So that was my excitement for the week, and I know it might
not sound exciting to everyone.
But it was at a tax conference, so that's pretty peak for exciting.
But all of that aside.
This week, the topic I want to talk to you guys about is something that
there is so much misinformation on.
It's something that's over simplified, and it is something that we are
seeing a huge uptick in audits.
So all of these things combined, there needs to be more solid
information out there about this topic.
I received some messages asking about it after the last podcast.
I teach about this and almost every conference where I speak.
Today, we are going to talk about the short-term rental loophole.
As a starting point, I hate that it's called a loophole.
That to me implies we're doing something like shady or kind of skirting the
rules and that's not happening at all.
There is just wording in the tax code that allows for a circumstance where short-term
rentals can be more preferential tax wise.
That's all it is.
If you haven't listened to my no reps, no problem episode.
I would go back and listen to that.
It's going to explain a little bit more for kind of a foundation.
But just as a recap.
Normally long-term rentals are passive, passive income.
What this means is the losses related to them.
Are subject to certain limitations.
Basically, if your income is under a hundred thousand dollars, you can only
use $25,000 a year of passive losses.
If it's over a hundred, you start to lose out on being able to
use those losses against your W2 income or your business income.
Once your income is above $150,000, you can no longer use any of
your passive losses for the year.
Against your other income types.
So it won't reduce your W2 or your business income or anything else?
No matter how big the loss is.
So all that said a lot of investors get really frustrated with their long-term
rentals, because if you put in a ton of money, if you have a bad year, whatever
the case, and you generate a large loss.
You may not be able to receive a benefit from it in that specific year, right?
The losses never go away.
It carries forward.
It can offset other passive income.
But if you spent a ton on your rentals and you are thinking, well, at
least this will pay off at tax time.
It may not.
If your income is over 150,000.
With that frustration point is why people are now so excited about
this short-term rental loophole.
Where this strategy stems from.
Is code section 4 69.
That is what defines what is passive, what isn't and all of the guidelines around it.
In that code section, there are two ideas, two key pieces that are
going to relate to today's episode.
The first one.
Says that for an activity to be non-passive the taxpayer needs
to materially participate in it.
Material participation is just a level of involvement.
There are seven different tests to use to prove that you've reached that level.
You only need to meet one of the seven.
The most common ones relate to how many hours you've put in.
Also in that code section.
It defines what a passive rental is.
It goes on to talk about the various types of rentals and then
some kind of unique circumstances where they may not be passive.
That is where it notes.
That an exception to a rental being passive is if the average
guest stay is seven days or less.
So in a nutshell, if you have a rental property where the average
length of stay is seven days or less.
And if you are materially participating in it.
It is by definition non-passive so there's nothing questionable to that.
It is clear in the code.
So that's the starting point to this loophole.
We can take a rental property, meet certain criteria.
Has it been on passive?
And what that means is that you are no longer subject to that passive loss limit.
Now, no matter how high you are in commands.
You can use the losses generated from your qualifying short-term rental.
So, this is huge, right?
This is incredibly exciting for people.
And it gets better.
The next piece to this.
Is that you can pair this with a cost segregation study.
This is typically the other part of the loophole.
What a cost segregation study does.
Is, it allows an engineer to look over your property.
And instead of depreciating, just one building across 27 and a half or 39 years,
what a study does is allows them to break out all of the pieces of a building.
And it's actually the more correct way.
To report depreciation.
You're not just buying one specific thing.
A building is made up of multiple things.
So what the study does is breaks all of those things apart.
The reason this matters.
Is that on average, about 30% of the value of a building that you buy.
Is of shorter life assets, things that we don't expect to actually last that entire
life, that 27 and a half or 39 year life.
Things like appliances flooring certain electrical components, window
coverings, all kinds of things that are going to have a life of either
five, seven or 15 years instead.
This allows you to have a larger write-off per year, So with this study, you're,
front-loading a lot of your depreciation.
You're taking it in those first years.
On those shorter life assets.
The second part to that is anything with a life.
Of 20 years or less qualifies for bonus depreciation.
