The Mark Perlberg CPA Podcast
The Mark Perlberg CPA Podcast
EP 57 - Dangers of the Short-term rental Loophole
Navigating the Short-Term Rental Loophole: Smart Strategies from Your Friendly CPA
Welcome to our deep dive into the world of short-term rental investing! As enticing as the tax benefits and wealth creation opportunities may seem, it's crucial to approach the short-term rental loophole with caution and a well-thought-out strategy.
Understanding the Nuances
Before diving in, it's essential to understand the intricacies involved:
- Average Stays: The duration of guest stays can significantly impact your tax classification and the associated benefits.
- Material Participation: Active involvement in the management and operations of your rental can determine whether your rental activity is considered passive or non-passive, affecting how losses are treated.
- Non-Passive Losses: These can offset other types of income, but qualifying for non-passive status requires meeting strict criteria.
Market Complexities
The short-term rental market is not without its challenges:
- Market Saturation: Increased competition can affect occupancy rates and profitability.
- Limits on Excess Business Losses: Recent tax laws cap the amount of business losses you can use to offset other income.
- Phasing Out of Bonus Depreciation: The gradual reduction of bonus depreciation can impact your tax deductions over time.
Strategic Investment
Success in short-term rentals demands more than just a cursory glance at potential profits. A comprehensive understanding of the financial landscape is key.
Savvy Tax Strategies
To help you navigate these waters, we offer smart strategies that can enhance your tax efficiency without falling into common traps:
- Cash-Out Refinancing: Leveraging your property’s equity to reinvest in your portfolio.
- 1031 Exchanges: Deferring capital gains taxes by reinvesting in like-kind properties.
- Roth IRA Conversions: Taking advantage of potential tax-free growth by converting traditional retirement accounts.
Achieving Real Estate Professional Status
For those aiming to qualify as a real estate professional, we discuss the significant tax advantages this status can confer, such as the ability to offset a larger portion of your income with real estate losses.
Join us as we guide you through these alternative pathways to financial efficiency, helping you deploy your time and resources strategically for maximum gain. With the right approach, you can turn the competitive world of real estate investment into a profitable venture while staying on the right side of tax regulations.
So you're scrolling through social media and you see a hip influencer telling you that if you make lots of money from your W-2, you need to invest in short-term rentals because it's going to save you hundreds of thousands of dollars in taxes and it's going to make you super wealthy, right? Well, hold on just a second. Before you make this decision, you really want to make sure you understand what this short-term rental loophole is and what short-term rental investing is. Remember, we're not just investing to reduce our taxes. You really need to do a little bit more investigation and research and talk to a tax professional in order to understand how this is going to impact you and make the best decisions, not only for reducing your taxes, but to invest and build wealth. So this episode, we are going to talk about some of the dangers, limitations and misperceptions of short-term rental investing.
Speaker 1:This is the Mark Probert CPA Podcast. Welcome aboard. If you haven't seen us like, subscribe, share all that stuff. Go to markprobertscpacom if you want to be a client and talk to an elite group of tax strategy specialists working with affluent real estate investors and entrepreneurs. Also, send us some hires. Anyways, let's talk about this short-term rental loophole a little more and what you need to note and what kind of dangers do we have to watch out for if we're going to pursue this?
Speaker 1:Now to backtrack in our most recent episode we did a breakdown of what is the short-term rental loophole. How can we create non-passive losses with short-term rentals to offset our other sources of income? Remember we needed seven days or less and we needed material participation, which most often is substantiated by putting in 100 hours more time than any other individual in that activity. So let's talk first about limitations, and I'm not too concerned about how much we can deduct to offset our other sources of income. It's usually pretty good for most of our clients, but the losses we can create from our short-term rental losses are capped at what we call the excess business loss limitations. So let's say you make a million dollars a year. If you're single, you could only use $305,000 of those losses to offset your income. If you're married, that is $610,000. And that is based on the current amounts for 2024. And that amount is going to likely increase gradually.
