Short Term Rental Tax Loophole for Physician

[Dane C.]

I'm a physician with a fairly high W2 income (and thus high tax liability). I've wanted to get into real estate for a while as a means of diversifying my assets and reducing some of my tax liability. I'm facing a $280k tax liability this year ($205k federal). I have been looking into buying some multifamily homes and using the STR loophole to claim passive losses against W2 income and had some questions about this, including the legality of it. This is mostly a thought experiment at this point so below is the case:

The property: A newly built $1MM multifamily home (3 units)

The Case:
I purchase the property this year. I do a cost segregation study and claim bonus depreciation. I put it on airbnb as a short term rental. I meet the requirements of material participation. I claim the passive losses against my active W2 taxes. I convert the property to a LTR the following tax year.

Questions:
1) Are cost segregation studies worth doing on newly built multifamily homes or is it specifically for businesses or business type properties? Is this a case by case basis?
2) If I own the property for part of the year, is the tax deduction prorated in any way?
3) After the upfront depreciation is taken and the STR loophole is used, do I need to continue with the unit as a STR or can it then be converted to a long term rental (LTR) for the following tax year (or at any point down the line)?

[Greg Scott]

Dane:

I'm not familiar with this tax incentive* but I can speak to bonus depreciation.

1) Cost seg studies can be costly and the ROI tends to be much better on expensive assets. However, in your case, if you can take bonus depreciation, it may be totally worth the cost. I would talk to a cost seg specialist. They can estimate the cost for your property. Given its size, it will be on the cheaper end.

2) The portion of your depreciation that is straight line will be pro-rated. Bonus depreciation has no such requirement.  We bought an apartment at the end of October last year and took bonus depreciation giving every one of our investors a paper loss of 68% of their original investment.

3) I am not familiar with this aspect.

* FWIW, Loophole is the term used by politicians who want to show they are fighting for the taxpayers to fix "mistakes" in the tax law. I prefer the term Tom Wheelwright, CPA, uses. He calls those "incentives" that were purposely put in the tax code to drive a specific behavior. The STR one was clearly put in there by someone who wanted to increase the number of STR inventory. Therefore, it is an incentive, not a loophole.

[Jon Fletcher]

@Dane C. I'm waiting for a CPA to respond and confirm, but I believe there is a flaw in your plan. The only way your material participation in Short-Term Rentals ("STR") can reduce your W2 tax liability is if you spend MORE HOURS working on your STR's than you do on your physician job. I'm hoping I'm wrong here... CPA's please jump in!

[Dane C.]

Quote from @Jon Fletcher:

@Dane C. I'm waiting for a CPA to respond and confirm, but I believe there is a flaw in your plan. The only way your material participation in Short-Term Rentals ("STR") can reduce your W2 tax liability is if you spend MORE HOURS working on your STR's than you do on your physician job. I'm hoping I'm wrong here... CPA's please jump in!

Thanks for the input. While I know this is the case for REP status, my understanding was that there is no such constraint for the STR "incentive." I'm basing this thought process on this post. 

[Greg Scott]

Quote from @Jon Fletcher:

@Dane C. I'm waiting for a CPA to respond and confirm, but I believe there is a flaw in your plan. The only way your material participation in Short-Term Rentals ("STR") can reduce your W2 tax liability is if you spend MORE HOURS working on your STR's than you do on your physician job. I'm hoping I'm wrong here... CPA's please jump in!

Jon:  If you are referring to real estate professional status, yes, that is true.  There are a handful of other requirements.  However, real estate professional status is not specific to STRs.

Dane:  With your income and the huge benefit you would get from tax avoidance strategies, it is worth the time and money for you to find a CPA that you can talk through these things.  The one thing I do not like about the post you shared is the author does not reference any specific section of the tax code.  It is difficult to verify whether he speaks truth or is making something up.

[Caroline Gerardo]

Do you own your practice? Might be easier to prove you are working a full time second gig and invest in something medical that is in your wheelhouse. Buy an expensive medical tech widget and sell it for a loss? Marry a person who has long term loss? Starting a 3 unit rental STR is a business, how many hours do you have to work this? If married can partner be the operator? Get your CPA involved now.

[Ashish Acharya]

Questions:
1) Are cost segregation studies worth doing on newly built multifamily homes or is it specifically for businesses or business type properties? Is this a case by case basis? MF is perfect for Cost Seg but It will not offset your W-2 income without the REP status. 
2) If I own the property for part of the year, is the tax deduction prorated in any way?- no, Bonus dep is not prorated. 
3) After the upfront depreciation is taken and the STR loophole is used, do I need to continue with the unit as a STR or can it then be converted to a long term rental (LTR) for the following tax year (or at any point down the line)? - Down the line, yes with correct planning and documentation. 

STR "loophole" is not as easy as you read. Please work with professional. 

[Scott Mac]

Quote from @Dane C.:

I'm a physician with a fairly high W2 income ......

 Hi Dane,

Lets talk YOU for a moment.

Every high income physician I know makes that income by putting in the hours.

And then there are the required "Unwind" hours that increase with the increase in billable hours.

And then there are the "getaways" //recreational travel to recharge your batteries// if you do that.

Look at your daily, weekly, and monthly current time commitment and figure out where the time will come from to handle a psudo-hotel business.

How many times must you take a call for the business when you are treating Mrs. Xyz for her Abc, and it interrupts your medical practice day, before it become "too much" of an "Interruption.

Because my guess is the Medical practice will not be allowed to suffer, nor will the practitioner (for very long).

