The Short- Term Rental Loophole Explained

[Julio Gonzalez]

Short-term rentals have become an increasingly popular investment strategy for real estate investors to increase wealth and passive income. STRs have very substantial tax advantages compared to other strategies as long as proper tax planning is done.

Let’s start by getting an understanding of how rental property loss recognition has evolved over time. Prior to the 1986 Act, real estate investors were able to offset their rental property losses against their active income including w-2 earnings and profits from businesses. Rentals were a very attractive tax shelter. Under the 1986 Act, the Passive Activity Loss Rules were introduced. This defined rental income as passive income and no longer allowed rental property losses to offset active income. Instead, they could offset passive income or be carried forward. Eventually, lawmakers realized the negative impact this was having on the real estate sector and created what is known as Real Estate Professional Status (REPS). For individuals that qualify for this, they can use their rental property losses to offset their active income. However, this is a difficult qualification to meet, especially if you have a full-time job outside of real estate.

Don't worry if you aren't able to qualify for REPS status, because there is another strategy that is referred to as a "loophole", which is the STR strategy.

Per Section 1.469-1T(e)(3)(ii)(A): there are six exceptions where your rental property income is not automatically considered to be “rental activity” and thus may unlock the door for being able to offset these losses against your active income.

1. The average customer use is seven days or less.
2. The average customer use is 30 days or less and significant personal services were provided (for example, daily housekeeping).
3. Extraordinary personal services are provided, regardless of the duration of customer use.
4. The rental is incidental to a non-rental activity.
5. The property is available during defined business hours for non-exclusive use by various customers.
6. The property is used in an activity conducted by an S Corporation, partnership or joint venture in which the taxpayer holds an interest.

If your property qualifies by meeting one of the exceptions above, the next step is to demonstrate material participation in the rental activity. There are seven tests, however the most relevant tests for STR investors include:

• Perform substantially all the work related to the activity.
• Participate over 500 hours during the tax year.
• Participate over 100 hours during the tax year and no one else participated more.

If your property meets one of the exceptions above AND you meet one of the above tests, you can qualify to treat your rental activity as non-passive. By doing so, this unlocks the door for having a cost segregation study performed on your property. A cost segregation study is a strategic tax planning tool that separates the assets that have a shorter useful life and can be depreciated over 5, 7 and 15 years from the residential rental property or nonresidential real property that are depreciated over 27.5 and 39 years, respectively. By accelerating your depreciation schedules, you reduce your taxable income which in turn increases your operating cash flow.

So why is this called a “loophole”?

When lawmakers wrote these provisions, they were originally intended to be used by hotels and motels rather than VRBO and AirBnB hosts. They did not anticipate these being able to be utilized for STR owners.

Have you utilized this strategy as an STR investor?