Even if you do not own a short-term rental, odds are that you have stayed at one before (or at least someone you know has). Although the whole concept of short-term rentals is still somewhat new, this segment in real estate investing has really taken off recently.
What a lot of people may not know is that in addition to getting higher cashflow, investing in short-term rentals (STRs) can also come with some really great tax benefits as well. In fact, some of those tax benefits may be even better than those from investments in regular long-term rental properties.
In this post, we will explain how to use short-term rentals to reduce your taxes as an investor. By the end of this post/guide, you will have learned:
- The tax benefits of short-term rental investing
- How to use short-term rentals to reduce taxes from your job
- What exactly is a short-term rental for tax purposes
- Ways to maximize your tax deductions
- The right (and wrong) legal entity structure
- How to track your expenses to optimize your tax savings
Real Estate Tax Savings Even If You Work Full-Time?
For those of you who are in the long-term rental space, you probably already know some of the restrictions with respect to the passive activity loss rules. In short, if your adjusted gross income is over $150,000, then the rental losses from the long-term rental properties can only offset taxes from other passive income. When there is an excess loss, those losses are not used to offset taxes from your W-2 income and are instead carried forward into future years to offset taxes from future passive income. In order to use the net losses from the long-term rentals to offset taxes from W-2 income, the investor must be able to claim real estate professional status.
Although there is a lot of planning that can be done to claim real estate professional status, it is nonetheless something difficult to achieve for an investor who may be working a full-time job. One of the main hurdles for this is that the investor must spend more time in real estate than their job. So for someone working 2,000 hours a year at a job, they would need to spend more than 2,000 hours that year in real estate. As a result, real estate professional status is often difficult for investors who are still working full time. This means that the excess rental losses are not as helpful to immediately offset taxes from W-2 or other non-passive income.
One of the perks of investing in STRs is the fact that the investor’s ability to use excess rental losses from the STRs to offset taxes from W-2 and other income is a little easier to achieve. This means that if you are operating in the STR space, you do not need to be a real estate professional to be able to potentially use rental losses from those STRs to offset taxes from W-2 and other income.
Material Participation Requirements
You do, however, still need to show that you are materially participating in your STRs. So what exactly does it mean to materially participate in your STRs? There are seven tests, and you only need to meet one of them. Out of the seven possible qualifications, here are the top three that are most commonly used:
- Investor participates for more than 500 hours during the year on the STRs.
- Investor participates for more than 100 hours in the STR and no one else incurred more time than the investor.
- Investor’s participation was substantially all of the activities in the STR where it exceeds the combined time of all other individuals.
Material participation time includes tasks such as staging the property, managing the property, dealing with guests, repairing, cleaning, restocking the property, and other similar things.
If you can pass one of the material participation tests for your STRs, then any net tax losses may be deductible in the current tax year and thus help offset taxes from W-2 income. Let’s go over a quick example to see how it works.
Jane works full time at a tech company. She decides to buy a property nearby and rent it out as a STR. Although she had to spend a little more on the purchase and start-up costs to get the property ready, it had phenomenal cash-flow in the first year. By working proactively with her tax advisor, she decided to be very involved in managing her STR. She documents her hours during the year to ensure she meets one of the material participation rules. Her tax advisors assisted her with maximizing her tax deductions by writing off the business use of her car, computer, and home office. In addition, she obtained a cost segregation study to accelerate the depreciation deduction for her STR. At the end of the day, not only did Jane not have to pay taxes on all of that cashflow she received from the STR, Jane also created a large net loss of $50,000 for tax purposes. Because she materially participated in her STR, Jane could use the $50,000 loss from the STR to offset taxes from her W-2 income. Based on her federal and state tax rates, Jane saved over $23k in taxes that year.
A side note: even if Jane did not meet the material participation standards for her STR, she would still be able to use all of her rental tax deductions to offset taxes from the rental income. The only difference is that any net losses would be carried forward as passive losses instead of being used to offset taxes from her W-2 income in the current year. So still not a bad deal.
What Exactly is a Short-Term Rental?
Next, let’s define what is a STR for tax purposes because this is an area that we have seen a little confusion. Some investors think that just because they list their properties on a platform like VRBO or Airbnb, then those properties are automatically considered STRs. For tax purposes, what matters is not where your properties are listed. Rather, it is defined by the number of days that a property is available for rent. For the most part, if the average number of rental days per guest is seven days or less, the property is considered a STR for tax purposes. On the other hand, if the average guest stay is longer than 7 days, that property will still likely be treated the same way as a long-term rental even though it might be advertised as a short-term property on one of those platforms.
Where to Report it on Your Tax Return?