This is something that basically says you can deduct a big chunk of your purchase.
All in the year, it's put in service.
It applies to anything with life of 20 years or less.
And the amount you could take is going to depend on the year that
that asset was put in service.
So from 2017, through 2022, it was a hundred percent.
So if you put your rental and service during those years,
Now you do a cost segregation this year.
You would still get 100% it's based on the year.
It goes in service.
For 2023 that dropped down to 80%.
So you could write off 80% of the purchase price that first year for 2024 drop to 60.
And it's set to continue phasing out.
But my guess is that that will change.
So the components we have to this strategy so far.
Are you make sure your average guest stay is seven days or less.
You materially participate in the property.
You do a cost segregation study, which allows you to take a chunk
of the cost of the building, move it all into shorter lives, giving
you a higher annual write-off.
And then you can accelerate that even farther.
By using bonus depreciation that will let you then take
a huge chunk of that expense.
And the very first year.
So all of these things combined.
Give us a really unique opportunity to strategically create a large
amount of deductible loss.
In a year when it's needed.
So that can be tremendous for tax planning.
when it comes to this short-term rental loophole.
It's an annual test.
So for that calculation for the average guest stay.
That is looked at on a calendar year basis.
It is annual.
For the test of seeing if you materially participated, that is based on that year.
It's an annual test.
This allows a short-term rental to be somewhat of a chameleon.
We can shift the way it is taxed by intentionally passing
or failing these tests.
The way we figure out the average guest stay.
It's going to take the, all of the days it was rented during the year.
And divide it by the number of independent, separate guests
that stayed at the property.
So it's just an average.
So you can have some that are more than seven days, as long
as you have some that are less.
And the average stay is under seven.
A common mistake.
I see with this.
Is that because this is an annual test.
If you have a longterm rental that you are converting to short term.
That longterm stay is going to be part of your average.
that's going to throw your average much higher than seven days.
So if you have a longterm rental that you are considering switching to short-term.
You are going to want to do that as close to the start of the year as possible
The way the code is written, we need to prove an average of seven days or less.
You need two or more stays.
This was recently reaffirmed through a ruling that is exactly what they said.
We can not figure out an average of something unless we have at least two.
So if you buy a rental property that you are going to put in
service as a short-term rental.
You need to both put the property in service.
And have at least two fair market value, independent stays
before the end of the year.
These are the two biggest mistakes I see, or things that people kind of
didn't expect to happen when it comes to putting a short-term rental in service
and getting to use this strategy.
One of the pushback items that I will hear from people.
Is that they don't want to manage a short-term rental.
It's more work, right?
They can often be more work.
There's more turnover.
You have to deal with furnishing.
You're dealing with a lot more people throughout the year.
And if you want to materially participate.
That is going to be close to impossible to do.
If you have property management.
What this means in real world terms is that you need to manage that
short-term rental for the year.
You are wanting to implement this strategy.
Additionally, you are going to have to be mindful.
Of how much time is spent on it by anyone else?
I mentioned earlier, there are seven different rules
for material participation.
The two most common rules that we see taxpayers use.
Are at least 500 hours during the year on the activity.
If you don't hit that 500 hours.
The other rule that is commonly used, says that you have spent
at least a hundred hours.
But it was also more time than anyone else.
So what this means is that not only do you have to track your time and be able
to prove you spent a hundred hours.
You also have to track the time of your house cleaner.
if you have a co-host You now need to track the time of
anyone who was spending us.
Stanzel amount of time on your property.
So that you can prove they are not spending more time than you are.
I actually just heard about someone who is going through an
audit specifically on this topic.
And that is the hangup.
The taxpayer is able to prove they spent at least a hundred hours.
But on a short-term rental, if you have guests switching weekly.
Your cleaner spends quite a bit of time at the property.
So they are having a very hard time proving that the cleaner did not
spend more time on the property than the taxpayer did, and they
didn't track the cleaner's time.
So they're now going through and trying to reconstruct that time using, you know, the
camera dates on it and the key pad log-in.
And trying to reconstruct it and hopefully prove that the taxpayer had more time.
