Navigating STR Loophole Tax Strategy: Success Stories and Cautionary Tales

[Ryan Leake]

Alright guys and gals - this one is juicy (and a bit lengthy), so buckle up,

Today, we're diving into the world of short-term rental tax strategy, exploring both the opportunities for success and the pitfalls to avoid. Let's jump right in.

The Power of Short-Term Rental Tax Strategy:

Short-term rentals offer a unique opportunity to offset your W2 income with real estate losses, thanks to an increasingly popular STR tax loophole.

It works like this:

(1) Save up enough money for a down payment

(2) Buy a single family home that you will Airbnb/VRBO

(3) Ensure the “average period of customer use” is <=7 days

(4) Materially participate

(5) Cost segregate the property, resulting in large depreciation deductions

(6) Use the losses from step 5 to offset your W2 income

What makes this possible is that operating an STR is considered "non-passive." Non-passive losses can offset non-passive income (like your W2). Passive losses can only offset passive income or gain on sale from a passive activity. Real estate, by default, is passive and the primary way to avoid the passive loss rules is to qualify as a real estate professional.

Full-time employees and non-real estate business owners cannot qualify as a real estate professional (aka REPS status) because one of the tests is to spend more time in real estate than anything else (and it’s unlikely that you can convince the IRS or Tax Court that you spent more time in RE than your day job). So they invest in real estate and watch all of the great tax losses get suspended and carried forward.

The short-term rental loophole avoids this issue. Thanks to step 3 and 4 above, the short-term rental will be considered “non-passive” and losses can be used to offset your W2 income.

The problem?

Those people overlooking what it means to “materially participate”

Here’s the Material Participation Criteria:

• Spend more than 500 hours on the short-term rental business
• Do substantially everything for the STR business
• Spend more than 100 hours on the activity and no one other individual spends more time than you do
• Significant participation activity for more than 100 hours, and your combined activity in all significant participation activities exceeds 500 hours
• Participating in the business for five of the 10 previous taxable years
• Personal service activity (non income-producing) for three of the previous taxable years
• Regular, continuous, provable participation in the business for more than 100 hours

A Cautionary Tale: The Story of Jackson

Let's take a moment to learn from the mistakes of others. Meet Jackson, a real estate investor who thought he had it all figured out. He jumped on the short-term rental bandwagon, hired a property management company to handle the day-to-day, and hoped to write off a hefty sum against his W2 income.

However, his journey took a turn for the worse when he got audited by the IRS. Jackson held that he did meet the material participation standard by meeting the “100 hours and more than anyone else” test.

Jackson logged time spent on things like paying bills, coordinating with the property manager, and preparing tax returns. Unfortunately, these are considered “investor hours” and will not count unless Jackson was involved in the day-to-day management.

The Tax Court also threw out Jackson’s driving time between his home and the STRs. Additionally, Jackson inflated hours spent on activities, for example, spending 2 hours shopping for Nespresso pods.

Despite his best efforts to prove material participation, Jackson fell short, ultimately losing his case in tax court. His $43,220 loss was reversed, leaving them with back taxes, penalties, and interest.

Lessons Learned:

Jackson’s story serves as a cautionary tale for aspiring real estate investors. While the allure of short-term rental tax savings is undeniable, success hinges on attention to detail. Material participation isn't just a box to check; it requires active involvement in the day-to-day management of your properties and meticulous time logs of not only the investor’s time but also other parties (like the PM company) activity.

Navigating Short-Term Rental Tax Strategy:

So, how can you avoid the same fate as Jackson? It starts with understanding the material participation criteria and diligently tracking your time and activities. I believe that self-managing your property and maintaining detailed records is the only true way to demonstrate your material participation and safeguard your tax savings. And I'm saying that as an STR manager who wants your business. But I'd rather see you get massive tax savings and then work with you down the line.

We’re Here to Help

If you're still feeling ready to go after short-term rental tax strategy and significantly reduce taxes from your W2 income, don't hesitate to reach out. Whether connecting you with an STR-specific CPA or guiding you through the process of trying to self-manage an Airbnb/VRBO, Host Del Casa is here to help you achieve your goals and navigate the road ahead. Contact info below if you'd like to connect!

Here's to your success,