Avery Carl, founder of The Short Term Shop and The Mortgage Shop, has helped over 5,000 clients become short term rental investors.
Many high-income earners and business owners share the same frustration. They consistently bring in a substantial amount of income, but they hand over a large chunk of that income to the IRS every year.
They often do what they believe is everything they can to reduce the amount they pay to the IRS: max out their 401(k)s, fund a backdoor Roth, maybe even invest in an opportunity zone. Beyond that, many CPAs shrug. High taxes are just a reality of being a high-income earner.
But there’s an income tax reduction strategy that has gained popularity over the last few years among high-income W-2 earners and business owners. It doesn’t involve opportunity zones, investing in oil and gas or even having to qualify for real estate professional status (REPS). It’s called the short-term rental tax strategy, and it involves buying a short-term or vacation rental property as an investment.
Disclaimer: Please consult a licensed CPA before attempting to execute this strategy.
How The Short-Term Rental Tax Strategy Works
The IRS separates passive versus non-passive income. The income earned on traditional long-term rentals or commercial real estate is typically designated as passive. This means that any losses from a long-term rental property can only offset other passive income, not a salary or business profits. This is why long-term rental investing is not an attractive option for high-income earners; it can’t reduce the income taxes on their W-2 earnings.
This is where short-term rental investing comes in. When an individual owns a vacation rental property with an average guest stay of seven days or fewer, and they materially participate in managing it, the IRS treats that activity as a non-passive business.
Since short-term rentals are classified as non-passive in the tax code, losses on them can be used to offset other non-passive income, like W-2 or other business income.
After the property is purchased and made available for rent, the next step is to leverage a cost segregation study. A cost segregation study is a process where an engineer breaks a property down into its individual components, things like appliances, flooring, fixtures, landscaping and cabinetry, and assigns each one a shorter depreciation timeline.
Instead of depreciating the entire property over 27.5 years, with 100% bonus depreciation, the investor can take 100% of the depreciation write-off in year one. Utilizing 100% bonus depreciation in the first year is what creates the significant paper loss on the non-passive short-term rental income. That paper loss can then be applied to offset other non-passive income, like W-2 or other business earnings.
What This Looks Like In Practice
Let’s look at an example:
A W-2 earner making $400,000 a year purchases a short-term rental investment for $500,000. After running a cost segregation study with a qualified firm, the investor determines they can generate $150,000 to $200,000 in first year deductions against their active W-2 income.
At a 20% down payment of $100,000, the investor has essentially reduced their taxable W-2 income by more than the amount they spent on the down payment. Paired with the annual cash flow generated by the short-term rental income, they have an effective wealth-building tool.
The Requirements For Investors
In my experience, the short-term rental tax strategy tends to be relevant for high-income earners who are looking for legitimate ways to reduce their tax liability, are willing to invest in an asset that also generates rental income and who can meet the IRS material participation requirements.
The investor must self manage the property, (not hand it over to a full-service property manager), and meet at least one of three material participation tests:
• Log more than 500 hours per year managing the rental
• Spend more than 100 hours on management, with no one else contributing more time than them
• Perform all of the day-to-day management and spend more time than any other party on the management of the property
Remote self-management sounds like a heavy lift, but it’s become easier for working professionals to manage a short-term rental remotely through the use of technology, property management software and dynamic pricing tools. AI tools have streamlined the process further, making it easy to respond to guests and vendors while working a busy schedule.
The Caveats
While the short-term rental tax strategy offers many benefits, investors need to ensure that they execute it correctly without cutting corners. They must meet one of the material participation tests stated above, and the average guest stay must be seven days or fewer.
This strategy is different from qualifying for real estate professional status (REPS), which carries its own requirements and is often confused with the short-term rental tax strategy. It’s an important distinction that should not be overlooked. I’ve found it is nearly impossible for a full-time W-2 earner to qualify for REPS, what makes the short-term rental tax loophole appealing to many W-2 earners, as investors do not have to qualify for REPS to utilize it.
The Bottom Line
High-income earners have more tax strategy options than many CPAs present to them. With 100% bonus depreciation now permanently restored, the short-term rental tax strategy is more accessible than it has been in years.
For investors willing to do the work, both in owning the property and structuring their taxes correctly, the tax savings and the rental income could help build long-term financial freedom.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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