I actually spent a few hours on a phone call with a friend of mine who
is also a real estate tax strategist.
And what we are both seeing is an increase in audits related to this
and that it tends to be related to.
Proving the time and proving those cost segregations.
So it doesn't make the strategy any riskier, as long
as you're doing it correctly.
You will be good.
So all of that said it doesn't make this a risky strategy.
It doesn't make it something you shouldn't consider.
It just means that what you're hearing on social media, where all you are
told is by a short-term rental average day of seven days and materially
participate, you can take all your losses.
There's more to it.
And now that it's being looked out a little more closely, you
want to make sure you are crossing your T's and dotting your I's.
The checklist of things you are going to want to do to make sure that you do
not get it handed to you in an audit.
You're going to want to make sure that you can prove an average
guest stay of seven days or less.
By having at least two qualifying stays before the end of the year.
If you have your friends stay there and they're not paying you for it.
The other big thing.
Is proving your material participation.
That means you are going to want to track all of your time spent on that property.
And ideally prove that you spent at least 500 hours on it during the year.
If you really can't hit 500 hours.
You are going to want to also track.
The time of anyone else who is working on or involved with that property.
Another caveat to this is with material participation.
You can not include investor hours.
So the time you spend looking at financials, writing checks, kind
of the in-office unrelated to the direct day to day of the property.
Those don't count.
So really make sure that you're documenting all of this accurately
and on a continuous, ongoing basis.
Because I will say after reading hundreds of court cases, Any case related to ours.
Whether that's material participation or real estate professional.
There's a couple things where it always gets thrown out in court.
The first one is not having a log.
If you have no log whatsoever, you can't prove anything.
That's obviously going to shoot you in the foot.
The second, most common thing.
Is if you have a log.
But it seems wrong or like you falsified or that it's just not super believable.
It's kind of like once they've determined.
One part of it isn't reliable.
The whole rest is thrown out.
So you want to make sure that you not only have a log.
But that it is sensible and accurate and ongoing.
You want to make sure that if you are going to say that you qualify to
write off a hundred thousand dollars.
That you are willing to take the extra 15 minutes a month to prove that.
So it is a great strategy.
It is a fantastic way to create a large loss in a specified year.
A lot of people.
We'll by default.
Do a cost segregation study and qualify the property is non-passive
in the year they acquire it.
And that may be the best of your to do it.
It's the easiest from a reporting standpoint.
Because when you do a cost segregation study, we can just set
up depreciation with those amounts.
However.
From a tax planning standpoint, it might not always be what's best for you.
If the year you put that property in service.
And it qualifies for a non-passive short-term rental.
If in that year, your income is much lower than, you know,
what's going to be the next year.
You might want to wait until the following year to do a cost segregation study.
And then in that following year, you will have to materially
participate and have that average guest stay of seven days or less.
If you can have a much larger benefit from the same amount of deductible loss.
Then you might want to save it for that year.
When you do a cost segregation study.
You can do it at any point.
It does not have to be during the year.
The property is placed in service.
And you can do it in any later year.
The longer it's been the less benefit it has because you're chipping
away at that depreciation already.
So if it's 20 years in, you don't have a lot left.
But if it's your two or your three.
Absolutely look at which of those years will that large
amount of lost most benefit you?
It might not be the current year.
If you wait and do it in a later year.
For taxes, you need to include form 31 15 with your tax return.
The reason we can pick the year we take the loss.
Is that if you are changing depreciation, You don't go back and amend.
So if you put a property in service in 2020, and this year
you do a cost segregation.
You don't go back and amend those past few years tax returns.
You file form 31 15 with your current near return, and you are allowed
to take the loss adjustment that depreciation adjustment for the expense.
In the current year.
So even if the property was put in service several years ago, You can
do a cost segregation study now.
And you would get the write off on the current year tax return.
The deadline for doing a cost segregation study and having
it included on a tax return.
It's just the filing deadline for that tax year.
So you would just need to complete the study by April 15th or October 15th.
If you file an extension.
So there's a great planning opportunity here to choose when you use that loss.
And to figure out if the ease of doing it first year is actually worth it.
