Short Term Rental Tax Loophole for Physicians
Investing in short-term rental (STR) properties and using the STR Tax Loophole is one of the few tax strategies that can save physicians with a fairly high W2 income 6 figures in taxes without working full-time in real estate.
It is difficult for a physician, or other professional to become a real estate professional as they can't spend half of their working hours in a real estate business. This is where the short-term rental tax loophole can help. To ensure you can apply the tax deductions against ordinary/active income, you have to materially participate in the STR business.
Material participation tests are the rules the IRS uses to determine if you worked on your short term rental business on a regular basis during the year. There are seven ways to accomplish this, but the 3 most common and easiest material participation tests used to shelter income for physicians are:
1. Your participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year.
2. You participate in the activity for more than 100 hours during the tax year, and your participation in the activity is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year.
3. You participated for more than 100 hours in a regular, continuous, and substantial basis during the year.
The goal is to use your short-term rental for non-passive losses. Because non-passive losses can offset non-passive income/ active income. If you can meet the criteria, your short-term rental will save you significant amount of money on taxes. That’s the first big component of a short-term rental tax strategy. The second is depreciation.
Depreciation for Your Short-Term Rental Tax Strategy
you need a savvy real estate CPA who's going to lead you through leveraging depreciation for your short term rental. You will have your CPA do a cost segregation study on your property. That cost segregation will reclassify certain components of your property from 39 year life (depreciation life for an STR property) into 5 and 15 year life. 5 and 15 year property can generally represent anywhere from 20-30% of a property's purchase price.
So, if you had a $1 million dollar property and did a cost segregation structure, anywhere from 20-30% could be resegregated and fully depreciated. This would give you a $250,000 deduction. This is powerful because your losses are non-passive, and that tax loss can be used to offset taxes on your W-2 income.
Steps to take in order to shelter your W-2 Income
#1. Buy a short-term rental.
#2. Materially participate in the rental.
#3. Obtain a cost segregation study.
#4. Use accelerated depreciation the first year.
#5. Claim paper losses from your business.
#6. Hire a real estate CPA who understands how to use the tax deductions from your short-term rental and apply it to your ordinary income.
What’s Changing About Depreciation for Short Term Rentals & Why it's the time to act NOW.
Certain aspects of this strategy will phase-out over the next few years. 2022 was the last year of 100% bonus depreciation. It is currently slated for a phased approach to decrease the percentage every year for the next five years. In 2023, it dropped down to 80% bonus depreciation. So, if you were going to get a $250k deduction, you’d get $200k in 2023. In 2024, it will drop down to 60%. The $250k deduction would become $150k. Still sizable, but the power of the strategy will decrease.
Quote from @Sammy Habbaz:
Quote from @Ron Singh:Assume 80% is building. 400k. Assume 20% is personal property eligible for bonus. 80,000. Assume you close and PIS when bonus is 80%. 64,000.
Quote from @Ron Singh:Tagging gurus:
Quote from @Jon Martin:
Quote from @Lisa Marie:
So, along that line, I would like to know how many people on this thread have actually done cost segs on their properties and how much W2 income tax you saved from that.
I paid $600 for a cost seg that will take $60K (80%*75K) off of my taxable income for 2023. I won't say what my W2 income is but I will say I expect to save over a quarter of that of that amount between fed and state taxes. So yeah, absolutely worth it. I can also say that the money I save by self managing, even when broken down per hour, is not far off from my "hourly wage" based on my salary. I look at it as a side hustle where I pay myself.
Like @Ryan Moyer said I can utilize that cash now to invest in more properties and kick the can down the road, potentially past my time on earth. That cash is worth much more to me now in the scaling stage.
As for your "better off in the stock market" comment, your analysis is flawed because it is based on an equal cash vs cash assumption. Most people do not have that kind of cash to put into the market, but maybe we can scrounge up 15-20% of that for a down payment. That's the power of leverage in real estate, where I can pull the returns of a $1M investment with 20% of the cash. I can't do that at Charles Schwab.
