Information as of July 30, 2024.
How a high W2 income earner can use real estate income from a short-term rental property and deprecation from a cost segregation study to offset W2 income taxed at 37 percent at the federal level.
The Short-Term Rentals tax loophole (STR) can benefit people with high W2 incomes who invest in short-term rentals and spend time self-managing their property, allowing them to save on federal taxes.
In this article, I’ll discuss some of the criteria for meeting short term rental cost segregation requirements.
Short-Term Rental Loophole (STR)
A short term rental loophole involves using short-term rental properties to generate income while offsetting taxable W2 income by deducting depreciation (a non-cash expense). It is essential with this strategy to distinguish between passive and non-passive activities in real estate.
What makes the Short Term Rentals tax loophole unique is its exemption from the “passive loss limitation rules” that usually apply to rental properties. This could potentially offer tax benefits similar to those of the Real Estate Professional Status (REPS). Owning a traditional rental property is usually considered a passive activity and subject to passive loss limitations. In this case, the owner cannot use losses from rental activities to offset W2 income.
There are key specific conditions in the federal tax code to meet the standard for income from your short term rentals tax loophole property to qualify as non-passive; speak to your CPA to see if you are eligible.
The federal tax code delineates the standards for demonstrating that income produced by a rental property is non-passive.
Passive Income Exception
Here are a few of the conditions to meet the passive income exception, according to the IRS:
- The average stay of a guest does not exceed seven days.
- The average period a guest occupies the property as a rental is 30 days or less, and the owner offers basic services comparable to those provided by a hotel.
- Owners deliver exceptional personal services to prepare the property for use.
- Property rentals are deemed incidental to the owner’s non-rental activity.
- Use of the property is accessible during specific business hours and is not exclusive to any one guest.
- Any provision of the property for use in activities conducted by a partnership, S-corp, or joint venture in which the property owner has an interest is not considered a rental activity.
Non-Passive Material Participation
If your property qualifies as a short-term rental, you must demonstrate non-passive material participation.
The most common ways to meet the criteria for non-passive material participation include:
- Participating in the activity for more than 500 hours,
- Having your participation constitute virtually all of the participation in the activity, or
- Participating in the activity for more than 100 hours when no other individual participates more.
Again, speaking to your CPA about your specific circumstances is essential to determine your qualifications for short term rental cost segregation.
Suppose your property qualifies as a STR and meets non-passive participation criteria for short term rental cost segregation. In that case, you may be able to apply the deprecation from your STR To offset some of your W2 income. This can benefit you if some of your income is in the 37% marginal tax bracket.
We can help accelerate the deprecation in your short-term rental property. With your study in hand, you can work with your CPA on a strategy to mitigate your highest marginal tax rates.
Cost Segregation helps owners accelerate deprecation, you should consider that accelerated deprecation results in reduced deprecation later for the property. If and when you sell your property, it’s important to remember that you will likely be subject to capital gains taxes and deprecation recapture depending on your circumstances.