Or if it's worth it to save it for a later year.
Again, you don't go back and amend.
We can't go backwards and amend appreciation.
The only time that that's an option is if only one year has been filed.
So, for example, if you're listening to this right now and
you already filed your 2023 taxes.
And you had a new property in 2023.
If you did a cost segregation study.
At this point, you would have the choice of either amending 20,
23 and changing the depreciation because it's only been one year.
The way depreciation works.
Is, if you have reported a method, if you've sort of said,
this is how we're doing it.
The way you establish that method is by doing it two or more years,
you have established a pattern.
You've set that this is what you're doing.
You didn't change your mind.
If it's only been one year, they don't consider that set yet.
So, if you had a new rental in 2023, you could go back and amend 23 to add the
cost segregation study two that year.
If it would have more benefit to you.
Otherwise for years, 20, 24 and forward, you could do a cost
segregation study in any of those years.
You would take the expense adjustment in the current year's tax return.
You would file 31 15 and you would have what's called a 4 81 a.
Adjustment on schedule E.
So you have a lot of planning opportunity with short-term rentals.
This is why Hearing about the short-term rental loophole has become incredibly
popular and it's a fantastic tax strategy.
I love this and I implement this with a lot of my clients.
All I'm here to tell you is make sure you're doing it correctly.
You just don't want to kind of skirt the edges and do the high risk
things because it's not worth it.
Right.
Why open up an audit for no reason?
Like I mentioned earlier because it's a year to year test.
Even if you're someone who's sitting there thinking, this sounds great, Natalie, but
I don't have time to manage a property.
I don't want to deal with that.
All of my properties are fully managed.
I'm hands-off.
That is what I have always been taught to do as an investor
is it's not worth my time.
I understand that.
It's a year to year test.
If you had the potential to take.
A hundred thousand dollar loss on your taxes this year.
Do you think you could deal with managing a property for one month?
Could you try to buy a property to use as a short-term rental?
For only the month of December of this year.
Making sure that you put in the hours, making sure that the average stay there's
at least two that are seven days or less.
At the end of the year, that test resets.
So even if you buy your property late in the year, As long as you can meet that
100 hours and more time than anyone else.
Or that 500 hours.
And you can prove two or more stays with an average of seven days or less.
You can have that rental qualified as non-passive for that year.
Then January 1st.
If you want to change it over to a longterm rental where you want to hand
it off to be fully property manage where you're not involved anymore.
That's fine.
This strategy allows us to take a decent amount of loss,
typically in a single year.
That's what we're doing.
If you don't need that large loss in one year.
So you are not using bonus depreciation.
You just say, you know what.
I do like the idea of taking 30% of the cost of this building and having it across
these first five, seven and 15 years.
I never keep properties longer than 10 years.
So that really lines up.
That works well for me, that's going to get me to an amount of tax.
I'm happy with.
Then you would need to keep it non passive for all of those years.
And then if you switch it back to passive the next year, there's no clawback.
So if it is non-passive and you take a huge loss in one year.
And literally the next year, a month later, you say, actually, we're
going to sign a year long lease.
This will be a passive rental again.
You don't have to pay anything back.
There's no reprimand.
There's no provision that says, oh, well, since you didn't keep
it short term for at least this amount of time, it doesn't qualify.
It's an annual test.
The last item that I will touch on related to short-term rentals.
Is the depreciable life.
So this catches a lot of people off guard.
Like I said, we get to depreciate property at either 27 and a half years.
If it's residential.
Or 39 years, if it's non-residential now tax terms.
Are almost always going to be different than lending terms.
So a lot of people are going to look at a single family house and say
that is residential all day long.
For taxes, it may or may not be.
If you have a single family house, but you are using it to run a business out of you
run a hair salon in the whole property.
That is a commercial use of the property for tax purposes.
Because a short-term rental.
Does not meet the defining factor of a rental property.
It falls out of the standard depreciation life for being a residential rental.
Residential rental would be 27 and a half years.
And again, there's an exception in the code.
In 1 68.
There's a note that this excludes properties that are basically
used on a transient basis.
So this is going to apply to hotels and motels and things like that.
