I 'm sure we have all heard about the short-term rentals tax strategy, but how does it actually work?
Under Section 469 of the tax code, if your income exceeds a certain threshold, your rental deductions will gradually phase out, and eventually, you won't be able to claim any losses on your tax return. This means that for many high-net-worth taxpayers, rental income is offset by rental losses, which is indeed beneficial. However, these real estate losses cannot offset other types of income, such as wages or self-employment income, since real estate is generally considered a passive activity. These passive losses generally get carried over to future years until the rental is sold. This is unfortunate, because many of us want to take a tax benefit in the current year. Who knows what will happen in the future, right?
Is there a way to work around passive losses limitation? Can you use substantial rental losses to offset your hard-earned income? The loophole can be found in Treas. Reg. 1.469.1T(e)(3)(ii), which provides exceptions to the passive activity rules. According to this regulation, if a rental property has an average stay of 7 days or less, and the taxpayer materially participates in the rental activity, it is considered a non-passive activity and is not subject to the passive loss rules. Non-passive losses can be deducted on page one of your 1040 form and can offset some of your regular income. This is great news!
Now, let's dive into some definitions. If a rental property has an average stay of 7 days or less, the owner materially participates, and also provides substantial services, the rental activity is reported on Schedule C and is subject to self-employment tax. Substantial services refer to going above and beyond typical rental activities, such as daily cleaning, bed turn-down services, providing meals, and more. Cleaning common areas or performing basic tasks between guests does not count as a substantial activity. It is rare for a short-term rental to belong on Schedule C.
On the other hand, if a rental property has an average stay of less than 7 days and the owner materially participates, the rental activity is reported on Schedule E as a "non-passive" activity. Non-passive losses are not subject to income limitations and can wipe out your other taxable income on the first page of the 1040 form.
Please note, the owner still need to prove material participation to be able to deduct losses if the average guest stay is 7 days or less. There are 7 tests for material particiption but the 2 most commonly used are:
Now, let's discuss the depreciable life of a rental property. Usually, residential long-term rentals are depreciated over 27.5 years. However, short-term rentals are written off over 39 years since a significant portion of their income comes from transient stays. But what happens if your rental property is a short-term rental in one year and a long-term rental in another? How do you treat it on your tax return? If your property changes from a non-passive to a passive activity or vice versa, you would simply need to check an appropriate box in your software – passive or non passive activity. No complex procedures are required. Regarding the depreciable life of the asset, no 3115 form is needed since there is no change in accounting policy. It's just a matter of adjusting the life allocation from 39 years to 27.5 years or vice versa while retaining the accumulated depreciation. In the following year, depending on the circumstances, you can switch back to the original depreciable life. It is important to maintain accurate records throughout this process.
Lastly, let's explore a few tax planning opportunities related to rental properties:
- Consider converting your rental property to a short-term rental at the time of sale to potentially avoid Net Investment Income Tax (NIT).
- Conduct a cost segregation analysis to allocate more assets to shorter 5- and 15-year lives, allowing you to deduct the majority of expenses in the same year.
- Explore opportunity zones, zones where you don’t need to pay taxes on gains from sale of your property.