Speaker 1:Some other potential misperceptions here on limitations A lot of these videos where they're talking about all these case studies where they buy a rental and it wipes out all their income. Well, that was probably a prior year. Right now bonus depreciation is at 60%. Last year was at 80%. The prior year it was at 100%. Each year we're getting less and less bonus depreciation, which means if we're going to do a cost segregation study to create lots of depreciation, the impact of that cost segregation study is going to be less and less and less impactful unless they change the tax code. So back in maybe 2019, where you would write off maybe 30% of that price, now we're down to 18%. So we might be a little disappointed that the numbers of how much we actually create in the tax loss from those cost segs aren't quite what we were seeing in the influencer videos.
Speaker 1:Another thing we want to think about here is if we are investing in short-term rentals, it is not guaranteed that those two attributes are going to be in place. We have the seven days or less and material participation. Let me explain to you some instances where this may not be true. If you get a rental property and it's not in a vacation destination, or even if it is, if you get a rental property, someone can still book it for more than seven days. So there is a possibility if someone wants to stay longer, maybe for a few months as they're waiting for a new home. They may stay long enough so that the average length of stay is now over seven days. And then we move this rental property from being treated as a business activity into the category that we see with long-term rentals, where we have far more restrictions on how we can use these losses.
Speaker 1:Another thing here material participation. A lot of people assume that material participation is in place as long as we self-manage our rental, which is great, so now we can use these losses, really want to create massive losses and we get a huge rental property. Let's say we get one of those six bedroom mansion cabin rentals. Think about the man hours to clean this place. If you were scrutinized under an IRS audit, they may find that with however many cleaners were serving your property because it was so massive the time taken to clean this may be in excess of the time it takes for you to oversee the guests and it might be very hard for you to disprove that assumption by the IRS Because even though you're keeping your time log, we can't log every single cleaner, so we're going to have to defend this. So here's another example of why material participation is not guaranteed. Additionally, sometimes we buy these short term rentals and they are already under contract to be managed by another property manager and that makes it harder to materially participate. Or we buy the rental towards the end of the year and we may not have enough time to get those 100 hours, so it's not guaranteed that we're going to have the 700 hours or the material participation, so you may not actually be able to use the losses in the first year you buy it.
Speaker 1:Now I used to say and I think I mentioned this in the prior year, but I used to say that short-term rentals were the easiest way to get rich and make money. I saw so many people just pulling in tons and tons of cash just by buying a short-term rental. And it used to be. You just had a house, you could just move out of your house and leave the furniture and it would be guaranteed cash flow. It was so easy. But because it was so easy for so many people for so long, people started catching on.
Speaker 1:Now the doctors and the dentists in California getting hit in the head with the taxes are catching on and now they're buying their short-term rentals as well and they're investing in the Smoky Mountains of Tennessee and driving up price. So what does this mean? Well, this means that as prices go up and the demand goes up for buying these houses because of the tax benefits, because now the word is out and everybody is getting super excited because they're learning about this short-term rental loophole, is getting super excited because they're learning about this short-term rental loophole and their CPAs are talking about it and the bigger pot lives are talking about it that tax savings is starting to be factored into the price and it's a lot harder to find a property that cash flows. So now you've got to be in it for the long run and you're looking to and we've seen this where our clients invest in short-term rentals. They're super excited for the savings.
Speaker 1:You do the cost segregation study, but then when they actually go into managing these properties, they're pretty disappointed to find how much work it is and how much little money they make. A lot of them are going to tell you hey, you know, we've had our clients say you know, I really thought this was going to be an awesome idea. I was ready to quit my job and be a full-time entrepreneur, but the money I make per hour working on this rental is so much less than what I would have made at my job, and I don't even like it. I don't like being called in the middle of the night because the air conditioners aren't working. They're having to replace toasters. So if you're relying on cash flow, it's a little trickier these days to guarantee your cash flow and it's a lot of work. So even if you do have the tax savings remember we're not just in this to create tax savings.
Speaker 1:Let's say, when we buy these short-term rentals in year one, we do the cost size, we create the tax savings, we get the refund. Well, that's all fantastic, we're doing good on our money, right. But what happens if we're cash flow negative, year after year after year, month after month after month, and we have to invest into renovations and we have costs and repairs and we're working a lot and we may not enjoy self-managing these rentals. Pretty soon, some of these folks who were getting seduced by the influencers to buy these short-term rentals because they were paying a ton in taxes, they're starting to realize this may not be the best deal out there. Yeah, I got a refund in year one, but now it's year two. I was spending money hand over fist. 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. That's info at markperlbergcpacom.
