to be applied. That also apply business activity. So it's no longer a rental activity and no longer has that really unique treatment where it's kind of stuck in that passive income bucket without rep status. We've moved it into now. When we evaluate whether it's active or passive, we need to look at whether or not the owner materially participated and to say that they materially participated. We don't need rep status. All we need to say is that one of these two features are true 500 hours or more, 100 hours and more than any other single individual, if you.

Speaker 1: 18:03

And what we found is almost all of our clients when they first purchased these rentals, these short-term rentals, almost all of them materially participated. And so when we started getting these folks and this was before it became really, really popular to take advantage of this stuff, we were surprised to find that these guys were putting in tons of time into this thing and I never really. When I took on my first short-term rental clients, I really didn't know there was a whole lot of meat on the bone here. But time and time again, through our evaluation of these clients, we have found that almost all the time you're going to have that material participation if you self-manage and you're going to have the average length of stay of seven days or less in almost all those Airbnbs, without even trying. Now you can do a pricing methodology and you can maybe set the settings to make sure the average length of stay is seven days or less if you want to ensure that you see the tax advantages. But we have found that these attributes were almost always true and they create massive opportunities for us.

Speaker 1: 19:18

When I first started doing this with short-term real investor clients on their 2019 returns and it was a little bit nerve-wracking because not a lot of people were doing it and it was a little bit nerve-wracking because not a lot of people were doing it and the tax code was I mean, really go online and look up IRS publication 925. They really break it down and it's just black and white night and day. It's so clear that these short-term rentals can be used to offset other sources of income. It's just. You can't argue against it when you read the publication there. So, yeah, the really cool thing here. Let's break this down on what it's worked out for for our clients. You want to learn more? You or anyone you know is interested in using our services or would like to join our team? Go to info at markperlbergcpacom. Again, email info at markperlbergcpacom. Go to I believe it was episode.

Speaker 1: 20:18

Let me pull this up episode 14, short-term Rental Success Stories with John Basilio, where we talk about in the beginning the tax treatment and then what he's done with his business portfolio. But what we've seen is you can get a rental property with only 10% down instead of 20% down when you have a second home mortgage. And so what a lot of folks were doing now and this has created tons of tax savings, millions of tax savings and wealth generation is they would find a place and get a second home mortgage, and it has to be. I believe it's either 50 or 60 miles away from your primary residence. But when you do this, you only have to put 10% down. So folks were finding these second home mortgages in areas in the mountains, in the beach or wherever and they were only putting 10% down and a lot of this property already came furnished, ready to go for short-term rentals.

Speaker 1: 21:13

And back in the day, as a result of having a former president who was a real estate investor, bonus depreciation was at 100%. And we often find we estimate that we'll do a cost segregation study and identify as five or 15-year life property About 30% of the purchase price is either five or 15-year life property. If this doesn't make sense, watch my episode on cost segregation. But anyways, what we would do is you would buy a place for, let's say, half a million dollars by the beach and 30% of that would be items identified in the cost segregation study, whether it be cabinetry, furniture, dishwashers, et cetera, items that would depreciate a lot faster as a result of this cost. We would create massive losses with this cost segregation study and in this example we would get about $150,000 write-off. But imagine you're only paying $50,000 to purchase this property, so you're getting a write-off that's three times the down payment into this property.

Speaker 1: 22:25

So a lot of clients they were finding that the refund from their W-2s from the losses created on their short-term rentals was able to give them enough tax savings to finance the down payment into another rental property. So now we have this snowballing effect by which we're driving down taxes, getting refunds and creating tax savings to reinvest into more real estate where you do more cost segregation studies and create more losses, and create more wealth and refunds to just reinvest and really compound and grow our wealth, not to mention the cash flow from these short-term rentals. So that was really I mean, it was just so awesome to see these opportunities for our clients. Right now, however, what we're seeing is bonus depreciation is phasing down. There's a lot of talk about it going back up to 100%, but we're expecting it. Right now at least, with the way the current code is, we're expecting to only get 60 instead of 100% bonus depreciation, and what basically that means is what I project is if you buy a short-term rental that's fully furnished, instead of writing off 30%, you would write off around maybe 18%. Still a really good opportunity to offset your W-2 income. But I'll tell you what it isn't like, what it was in the past, where it was so easy to make money and the tax savings were so great, what it was in the past where it was so easy to make money and the tax savings were so great. So we're going to talk in a later episode on some of the misperceptions out there and some of the dangers for some people getting a little bit too excited and seduced by the short-term rental loophole here. So let's get back on track, because I kind of go on tangents here to talk about the short-term rental loophole. So the average length of stay is seven days or less. You most likely will accomplish this if you self-manage your rental and if you group it with other rentals that are short-term rentals, it'll be even easier for that material participation test.

