Have a Short-Term Rental? Use this Tax Loophole

Feb 12, 2024Real Estate

Owning short-term rentals can be a lucrative stream of additional income. If you are earning well in your current profession and have the financial freedom to get into short-term rentals, it can be a worthwhile investment of your time and money. However, navigating the tax implications of these types of investments can be confusing. This article will discuss a short-term rental tax loophole you may not know or have even heard about. This loophole can help you maximize your earnings while complying with the law.

A short-term tax loophole, also known as the Airbnb tax loophole, refers to a provision in the law that allows real estate investors to deduct certain expenses associated with their short-term rental activities. It considers short-term rental as non-passive income and can help reduce rental income tax by offsetting income with losses.

If you’re unsure how it works, contact Emerald Expectations today to learn more about this loophole and if you can benefit from it.

What is the Short-Term Rental (STR) Tax Loophole?

First, let’s define short-term rental for this tax loophole. A short-term rental is considered a non-passive rental activity if the average stay of a guest is seven days or less and the owner materially participates in the activity.

The short-term rental tax loophole is often used by people who hold full-time positions or work in other industries (not real estate), such as law or medicine, that prevents them from meeting the 750-hour requirement working in real property trades or in a real estate business to achieve a Real-Estate Professional Status (REPS). For example, a surgeon who spends all their time in the operating room cannot spend an additional 750 hours reaching REPS.

People with REPS can use losses from rental properties and are classified as non-passive income. The good thing about the STR tax loophole is that it doesn’t require a person to be a real estate professional to have non-passive income. It can be found here in our tax code and provides exceptions to the meaning of “rental activity.”

How the IRS defines a short-term property

For a short-term property to fall under this loophole, it is not considered a rental activity for a taxable year if the following is met:

  1. The average stay of a customer is seven days or less
  2. The average stay of a customer is no more than 30 days, and the owner provides substantial personal services to make the property available for use by customers
  3. Significant personal services are provided by the property’s owner, or someone on behalf of the owner, to make the property available for use by customers
  4. The rental of the property is treated as incidental to the non-rental activity of the taxpayer
  5. The taxpayer makes the property available during business hours for nonexclusive use by various customers
  6. The provision of the property for use in activity conducted by a S corporation, partnership, or joint venture in which the taxpayer is an owner is not a rental activity

For example, full-time doctor Dan owns a beach property he rents out through Airbnb. His customers stay for an average of seven days or less. He manages the property himself and is the person who works on it the most. This would meet the criteria above.

On the other hand, Lisa owns a rental property that she rents out monthly and uses a property management company to help her manage it. Her customer stays on average 35 days per stay, and she hardly knows what’s going on with the property. This type of situation would not fall under the criteria.

There’s another rule that some owners use to lessen tax payments – the Augusta Rule. Some businesses use this tax strategy to save money and get a significant tax deduction. The Augusta rule allows someone to rent their home tax-free for 14 days or less a year. There are specific requirements you must meet, and you should also keep meticulous records of all your transactions.

There are three basic requirements to meet the Augusta rule:

  1. The rent must be at par with other similar rentals in the market.
  2. The property must be in the US, not a vacation home in another country.
  3. The total days rented for the year must be 14 days or less.

In case you’re wondering, the Augusta rule’s name came from Augusta, Georgia where residents rented out their homes during the famous annual golf Masters Tournament.

Material participation test

Going back to the short-term tax loophole, below is the material participation criteria to consider if you want to avail of the short-term rental tax loophole. These criteria assess the level of involvement in your short-term rental property. You must meet at least one of the criteria below to be eligible for the short-term rental tax loophole:

1. You spend more than 500 hours participating in the short-term rental business.

You, your spouse, or both of you must participate more than 500 hours during the year on the business. This makes the income or loss from the rental non-passive. Participation in the operations must be continuous, regular, and substantial.