Speaker 1:All right, let's get back to the show. Putting time into something that's not worth my time. I make so much more of my job and I'm only making the equivalent of like negative $10 an hour in my rental, and a lot of these folks are going to realize maybe I should have thought a little more deeply about what short-term rental investing is and what this STR loophole means. So we have saturation making it harder to find profitable cash flow and properties. A lot of people have had unprofitable short-term rentals. So it's not a walk in the park, it's not guaranteed money.
Speaker 1:Now let's talk about the exits here, and we see this all the time. Clients will invest in short term rentals. They realize they didn't want to do it, they're not making enough money, it's not worth the energy, and then they say you know what? I'm just going to sell this property, get rid of it, get it off my plate. It was nice to try it out, but I'm kind of done with it. So what happens?
Speaker 1:Well, what a lot of people don't realize is there's something called recapture, tax depreciation recapture and let me just illustrate this. And we see this with clients. We had a client who bought a property for maybe a million dollars, did a cost seg and let's say we got a tax deduction for a million as a result of cost seg. What a lot of people don't realize is that this depreciation recapture is going to kick in when you sell the property and any tax advantages and savings created from the cost segregation in the prior year is likely to be completely reversed in the form of recapture. So in year one, let's say we were super pumped to buy this short-term rental and create a quarter million dollar tax deduction.
Speaker 1:Year two, we realize we're losing tons of money we don't like being landlords or we're going to sell this and we find someone willing to buy for maybe $50,000 more than we sold, purchased it for Great. Let's get it off our hands and make a little bit of money. Well, what they don't realize is, even though they were creating a $250,000 loss in year one, in year two we have a cost basis. Instead of selling a property at a million dollars for $1,050,000 fifty at a profit, we're actually going to find that the cost basis is 750 because we wrote off a quarter million. That depreciation is accounting for the wear and tear of that real estate and it assumes that a core that quarter million dollars identified from the cost seg is part of the property that has been deteriorated over time and it's only worth that $1 million minus the cost sake.
Speaker 1:So what would happen in this example is, first off, the investor is going to be paying closing costs and now that's probably going to chip away at the majority, if not all, of their profits on the closing costs. And now that's probably going to chip away at the majority, if not all, their profits on the closing costs. And then what they don't realize is all those tax deductions, all those exciting fancy cost segregation tax deductions. Hundreds of thousands of dollars are now going to be taxable. And it's not going to be taxable at your long-term capital gains rate. It is going to be taxed at your federal marginal bracket and for most of our clients that means that any tax savings created in the prior year is almost like a loan and you're going to pay it all back to the IRS. So what I hope you did was you took some of that tax savings and set it aside for a rainy day. But if you had a cash flow negative property, you may have had to reinvest that tax savings back into that rental property and you may not have the cash to pay the tax due in worst case scenario.
Speaker 1:So the point I'm trying to get here is that nothing's really guaranteed. I think that we're seeing a lot of people presenting oversimplified solutions, and I understand why, and maybe when some of my stuff gets chopped up by my designer, some of the things I say may be oversimplified as well. Some of the things I say may be oversimplified as well. I'll say this If you are a high-paid W-2 earner or business owner, consider short-term rentals. It is not the only solution. There are many opportunities to minimize your taxes that do not involve short-term rentals. You also want to consider that we consider with our clients. Off the top of my head, I can come up with about six strategies that will offset and reduce your taxes if you are a highly paid W-2, and none of them involve investing and overseeing rental real estate and overseeing rental real estate.
Speaker 1:If you are going to consider pursuing short-term rentals, treat it like any other craft. It is not easy money. If you're going to use short-term rentals to reduce your taxes and to help build wealth and create financial freedom. It is a very powerful vehicle, but do not treat this as an easy. Don't think that this is an easy way to build wealth. It's going to be a challenge, just like any other entrepreneurial endeavor. Really look to master your craft. Join a mastermind, take a course, study your craft. You've got to be good at what you do to thrive at what you do. It is not easy money, but it certainly can be a powerful vehicle for building wealth.
