The Best Short Term Rental Tax Hack
Short term rental properties are a great investment for high earners. They deliver strong cash-on-cash returns and the underlying asset often appreciates. In addition to that, they also offer those with high W-2 income a massive opportunity to reduce their tax burden.
Key Takeaways:
Short term rental properties can be a great investment for high earners to reduce their tax burden. Using non-passive losses and depreciation strategies can help offset W-2 income.
Material participation in the business is crucial for classifying losses as non-passive. Renting for average stays of seven days or less is an easier option to maintain non-passive status.
Depreciation allows investors to spread the cost of the property over many years for tax savings.
A cost segregation study can accelerate depreciation and maximize tax benefits. Bonus depreciation allows for full expensing of components in the cost segregation study.
Working with experienced real estate tax strategists is essential for success in reducing taxes on W-2 income.
Doing this successfully requires the use of sophisticated tax planning strategies. Whether you’re considering purchasing your first short term rental property or already own a few, the right short term rental tax strategies could save you tens of thousands of dollars for years to come.
Successfully using short term rental properties to reduce the taxes on your W-2 income requires a specialized approach driven by a real estate tax advisor such as Derek Fujikawa. Our firm specializes in this service area and has a proud track record of helping short term rental property investors minimize their tax burden and build wealth.
Key Strategies to Use Short Term Rentals to Reduce Your Tax Burden
Investing in short term rental properties offers several ways to save on taxes and build wealth. A comprehensive tax planning strategy will include all of these. In this guide, we’re going to focus on the two strategies that are most impactful by far: using your short term rental for non-passive losses and depreciating your short term rental property.
Perhaps counterintuitively, you want your short term rental investment to show a loss. These losses can then be used to offset your W-2 income. Now, these losses don’t mean you’ll be actively losing money from your bank account every month; instead, you’ll be depreciating your investment over time.
How to Use My Short Term Rental Property for Non-Passive Losses
Before we explore how to use this strategy, it’s important you understand the distinction between passive and non-passive losses. To unlock many of the most impactful tax benefits, your involvement in your short term rental property must be classified as non-passive.
What are Passive Losses?
Passive losses are defined as losses arising from an investment where you are not a material participant. Losses from long-term rental properties are usually considered passive losses. You can deduct passive losses against your W-2 income, but there are limitations that hinder the effectiveness of this strategy for high earners who aren’t real estate professionals.
What are Non-Passive Losses?
Non-passive losses are defined as losses from an investment (like a short term rental property business), where you are actively involved and considered a material participant. Leveraging non-passive losses provides a powerful strategy for high-earning individuals looking to optimize their tax position.
How to Use My Short Term Rental Property for Non-Passive Losses
Before we explore how to use this strategy, it’s important you understand the distinction between passive and non-passive losses. To unlock many of the most impactful tax benefits, your involvement in your short term rental property must be classified as non-passive.
Passive losses are defined as losses arising from an investment where you are not a material participant. Losses from long-term rental properties are usually considered passive losses. You can deduct passive losses against your W-2 income, but there are limitations that hinder the effectiveness of this strategy for high earners who aren’t real estate professionals.
On the other hand, non-passive losses are defined as losses from an investment, such as a short term rental property business, where you are a material participant. To qualify as a material participant, you must meet one of the following criteria:
You participate in the activity for more than 500 hours during the year.
Your participation in the activity constitutes substantially all of the participation in the activity of all individuals for the year.
You participate in the activity for more than 100 hours during the year, and no other individual participates more than you.
By meeting one of these criteria, you can classify your short term rental property as a non-passive activity, allowing you to deduct the losses against your W-2 income without limitations. This can significantly reduce your tax burden and increase your cash flow.
To ensure you meet the material participation requirements, it’s important to keep detailed records of your involvement in the short term rental property business. This includes documenting the time spent on property management, advertising, guest communication, and any other activities related to the rental property.
Additionally, it’s crucial to maintain accurate records of the average stays, substantial services provided, and rental periods for each guest. These records can help support your claim of material participation if ever audited by the IRS.
Depreciating Your Short Term Rental Property
Another key strategy to reduce your tax burden on W-2 income is through the depreciation of your short term rental property. Depreciation allows you to deduct the cost of your investment over time, providing significant tax benefits.
To maximize the tax benefits of depreciation, consider conducting a cost segregation study. This study identifies and reclassifies components of your property into shorter depreciable lives, such as furniture, appliances, and fixtures. By doing so, you can accelerate the depreciation deductions
Conclusion
In conclusion, utilizing short term rental properties can be a highly effective strategy for reducing taxes on W-2 income. By implementing sophisticated tax planning strategies, such as non-passive losses and depreciation, high earners can save tens of thousands of dollars in taxes for years to come. It is crucial to work with experienced real estate tax strategists who specialize in this area to ensure success and maximize the tax benefits of short term rental properties. Contact Derek Fujikawa for a consultation and visit our website to learn more about how you can use short term rentals to reduce taxes on your W-2 income.
