The Short-Term Rental Tax Loophole: What Investors Need To Know

The short-term rental tax loophole, also sometimes known as the Airbnb tax loophole, is a strategy real estate investors can use to help mitigate their rental income tax by offsetting earned income with real estate losses.

You’ve probably learned about Real Estate Professional Status as a way to reduce your tax burden. But for many investors, meeting the requirements is simply not an option. However, short-term rentals provide another option.

This article breaks down the basics of how to take advantage of the short-term rental loophole, and what a strategic approach to short-term rental taxes looks like.

What is the short-term rental tax loophole?

A short-term rental is deemed a rental activity if the average stay period is seven days or less. According to Section 469, however, it is not classified as a rental activity but rather as a business, treating all income and expenses from the property as active income.

Originally designed for hotels and hospitality, Treasury Regulation Sec. 1.469–1T(e)(3)(ii)(A) outlines six exceptions to the rules defining rental activities, one of which states, "The average period of customer use for such property is seven days or less."

The significant rise of vacation rental platforms like Airbnb and VRBO falls under the same criteria as other short-term living arrangements.

Investors in short-term rentals do not necessarily need to meet the qualifications of a real estate professional to reclassify their passive real estate losses—they only need to materially participate.

This classification also extends to properties with average stays of 30 days or less, provided substantial services are offered to guests during their stay, such as linen changes, cleaning, vehicles, or vouchers for local attractions.

Material Participation Tests for the Short-Term Rental Tax Loophole

As previously discussed, obtaining real estate professional status is a route to offset losses on rental properties. However, this avenue is often unavailable to high-earning professionals like doctors or lawyers, who may not have the requisite time to dedicate half of their working hours to a real estate business. Fortunately, the short-term rental tax loophole provides an alternative solution.

The exceptions to the rental activities definition in the tax code, as mentioned earlier, can render losses non-passive for short-term real estate investors who meet one of the seven material participation criteria. These tests assess your level of engagement and involvement in your short-term rental property, determining your eligibility for this tax advantage.

Here are the material participation criteria:

• Spend more than 500 hours on the short-term rental business.
• Do substantially everything for the short-term rental business.
• Spend more than 100 hours on the activity, with no other individual surpassing your time commitment.
• Engage in a significant participation activity for more than 100 hours, with your combined activity in all significant participation activities exceeding 500 hours.
• Participate in the business for five of the previous 10 taxable years.
• Engage in a personal service activity (non income-producing) for three of the previous taxable years.
• Demonstrate regular, continuous, and provable participation in the business for more than 100 hours.

The first three criteria are the most commonly met by the majority of short-term real estate investors. Once you satisfy one of these tests and your short-term rental is no longer categorized as a rental activity, it is considered non-passive for tax purposes.

Depreciation for Your Short-Term Rental Tax Strategy

Engaging a knowledgeable real estate CPA will involve a strategic approach to leverage depreciation for your short-term rental. 

They will guide you through the following steps:

• Cost Segregation Study: Your CPA will recommend conducting a cost segregation study on your property.
• Reclassification of Property Components: The cost segregation study aims to reclassify specific components of your property, transitioning them from a 39-year life (the standard depreciation life for a short-term rental property) to 5 and 15 years. This applies to tangible personal property, land improvement property, and qualified improvement property.

Here’s why this matters

The power of this strategy lies in the fact that 5 and 15-year property components typically make up 20-30% of a property's purchase price.

Financial Impact Example: For instance, if you own a $1 million property and undergo a cost segregation study, approximately 20-30% of the property's value could be re-segregated and fully depreciated. This translates to a substantial deduction, such as $250,000.

This is powerful because your losses are non-passive, and that tax loss can be used to offset taxes on your W-2 income.

What’s Changing About Depreciation for Short-Term Rentals?

Since 2018, the bonus depreciation rate for short-term rentals and other business activities has stood at 100%. However, 2022 marks the final year of this 100% bonus depreciation, as a planned phased approach is set to gradually reduce the percentage over the next five years. Here's what to anticipate:

• In 2023, the bonus depreciation will decrease to 80%. As an example, a $250,000 deduction in 2023 would now be $200,000.
• In 2024, the rate further reduces to 60%, resulting in a $250,000 deduction becoming $150,000.
• By 2025, the bonus depreciation drops to 40%, making the $250,000 deduction now $100,000.
• In 2026, the rate diminishes to 20%, reducing the $250,000 deduction to $50,000.
• In 2027, the bonus depreciation is slated to disappear entirely, adhering to the current plan.

While changes and extensions are possible, this is the current trajectory. It's important to clarify that the short-term rental depreciation loophole itself is not under threat and may remain intact. However, the 100% bonus depreciation is naturally phasing out according to existing laws, diminishing the impact of the strategy.

Even as bonus depreciation diminishes, there remains an opportunity to depreciate portions of your property at 5 or 15 years instead of the standard 39 years, presenting a continued avenue for savings. Embracing a comprehensive short-term rental tax strategy remains the most effective approach for maximizing benefits from short-term rental investments.

Tips for Reducing Taxes on Short-Term Rental Properties

Whether you currently own a short-term rental or are contemplating a purchase, understanding how to reduce your tax liability is crucial. Here are additional recommendations to effectively lower taxes on rental properties.

• Maximize Deductions: Take advantage of every possible deduction to reduce your tax bill. Keep meticulous records of all expenses associated with your rental property, as even seemingly small costs can contribute to significant deductions. Thorough documentation ensures that you can claim all eligible deductions when filing your tax return.
• Utilize Depreciation: Leverage depreciation to achieve tax savings by accounting for the decreasing value of assets. For instance, if you're entering the short-term rental market, consider depreciating newly acquired appliances, fixtures, or furniture used to prepare the property for renting. This can be a valuable strategy for optimizing tax benefits.
• Track All Expenses: Beyond direct property-related costs, be sure to record other expenses associated with owning a rental property. If you maintain a dedicated home office for your short-term rental business, you may qualify for additional deductions. This can be done easily and efficiently with software like Landlord Studio.

If you're new to rental investments, building a support team can be beneficial. Collaborate with a certified public accountant to ensure you're capitalizing on all eligible tax benefits and complying with requirements for potential short-term rental tax advantages. 

Final Words: Tax Strategies for Short Term Rentals

In conclusion, delving into the realm of short-term rentals presents a compelling avenue for substantial tax savings. Using platforms like Airbnb and strategically expanding your property portfolio can be a lucrative tactic. 

However, this venture demands strategic acumen, a nuanced grasp of the tax code that you can only get by employing a qualified CPA or financial advisor that specializes in real estate. 

It’s also important to leverage the proper tools when navigating the complexities of short-term rentals. Landlord Studio for example can significantly aid you when it comes to managing the financial aspects of your rentals. 

Easily track income and expenses, collect rent online, and generate reports for tax time. Plus, streamline tenant communications and property management, stay on top of key dates, and more.

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