Speaker 1:Now, what we also have found here is there are so many other ways to invest in real estate and build wealth, and obviously creating a refund against your W-2 from your short-term rentals is a really sexy and exciting idea, and I know why and I'll tell you. It is super fun to show the refund checks to our clients from their short-term rental. But there are other things that we can do. Sometimes our tax strategy is to create tax savings so those tax savings can be used to buy the real estate. So, while a lot of people are talking about using real estate to create tax deductions and tax savings, we can also look at strategies related to our W-2 income and our business income that create tax savings which can be used to buy the real estate and invest to grow your wealth. So I still think that if you are it's not an isolated thing I know that if you're going to try to get into this game and really win the tax game and also be successful and build wealth, you don't need to have a rep status or short-term rentals to win the game. Yes, obviously you can get some great wins there, but there's other ways we can do it.
Speaker 1:So let's talk about this for a sec. How can we still win the tax game even if we're not doing short-term rentals, even if we don't have real estate professional tax status, to create non-passive losses? Where are some wins being yet? Well, first off, if you're good at what you do, you're going to make a lot of money. So, if you are good at building large portfolios of single-family rentals or self-storage, you're going to make a lot of money and that's pretty good, right? Remember, tax savings is great, but you know, what else is good is having a profitable enterprise, and that's another way to put money in your pocket. How about that Simple solution here? Right, you don't need a CPA to tell you that. But also, let's talk about what else could we do here that is advantageous in a tax perspective.
Speaker 1:So let's say we're building a large multifamily portfolio. Well, you still get to see the advantage of depreciation offsetting the cash flow. So as rent comes in, you still have your depreciation to offset that cash flow. You can do cost segs if it's more profitable to ensure that you have positive cash flow and rental coming in and you're not paying taxes. That's not a bad opportunity at all. Right, that's not a bad scenario where you have a profitable enterprise, an entity, and cash flow source. You're paying zero taxes. That's pretty good, even if you're not creating refunds from your W-2.
Speaker 1:Here's some other ways we can get money out tax-free Cash-out refis. We have a successful multifamily or maybe a self-storage and rental property, or maybe we have a mobile home park and we're increasing the value and now we can get a loan based on the increased value because we stepped up the profitability of this property and now we can get a good chunk of our down payment back in the form of a cash out refi, which is a completely untaxable event. It may not be the same thing as a tax refund, but again we're bringing cash into our pocket and not paying taxes. And let's say, after a few years we find some more lucrative opportunities and we sell the property. Well, now we can do a 1031 exchange and again we're not paying any taxes on this transaction and it's a profitable event and now we can roll it into even more lucrative opportunities. Also, consider the fact that as we build our portfolios, we may eventually get to the point where either you or your spouse can get that real estate professional tax status. So maybe we just start by thinking about okay, maybe we're not going to 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.
Speaker 1:Let's take this approach that we have to invest just to reduce our tax. Maybe we're going to think let's invest to build wealth and make money and be good at what we do and let's say you're really interested in a different form of investing. It doesn't just have to be short-term rentals. Give it some time. When you get really good at what you do, maybe after a few deals you realize either you or your spouse can now quit their job with all the cash flow and now you can get real estate professional tax status. And maybe now is the time that you run these cost segregation studies for the properties purchased in the prior years. Now maybe you can put the vehicle in the business and get some bonus depreciation and win the tax game. Or maybe you decide to retire because now you have a cash flow positive rental portfolio. Well, we don't have any ordinary income to offset. We've retired right. So where's the value in these losses, with all the cost side? Well, I'll tell you how about this.
Speaker 1:Let's say we have a 401k or an IRA from our job. We can now convert it into a Roth and do cost segregation studies from our rental properties to offset, moving that from that tax-deferred bucket into the tax-free bucket in the Roth. Think about this your 401k is going to grow and compound year after year after year. You think you're winning the tax game because that's what your employer told you to do, but eventually you're going to have to take the money out and that money is going to be taxed at your marginal rate, even though it's investment income and it's dividends and capital gain. No, it's going to be taxed at your marginal rate and if you don't plan for it, you can get hit pretty hard with taxes. So why don't we move this into the Roth and have it compound and grow and accumulate all this wealth tax-free, so you never have to worry about it. Properly tied, roth conversion can save you hundreds of thousands and millions of dollars in taxes and really amplify your wealth thousands and millions of dollars in taxes and really amplify your wealth. So that's just one of many scenarios we've seen play out with our clients and when you think about how are you going to win the tax game and build wealth, obviously we're all looking to get rich here.