Speaker 1: 24:33

And now we can use our losses to offset our W-2 interest, dividend and capital gains in job income and we can also maximize our savings by doing some of those basic foundational tax strategies that any entrepreneur has. So a lot of these W-2 folks have never had a business before. So this is their first time getting access to tax write-offs and this is very exciting. So now we can think about how else, in addition to cost segregation, can we create massive write-offs that can be used to create tax savings Now, even though depreciation is the bread and butter, the magic word for tax savings with real estate. We can still access all these other business owner related foundational tax strategies that will create massive opportunities for you Identifying all of your available tax deductions, writing up travel opportunities and business mail, identifying certain purchases that are now related to your business. There are just so many ways, if we are resourceful and understand the tax code, where we can create additional write-offs on top of that depreciation to offset any taxation on the profit of your rental and potentially create refunds and reduce your taxes from you or your spouse's other sources of income.

Speaker 1: 26:04

And I'm going to backtrack a little bit here. Now for that material participation test. Let's say you're saying to yourself this all sounds wonderful, but I don't know if I could put in the time. I really want to do this, but I might need some help. Well, when we say that 100 hours or 500 hour test, we can include your spouse's time in this as well. So let's say you and your wife work full time and you know you're going to really go hard on these short-term rentals, but you're not going to be able to put in a whole rentals, but you're not going to be able to put a whole hundred hours and your wife's not going to be able to put a full hundred hours, well, what we would do is we would keep a time allowed and we would allow both of your hours. And so when you're working together let's say you each spent four hours on a Saturday assembling furniture and painting the new property Well, now you have eight hours towards that 100 hours, and this just makes it a lot easier for you guys to pass those thresholds, to say that you have the material participation.

Speaker 1: 27:11

Sometimes we've had it where one spouse is buying it, the other one's managing it and you're working together. It's just a great way to create tax saving opportunities the date that we worked on a project, what we did, what property we were working on, and describe and have a reasonable allocation to all the activities we're doing. And we've seen a lot of people in court cases where people were abusing the tax code and saying they're spending 15 hours trying to oversee their property manager install a toilet. There's going to be a lot of wacky stuff out there. So it has to be reasonable. And, trust me, our clients do occasionally get audited. They will look at this time log. You're going to have to produce it if you get audited and you need to show that the time allocated to different activities is reasonable. And while we're on the topic of auditing, let's just talk about what may trigger an audit. So we've done this hundreds of times. We've never had a cost segregation study or the short-term rental loophole strategy generate an audit. What often happens, though, though, is other things will trigger an audit, and now everything is being placed under scrutiny. So we'll talk about that more later, and how to protect yourself against the IRS, but at a high level here.

Speaker 1: 28:50

Short-term rentals, if you have these two features in place rentals, if you have these two features in place, average length of stay is seven days or less, or I mean, and we materially participate. Let me say this again so I don't confuse you guys we need two attributes to be in place for short-term rentals to show that those losses are non-passive and can offset all our other sources of income. One is the average length of stay is seven days or less, and two is material participation. Material participation means that either we spend 100 hours more time than any other single individual in that property and when we say we, that may include the hours of your spouse. The other one is the $500 test. That is a little bit trickier to accomplish. But one of those things is true, and now we can create losses that are going to offset our other sources of income. We maximize those losses with the cost-saving engagement study. Now we are creating hundreds of thousands and millions of dollars of tax losses over the life of our investing careers and it is giving us tax savings to reinvest into more real estate and investment vehicles.

Speaker 1: 30:10

So I hope this helps you understand what is a short-term rental and how it may apply to you. We're going to do another episode just talking about some of the misperceptions of the short-term rental. And while I do love short-term rentals for our clients and the tax savings, it's not going to be the answer for everyone. It's not going to be your magic bullet. It's not going to be the golden ticket. There are other things to consider before you get gung-ho on these short-term rentals.

Speaker 1: 30:41

So we're going to do another episode talking about dispelling the myths of short-term rentals. But if you find this interesting or you're already interested in short-term rentals and you're paying taxes out of your W-2 or you're paying a lot of taxes from your business, this certainly can be a wonderful vehicle to create tax savings as long as those two attributes are in place, and we can help you out with identifying that. And also, if you don't want to do short-term rentals, there's tons of other ways to reduce your taxes. So don't just invest in short-term rentals for the tax savings, because it is a lot of work and you don't want to lose money doing this thing. All right, I hope you guys enjoyed this episode of me explaining what the short-term rental loophole is and how our clients use this. If you want to learn more, just go on my website and listen to all those podcasts. If you're interested again in being a client, go to wwwmarkprobertscpacom. Have a wonderful day. We'll.