2. You or your spouse do most of the work for the short-term rental business.

If you or your spouse, as the taxpayers, do most of the work for the business, the income or loss from the business is considered non-passive. If most of the work is done by an employee or an external company or supplier, you may be ineligible for the loophole. No set hours are specified, but it’s best to have detailed records that track how much time you or your spouse spend on the business.

3. You participated more than 100 hours on the activity during the tax year, with no other individual spending more time than you on the activity for the year.

A taxpayer must participate in the activity for more than 100 hours, and no other person (including any employee or non-owner) should have participated more than the taxpayer. For example, you have records of spending 110 hours on the property, and the cleaning crew spent 60 hours. This situation will make the income or losses from the activity non-passive.

4. You engaged in a significant participation activity (SPA) for more than 100 hours, with all combined activity in all significant participation activities exceeding 500 hours.

This is related to the previous point and means that when the sum of the taxpayer’s time in the SPA is more than 500 hours in a year, the income or losses from the business are considered non-passive.

5. You participated in the business for five of the previous ten taxable years.

You, as the taxpayer, materially participated in any five (they don’t have to be consecutive) of the previous ten taxable years.

6. You demonstrated regular, continuous, substantial, and provable participation in the business during the year.

In other words, you must show that you were the taxpayer who spent the most time managing and working on the business for the past year. When you meet one of these, your short-term rental property does not fall under the definition of a rental activity and is considered non-passive. The goal is to use the STR loophole for non-passive losses which can be used to offset non-passive income.

Tax Benefits and Advantages

After your short-term rental has met one of the requirements above, the IRS will allow you to front load the depreciation through a cost segregation study. And this is where you can save on taxes. A cost segregation study is conducted by a CPA and/or a qualified engineer. This study aims to identify various costs that can be depreciated over a shorter amount of time compared to the property. This reduces income tax obligations.

Here’s a simplified example of using the STR loophole for your property.

Lawyer Mr. Smith purchases a $1 million vacation rental in Hawaii. He can use depreciation to save around $250,000 to $300,000 of his income from being a lawyer. Mr. Smith makes approximately $300,000 of W2 income, he can save thousands on taxes because of his rental. For example, if he had a cost segregation study done on his $1 million vacation rental, 20 to 30% could be fully depreciated, giving him a $250,000 reduction in tax obligations.

Remember, he must meet one of the requirements discussed above to be able to do this. For example, he should coordinate with Airbnb clients, decorate the property, and purchase all the supplies. He spends the most time on the property.

Again, the example above is an overly simplified version of how a high-income rental property owner can use the STR loophole and there are many other requirements to consider. There are also other details you should know and do to ensure you qualify for the loophole and we recommend you consult a professional.

It can be complicated to figure out how to go about making the most out of this loophole. For the best advice on how to understand it better, contact us today.

Use the STR Loophole

In summary, if your rental property has an average guest stay of seven days or less, the IRS will consider it short-term. Short-term rental properties can consider losses as non-passive and are deductible from your income tax. Using the STR loophole can reduce high-income owners’ overall tax obligations.

Being the owner of a short-term rental property can be a rewarding investment, and if you are looking for a way to reduce your taxes, a short-term rental property is also an effective way to do it. Before you jump in and buy a vacation house in Vermont or start renting out your home to save on taxes, ensure you talk to a tax professional first. You need to understand the “short-term rental tax loophole” and “Airbnb tax loophole” first to minimize your tax liabilities and maximize your earnings as a rental property owner. Remember to keep accurate records and follow all the requirements mentioned above.

Consult with Emerald Expectations today to optimize your tax strategy when it comes to the STR loophole. This is right up our alley. With careful planning and attention to detail, you can enjoy your short-term rental property and minimize the impact on your bottom line. We can help guide you and give you all the information you need to make a wise decision. Contact us today to learn more about your options for reducing your taxes while staying fully compliant with the law.

Hi, I’m Kimberly.

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