There is also some confusion on where to report the STRs on your tax returns. Generally speaking, whether you have a STR or a long-term rental, both of those will be reported on your Schedule E. If you are operating your STR more like a hotel business or bed & breakfast where you offer additional services, then it may need to be reported on Schedule C. The downside to reporting it on Schedule C is that not only do you pay federal and state income taxes on the profit, you also may need to pay self-employment taxes. Common hotel type services include examples such as daily cleaning, turning down the beds for the guests, food & beverage services, or additional services like airport transportation, event bookings, etc. If you’re offering those types of services, your STRs may be paying higher taxes. Along those lines, a question we often get is “Does offering cleaning services after my guests leave constitute hotel type services?” The good news is that the answer is no.
Now here’s some more good news; the vast majority of investors we meet in the STR space are not typically offering hotel type services and thus can avoid the additional self-employment tax. Usually, you are going in to clean the property when one guest leaves and before the next guests check-in. That is completely fine to do. You may provide goodies for your guests like bottled water, salt, pepper, etc. Those things are also fine and generally do not rise to the level of food & beverage services. So, for the most part, STRs are going to be reported on schedule E and can escape self-employment taxes.
What Legal Entity is Best for Short-Term Rentals?
Another question that we get a lot is whether an LLC or Corporation is needed for STR investors. If you are like the majority of short-term operators where you’re not offering hotel type services, holding title to your property in your personal name or an LLC would both be fine from a tax perspective. The reason is because you would be able to utilize the same tax deductions and avoid self-employment taxes in either situation. On the other hand, if you’re one of the few people who are actually operating it like a hotel business, it could make sense to operate your STR through an entity like an S Corporation. The reason for that is that the S Corporation could potentially help you to reduce any self-employment taxes.
Now, one very important thing to keep in mind is that when we say using an S Corporation, we don’t mean holding the rental in an S Corporation. You would still want to hold title to the property individually or in an entity like an LLC. You then simply form a separate S Corporation to help you manage the STR. So you have two different buckets. The personal/LLC side that owns the STR. And the S Corporation side that manages the STR. The reason for this type of structure is that although we want to have the S Corporation help us minimize self-employment taxes, we don’t want the S Corporation to actually hold title to the property. There are lots of hidden pitfalls and traps when investors hold rentals inside of an S Corporation, so this is something you will want to make sure to avoid.
How to Maximize Your Tax Deductions
Oftentimes, investors will ask whether they can write off travel costs to their STRs. It is really important to keep in mind that if you travel to the STRs, make sure you have the right documentation for the business purposes for those trips. For example, are you going there to stage the property? Or dealing with repairs or guest turnovers, etc.? Travel to STRs are tax deductible against the rental income just like travel for any other type of real estate investing. The key is to make sure you have documentation to prove the reason for that trip.
With STRs, you may have larger start-up costs. Oftentimes, you may need to purchase furniture, fixtures, and appliances. Currently, most of these items are eligible for bonus depreciation. This means that instead of depreciating the cost of these items over multiple years, you may be able to take the full depreciation in the first year. In addition, even if you are purchasing used appliances or furniture, those may still be eligible for bonus depreciation currently. It is important to make sure you are keeping itemized listings of the items you spend money on. Of course, don’t forget the supplies. Towels, bedding, and toilet paper are all tax-deductible expenses, so make sure you are keeping track of all those items as well.
Here is why it is important: If you just told your tax advisor that you spent $30,000 to get your STR ready, it would be difficult for them to help you maximize your tax deductions. Alternatively, if you provide them with a detailed listing of what made up that $30,000, then they may be able to help you maximize your write-off by putting them in the most optimal category on the tax return.
Tracking expenses for STRs is just like any other rental property. You will want to make sure you’re tracking all of your expenses. We already touched on travel and furnishings. But don’t forget the other potential tax deductions such as the business use of your car, an eligible home office, or income shifting to kids or other family members who may be helping you out in your STRs. Since STRs can be very profitable, it is even more important than ever to make sure you capture all of your expenses to offset all of that income.
As you can see, a short-term rental can not only provide great cash flow but may also be a powerful tax saving tool, especially for those investors who might still have a full-time job and might not necessarily be able to meet real estate professional status just yet. Of course, you would never want to do anything just for tax purposes. However, if you love the concept of operating a short-term rental business and enjoy the property staging and guest interactions, it may be a great idea to consider this niche within real estate investing.
To learn more ways to save on taxes with maximizing your tax deductions, income shifting, retirement investing, and much more, we invite you to visit our website and download a complimentary copy of our eBook 5 Cashflow Strategies for Real Estate Investors.