And transient basis is typically looked at as under 30 days.
So if you are meeting the seven day or less criteria, your property is definitely
being used on a transient basis.
And your depreciable life is going to be 39 years.
If you have a valid short-term rental.
It is treated as a commercial property for depreciation.
Because we have pulled it out of the defining factors for being residential.
That being said.
There's even more unique opportunity here for depreciation, because some
of renovations, depending on when you buy, if it's in service, what kind
of the timing of how this happens?
You might have qualified improvement property.
That is also 15 years, which also allows bonus depreciation.
If you have a property that switches between long-term and short-term.
Your depreciable life is going to switch with it.
If you had it as a long-term rental for years and you were depreciating
it over 27 and a half years.
But for this year, you switch it to short-term.
You will only change the life.
2 39 years from this point forward.
something that gets asked pretty often.
Is if I am changing.
From long-term to short-term.
Do I need to file form 31 15, Natalie.
You just told me if we try to change depreciation after two or more
years, I have to file this form.
That is true.
If what is changing is the method of depreciation.
If it's the same activity, but we want to change the way we are depreciating it.
Then we have to file a 31 15.
If the actual activity is what changes, the method of depreciation
is allowed to change with it.
Similarly, if you have a primary home that you're living in.
You don't get to depreciate it.
It's personal, not a business asset.
No depreciation.
However, as soon as you switch it over to being a rental property, Now you
do get to depreciate it because now it is a qualifying business asset.
The activity is what changes.
So the amount or how you'd appreciate it.
Changes to match up.
So when we switched from a long-term rental that has 27 and a half years.
To a short-term that has 39 or vice versa.
The life is allowed to change with it.
You just changed the depreciable life from that point forward.
And you recast it.
You do not need a 31 15.
If you are switching back and forth.
From long-term to short-term rental.
And one quick mention on mid-term rentals.
There is another circumstance where rentals can be non-passive
and kind of the same.
Area of the code.
And that is if the stay the average guest stay is 30 days or less.
And you provide significant personal services.
Now here's the hangup.
Significant personal services.
Is part of code 4 69, which lets us say passive or non-passive
however, the definition of significant personal services.
Is almost identical to the definition of substantial services.
Which is what determines if a property is subject to self-employment tax.
So if you are doing a 30 day or less rental, And you are providing.
Significant personal services slash substantial services.
There's almost exact overlap.
These are going to be services to improve the experience of
the guests during their stay.
So think of a hotel.
This does not include services provided in between stays.
Cleaning in between guests.
Does not subject a property to self-employment tax.
Providing items does not subject a property to self-employment tax providing.
Supplies onsite.
If you provide some coffee, pods or toilet paper that does not subject
a property to self-employment tax.
The only thing that is going to convert your property from being non
passive, which is still reported on schedule E most short-term rentals.
Go on schedule E 98%.
I would say.
Non-passive on schedule E.
The only time it moves over to schedule C is if it is
subject to self-employment tax.
And the only time a rental is subject to that self-employment tax is if you
are providing those substantial services or those significant personal services.
These are going to be services during the guests stay.
Not things outside of it.
So if you have a maid who comes in and cleans the unit every day,
while the guest is staying there.
If you offer a room service where you'll deliver food to their room.
If you offer a hotel shuttle where you will pick them up from the airport
and bring them to your property.
If you provide any kind of lessons onsite, you do fishing lessons or hiking
or swimming or anything like that.
If a verb is occurring, it has to be a verb during the time the
guest is renting the property.
it has to be something of a pretty substantial value.
And it has to be occurring while the guest is there and to increase their experience.
So this is another one of those really common misconception points.
And this is where I see it being taught incorrectly on the professional side.
There's a fair amount of tax educators who get mixed up on this and want you to
put the short term rentals on schedule C because they believe providing anything
is a service and that's not the case.
If it is not happening while the guest is legally entitled to the unit, if
it is not increasing their experience while they are staying in the unit,
if you are not doing something with a verb, while that unit is rented.
It still stays on schedule E and it is still non-passive very rarely do I
see a rental with services at a high enough level to move, to schedule C
and be subject to self-employment tax.