Regarding what you said about not investing solely for the purpose of utilizing cost seg and bonus depreciation, sure, I would agree that your decision to invest in an STR should go beyond that and should work in its absence. In a related example, I was looking to get in to a property before year end to lower my tax bill further. Then I realized that if I don't have enough cash to invest in a property for 2024 tax year, then I am better off waiting until then because another cost seg will lower my tax burden within a reduced tax bracket for 2023. Whereas in 2024, that bonus depreciation, even at 60%, will be worth more if that's the only property I buy between now and the end of 2024. So yes, there is nuance and people should take a close look at their situation to see if it makes sense, but at the very least the first seg I mentioned is an absolute no brainer for me.
Great points
curious on 60k segregated value , what is the value of building just to get an rough idea.
I need to deduct similar amount in 2023, and trying to see how big of a property I have to buy to come close to your deduction numbers.
@Michael Baum, @Ryan Moyer, @Nancy Bachety, @Arda Bircan
Trying to see if you can share any rough idea on how big of a property would qualify for 80k-100K in deduction?
As segregation takes items into account like appliances, roof, building material etc.. would it be okay to estimate below:
>> 500k property value (150 land+350 built), can provide around 80K in max deduction on year 1 ?
Would it differ or matter if property is being used as short term(i.e airbnb) Or Longterm rental ?
can shortterm rental allow any additional deductions as compared to long term ?
No additional deductions. The difference is that in a LTR you need to be a real estate professional to offset active income. For an STR you can half a separate full-time job.
Tagging gurus: @Michael Baum @Nancy Bachety @Arda Bircan @Sammy Habbaz @Chad McMahan
Thanks
So even if STR is in different state and managed by property management company, would it be considered as active involvement ? and same above deduction applies similar to as if it is local STR and self-managed ?
Quote from @Ron Singh:No you would most likely need it to be self managed. Rules are nuanced, but you're more likely to get the benefit that way than hiring a management company.
Quote from @Sammy Habbaz:
Quote from @Ron Singh:Assume 80% is building. 400k. Assume 20% is personal property eligible for bonus. 80,000. Assume you close and PIS when bonus is 80%. 64,000.
Quote from @Ron Singh:Tagging gurus:
Quote from @Jon Martin:
Quote from @Lisa Marie:
So, along that line, I would like to know how many people on this thread have actually done cost segs on their properties and how much W2 income tax you saved from that.
I paid $600 for a cost seg that will take $60K (80%*75K) off of my taxable income for 2023. I won't say what my W2 income is but I will say I expect to save over a quarter of that of that amount between fed and state taxes. So yeah, absolutely worth it. I can also say that the money I save by self managing, even when broken down per hour, is not far off from my "hourly wage" based on my salary. I look at it as a side hustle where I pay myself.
Like @Ryan Moyer said I can utilize that cash now to invest in more properties and kick the can down the road, potentially past my time on earth. That cash is worth much more to me now in the scaling stage.
As for your "better off in the stock market" comment, your analysis is flawed because it is based on an equal cash vs cash assumption. Most people do not have that kind of cash to put into the market, but maybe we can scrounge up 15-20% of that for a down payment. That's the power of leverage in real estate, where I can pull the returns of a $1M investment with 20% of the cash. I can't do that at Charles Schwab.
Regarding what you said about not investing solely for the purpose of utilizing cost seg and bonus depreciation, sure, I would agree that your decision to invest in an STR should go beyond that and should work in its absence. In a related example, I was looking to get in to a property before year end to lower my tax bill further. Then I realized that if I don't have enough cash to invest in a property for 2024 tax year, then I am better off waiting until then because another cost seg will lower my tax burden within a reduced tax bracket for 2023. Whereas in 2024, that bonus depreciation, even at 60%, will be worth more if that's the only property I buy between now and the end of 2024. So yes, there is nuance and people should take a close look at their situation to see if it makes sense, but at the very least the first seg I mentioned is an absolute no brainer for me.
Great points
curious on 60k segregated value , what is the value of building just to get an rough idea.
I need to deduct similar amount in 2023, and trying to see how big of a property I have to buy to come close to your deduction numbers.