Speaker 1:If you're listening to this podcast, you either are or are looking to get rich, and part of that is reducing your taxes, and what we want to think about is the short-term rentals can potentially do this, but there's also so many other ways we can do this. Another thing I want you to think about is the value of your time. Before you start going crazy about this short-term rental loophole that you see everybody promoting, think about the value of your time. Is it so? Are you at the point where, let's say, we do this and we create some tax savings, but how valuable is 100 hours a year to you? How much time is this going to take and what else are you doing with your time, because some of you listening you may find that you're making a million dollars a year $1.5 million a year and you may find that your time is better spent investing into building your empire. Sure, if you put that time into the short-term rental, you can create a nice tax refund.
Speaker 1:But you may find that there are other tax strategies that are just as impactful for you, based on your situation. If you work with someone who understands advanced tax production strategies for affluent entrepreneurs and real estate investors, you may find also that the opportunity cost of managing these rentals and it is a lot of work the opportunity cost is greater than the potential tax savings. So maybe we also need to evaluate this as from the perspective of what's the best thing to do with our time. That's not only going to create tax savings, but it's going to make us more capable of having an impact on our organizations and on our objectives and our goals to build our, to take us towards what we're looking to achieve here. So we see a lot of times people get a little bit overboard on trying to make these tax savings and what they don't realize is if they were to just apply themselves into their businesses. They could potentially take that time that would go into the short-term rental and maybe, if that time was put into acquiring new skill sets or new technology or new businesses, the opportunities on that end would have been far more lucrative in the long run as it would have been to learn to be a property manager and organize and oversee all your guests.
Speaker 1:So before you jump into this, you really want to consider quite a few things here. First, make sure that you know you're actually interested in managing your short-term rental. Second, you want to think about if you go through with this, having proper documentation to protect yourself, making sure that you actually materially participate and actually the average length of stay is seven days or less. You also want to make sure that this property is going to be cash flow positive and that it is going to be profitable for you and it's not going to just be a money pit that you were unprepared for. You don't want to be like many that we've seen, where they get so excited but they find that they've invested into a money pit and it's just unaffordable to pursue the portfolio.
Speaker 1:And finally, you want to look at all things involved in real estate and don't just make your decision on the tax savings from that real estate. What are you interested in? What do you think you're going to be good at? Where's the most opportunity? What's the best opportunity for you? Taxes and tax implications are a part of that factor, but not everything. And also, let's face it, short-term rentals have been booming and they're really exploding, but also because of that, we're also very volatile and there's regulations and all sorts of things. But also because of that, we're also very volatile and there's regulations and all sorts of things you can't plan for that may impact your profitability and ability to do these short-term rentals. And finally, we want to think about what's the value of our time here. Yes, you can save a ton of money on your short-term rentals. You can self-manage and material participate, but are you the type of person that is going to be able to do this, or maybe you and your wife? If the answer is yes, fantastic, but you may find time is better spent doing other things and therefore we can help you out with finding additional strategies, whether it be related to tax advantage investments, entity structuring or charitable deduction of vehicles that can also create millions of dollars to be reinvested in other tax advantage ways.
Speaker 1:Hope you found this episode valuable and learned a little bit, and it's going to help you out with making some of your decisions. If you want to learn more and connect with us again, go to markprobergcpacom. We'll talk about connecting you with one of our elite tax advisors and we hope you enjoyed this. Stay tuned. We got more content. I'm sorry I've been a little inactive lately. We got lots of stuff coming your way that you'll enjoy and we will keep in touch. Talk soon, oh, one more thing. One more thing Make sure you join the mailing list. Just go to markperolverscpacom. Join our mailing list. We do lots of free live events. Be in the know. You'll be updated with our podcast. We'll send recaps and news articles. Lots of wonderful, free information. You want to say more? Give us feedback, ask us questions. We love to hear from you.