The same thing falls into place with the 30 day or less acception to being passive.
If you're saying my property is rented for 30 days or less.
And I'm providing significant personal services.
So it is non-passive and I can use my losses.
That is true.
But you will now.
Almost always.
Have to move it to schedule C and also pay self-employment tax on any income.
So be cautious there because it's a little bit of a double-edged sword.
Now.
One of the last notes that I'll kind of leave off on with this.
Is.
What is the downside to having the rental on schedule C if that's
what you've been doing, I've heard this from a lot of people.
We didn't know we were putting it on schedule C, but it turns
out it shouldn't have been there.
It's just non, passive.
And non-passive is not the same as subject to self-employment tax.
And only activities that are subject to self-employment tax.
Go on, schedule C there's a couple exceptions there specifically stated.
This isn't one of them.
So if a property has been on, see incorrectly,
If you had income on that property.
And you were paying self-employment tax.
You didn't have to that wasn't qualified.
You did not need to pay that extra 15.3% tax.
The other bigger concern I have.
Is because this was taught so heavily for a few years, because there was this
misconception that it should go on.
See most of the time.
If it didn't really qualify to be on schedule C if what you just had was
a non-passive short-term rental that should stay on schedule E you weren't
doing any kind of substantial services.
If you use that schedule C income to fund a retirement account.
It wasn't valid.
You are only allowed to fund retirement accounts with earned income.
And rentals, even if non-passive are not earned income, it has
to be income paid out of income.
That is subject to payroll tax self-employment tax.
So if you incorrectly had a short-term rental on schedule C.
Take a look at this review, your prior returns.
And see what the big picture impact was.
Did you pay tax for no reason?
Did you fund a retirement account when it really didn't qualify for
you to fund it and talk to your tax professional about sort of the risks
of what has happened or the potential benefits of amending to fix it?
Or the risks of not amending to fix it.
And find out what the correct steps would be to correct it
and move it over to schedule II.
If that is the case.
So that is everything I have for you guys.
I know that this is a lot of information.
There is.
Like I said a lot of nuance around this loophole that is often over simplified.
And I just want to make sure that even if you get this great tax advantage
today, It doesn't end up coming back to bite you four or five years from now.
So that's my summary for you guys.
I hope that you found this helpful.
one final run-through of what you should shouldn't be doing for your short-term
rental and what this loophole means.
If you rent the property for an average stay of seven days or less.
And if you materially participate, it becomes non-passive.
This means losses at creates can be deducted against your other income types
and you don't have that standard limit.
The only limit you can run into is an excess business loss limit.
Step two.
Is that you do a cost segregation study, which pushes a large
amount of your depreciation expense into those first years.
And that gives you a much higher write-off in each of those years.
You can take this even farther by applying bonus depreciation,
which will give you a large amount.
In the first year, between 160%.
Depending on what year the property went into service.
And then kind of the last note to this.
Is make sure you are.
Dotting your I's and crossing your T's.
Track your hours.
Track your cleaners hours, make sure you're not fluffing up your
hours or using investment hours.
And make sure that if you are doing a cost segregation study, Unless you
absolutely have to pay for a full study, go to an actual cost segregation from.
Typically I recommend to avoid the DIY version.
Whenever possible a lot less accurate, you're going to get a lower result
and they're a much higher audit risk.
We've even seen them disallowed.
So that is my recap for you guys.
Fantastic tax strategy.
Absolutely worth looking at.
Make sure you look at it with some foresight.
Look at the next few years.
When to implement it, how it's going to benefit you the time you
transition and make sure that you are putting everything in place.
So that if this has ever looked at, if you ever have to prove that you
absolutely deserved that hundred thousand dollar expense, that
you got to write off this year.
That they have no reason to question it or try to take it away.
So I hope you guys found this helpful.
If you have any additional questions, You can find me on social media.
I'm R E tax strategist on Instagram.
And you can find me at Natalie Claudy on Facebook.
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And reach out with any other topics that you want to hear on a future episode.
Thanks for listening.
And I will chat with you guys next week.