I'm not saying don't do this, what I am saying is try to get comfortable with the amount of time you will have to "give up" somewhere else to get this tax savings.

I don't do AirBnB, but it might be intelligent to try to figure out ahead of time how much time this will take YOU, to get set up, and to handle on an ongoing basis.

A significant other who is onboard with time commitment and chores involved might make this a no brainier too.

Good Luck!

[Dane C.]

Quote from @Caroline Gerardo:

Do you own your practice? Might be easier to prove you are working a full time second gig and invest in something medical that is in your wheelhouse. Buy an expensive medical tech widget and sell it for a loss? Marry a person who has long term loss? Starting a 3 unit rental STR is a business, how many hours do you have to work this? If married can partner be the operator? Get your CPA involved now.

All good points. As I mentioned above I'm a W2 employee and do not own my own practice nor will I ever based on my line of work. The questions above are more of a thought experiment at this point, as in if it's not something that is technically feasible it is not something that I would pursue further. As far as time commitments go, I would be looking at properties in my immediate vicinity and have the free time (up to 20 hours a week) and motivation to make it work if the opportunity is right. For example, if there are tax benefits available to improve the profitability of a relatively turnkey property, that is the kind of investment I would be looking at.

[Caroline Gerardo]

Nothing is turn-key. Real estate operations involves people and the property always needs repairs. Physicians typically work long hours and the IRS and your state know this. This is why I suggest a spouse as the partner to put time on the clock. I am not a CPA

[Dane C.]

Quote from @Caroline Gerardo:

Nothing is turn-key. Real estate operations involves people and the property always needs repairs. Physicians typically work long hours and the IRS and your state know this. This is why I suggest a spouse as the partner to put time on the clock. I am not a CPA

I appreciate the input those of you have given regarding whether or not to get into REI. I think it's fair to say that I'm in the pre-contemplative stage at this point. I.e. I don't have a specific investment I'm looking to jump into but I am gathering input/info/advice for a very specific tax situation.

[Julio Gonzalez]

@Dane C. I agree with Ashish's responses above. Once you've purchased a property and are looking for a cost segregation study, most engineered cost segregation study companies will provide a free cost/benefit analysis quote to help you determine if the benefits outweigh the cost. In your case, a million dollar multi-family property almost certainly will. Please feel free to reach out if you have any questions!

[Michael Plaks]

@Dane C.

As a purely hypothetical thought experiment - yes, it is possible. Which is not the same as realistic or advisable.

1. Running an STR is a business. You can outsource the operations to other people, but then you'll probably fail material participation test. Do you really want to acquire and operate a labor-intensive business merely for tax benefits? Especially when the economic sustainability of STRs is getting less certain.

2. Numbers. $1MM new construction. $300k cost segregation. $100k tax savings. You still have $180k tax left. 

3. This was year 1. In year 2, there is no more bonus depreciation. You only have minimal slow depreciation left after cost segregation. Not only you don't have the tax savings anymore, but you possibly turned your STR into a net-positive tax item, increasing your overall taxes. Quite common actually, especially in high-rent areas. Ditto if you convert it into a LTR. So, are you going to add a new $1 MM STR triplex every year, to keep the game going?

4. Take @Caroline Gerardo's advice to marry someone like her :)  Then you both can qualify for REP and have a much wider choice of tax-friendly investments.

Look at these older threads: https://www.biggerpockets.com/... and https://www.biggerpockets.com/...

[Dane C.]

Quote from @Michael Plaks:

@Dane C.

As a purely hypothetical thought experiment - yes, it is possible. Which is not the same as realistic or advisable.

1. Running an STR is a business. You can outsource the operations to other people, but then you'll probably fail material participation test. Do you really want to acquire and operate a labor-intensive business merely for tax benefits? Especially when the economic sustainability of STRs is getting less certain.

2. Numbers. $1MM new construction. $300k cost segregation. $100k tax savings. You still have $180k tax left. 

3. This was year 1. In year 2, there is no more bonus depreciation. You only have minimal slow depreciation left after cost segregation. Not only you don't have the tax savings anymore, but you possibly turned your STR into a net-positive tax item, increasing your overall taxes. Quite common actually, especially in high-rent areas. Ditto if you convert it into a LTR. So, are you going to add a new $1 MM STR triplex every year, to keep the game going?

4. Take @Caroline Gerardo's advice to marry someone like her :)  Then you both can qualify for REP and have a much wider choice of tax-friendly investments.

Look at these older threads: https://www.biggerpockets.com/... and https://www.biggerpockets.com/...

 Thanks for the input Michael.

1. My understanding for material participation for an STR is that you have to contribute 100 hours work or more and have contributed more "work" than anyone else. That would be very feasible for me on a single property.

2/3. My goal is not necessarily to pay no taxes. To be perfectly honest, I wouldn't even say that my goal is to become a real estate investor, a landlord, or a STR business unless the opportunity was perfect for me. I don't believe that it is easy work and so I apologize if I've given that impression. The reason I'm asking these questions is mostly motivated by an interest in personal finance, investing, taxes, and general intellectual reasons. I think the best point I've seen mad in this thread though is that after the initial tax savings you've created a tax liability by having an income generating property with reduced passive losses moving forward so thank you for that!

4. Missed the boat on that one, but thankfully I love her for different reasons :).

Thank you all for the input, it's been a really enlightening thread. Fear not, for now I'm not planning to quit my day job and will continue doing what I'm good at, it's served me well thus far.