@Michael Baum, @Ryan Moyer, @Nancy Bachety, @Arda Bircan
Trying to see if you can share any rough idea on how big of a property would qualify for 80k-100K in deduction?
As segregation takes items into account like appliances, roof, building material etc.. would it be okay to estimate below:
>> 500k property value (150 land+350 built), can provide around 80K in max deduction on year 1 ?
Would it differ or matter if property is being used as short term(i.e airbnb) Or Longterm rental ?
can shortterm rental allow any additional deductions as compared to long term ?
No additional deductions. The difference is that in a LTR you need to be a real estate professional to offset active income. For an STR you can half a separate full-time job.Tagging gurus: @Michael Baum @Nancy Bachety @Arda Bircan @Sammy Habbaz @Chad McMahan
Thanks
So even if STR is in different state and managed by property management company, would it be considered as active involvement ? and same above deduction applies similar to as if it is local STR and self-managed ?
@Nancy Bachety A cost seg does not "only delay tax day". Cash Flow is the most valuable part of any business and getting the use of the cash that you don't have to leave with the Treasury Department is like getting a free loan from the government. It is about the time value of money. BTW, the structure of the building goes on to depreciate for the 27.5 or 39 years of ownership after the cost segregation study is completed. It is a rare investor that does not benefit with a cost segregation study.
Do you really think that carpet is worth the same in 5 years when you are going to sell as it was worth when you bought the property and did the study? It may only be worth scrap value. Cost seg is a no-brainer unless you are going to sell the property in a year or two, you don't pay taxes, or have purchased the property for less than $200K.
Love this strategy, so many of my clients (and myself) are saving thousands when executed properly.
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Thanks everyone for such detailed replies.
Quick question- After you had the STR for 5-10 years and want to sell it now, can you just roll 1031, all the capital appreciation, and the bonus depreciation (claimed early on) into the next property and keep rolling the tax bill down the time lane?
Thanks
Quote from @Gucci S.:
Thanks everyone for such detailed replies.
Quick question- After you had the STR for 5-10 years and want to sell it now, can you just roll 1031, all the capital appreciation, and the bonus depreciation (claimed early on) into the next property and keep rolling the tax bill down the time lane?
Thanks
Gucci, the short answer is yes. If you leave the property to your heirs, you never have to pay the recapture tax and your heirs can do the cost segregation study again on the market value inheritance. Short-term rentals can be tricky when it comes to the tax filings and benefits. I am working with a client now to get studies done on six STRs where the initial tax filing was done on 27.5 years instead of 39 years. This person now has about $100K in tax benefits that were taken too early and now has to pay them back. Not a good situation to be in. Most CPAs/tax professionals do not have the time to study this calculation intense niche of real estate regulations. Taking on the risk of doing it wrong is another concern. They usually source it to a company that specializes in this area and offers audit defense if the client is ever questioned and at no cost. The best study is an engineering-based study with on site reviews of the property both inside and outside.
I am looking at a STR and a seasonal rental. Does this tax rule apply to seasonal (4-6 months), rentals as well?
thanks everyone for all your posts. I am learning a ton
Quote from @Jose Perez:Hi Jose, the property you are describing can most likely have a cost segregation study done on it. The best way to know is to get a no cost pre-analysis/estimate. There are some things you need to know. If you are occupying it at anytime, you may not be eligible if you don't abide by the length of time IRS lets you stay. If the average number of tenant occupancy days in a year is 7 days or less, it is a STR and if you are actively participating at least 100 hours per year, and more than any other person or company, you can consider this an active investment. If the average number of rental days in a year is more than 7 but less than 30, it is still a STR and is treated as such but it is not an active investment, unless you have Real Estate Professional status. STRs are depreciated over 39 years (regardless if they are active or passive properties). If the rental averages 30 days or more, it is a long-term rental property and gets depreciated over 27.5 years. Let me know if you have more questions.
I am looking at a STR and a seasonal rental. Does this tax rule apply to seasonal (4-6 months), rentals as well?
thanks everyone for all your posts. I am learning a ton