Introduction
Properties available for short-term rental (STR) are an excellent investment option for high incomes. They generate impressive cash-on-cash returns, and the underlying asset typically increases in value as well. In addition to that, they provide individuals who have a large W-2 income with a significant potential to minimize the amount of tax they have to pay.
Utilizing complex tax planning tactics is necessary for accomplishing this task with any degree of success. The right tax techniques for short term rentals might save you tens of thousands of dollars over the course of many years, regardless of whether you are thinking about buying your first property to rent out for short term stays or currently own a few such properties.
This post merely attempts to scratch the surface of a few of the more important factors to consider when it comes to STR taxes. For the purpose of ensuring that you are making the most of this investment and doing everything in your power to get the most out of it, you should make sure to keep your tax advisor informed about any changes to your investments.
Key Points
- Understand the rule behind passive and active loss. Active loss can offset your other income, while passive loss can offset for fewer cases.
- Understand the concept of long term rent and short term rent. Renting out property for less than 7 days is treated as short term rental.
- Understand the depreciation rules and cost segregation. You can accelerate the depreciation with help of cost segregation and bonus depreciation.
- Understand the tax computation and taxation form to capture cost, depreciation and income.
What is Short Term Rental?
Short-term rentals, also known as holiday rentals, are fully furnished houses that are typically rented out to tourists who are looking to spend anywhere from one night to one month (depending on your market). Short-term rentals are also commonly referred to as vacation rentals. The normal length of stay for a guest at one of these rentals is three to five days. People are driven to vacation rentals as an alternative to hotels mostly due to the additional space that vacation rentals offer in comparison to hotels as well as the household conveniences that vacation rentals provide, such as a kitchen and a washing and dryer.
Short Term Rental taxation
From a taxation point of view, there are two reasons why short term rental is more attractive: (1) if the activity of short term rental is treated as active business activity, the loss from short term rental activity will offset any other income you have, and (2) the depreciation of short term rental property generates a significant paper loss.
To be eligible for the advantages of short-term rentals, the owner of the rental property needs to take care of the following:
What are the parameters of my use of the property? Although it is permissible, the manner in which you utilize your rental property for personal reasons (which includes using it with your family and leasing it to charities or selling it at auction) might have an effect on how your STR taxes are calculated. If the owner uses the property for more than 14 days or 10 percent of the total number of days it is leased out – whichever is greater – then certain expenses related to the property may be reduced. If an owner intends to use their property for a total of 20 days during the course of the year, they will need to rent it out for a total of 200 days during the remainder of the year in order to avoid certain constraints. It’s an interesting fact, but you don’t have to pay taxes on the rental revenue you make if you just rent out your personal or vacation home for a period of 14 days or less. The caveat is that the expenses are not tax deductible in any way, except for those that are permitted to be itemized deductions.
Your participation level is important. Your level of involvement in the rental activity will determine how the Internal Revenue Service (IRS) treats your revenue and expenses from renting out your property. Your net passive rental losses can only be used to offset income from other passive activities if you qualify for “materially participating real estate professional”. Rental properties are generally considered to be a passive activity.
Considerations such as your level of involvement in making significant management decisions (decide on rental terms, approve expenditures, and new tenants), as well as the amount of hours you participate in rental activities, will make a difference in whether or not you classify the rental activity as passive or non-passive on your tax return.
If you run your short-term rental more like a bed and breakfast, then the Internal Revenue Service will consider your rental activity to be active rather than passive, and it will not be subject to the laws governing losses from passive activities. You can reduce the impact of other types of income, such as wage income, by offsetting some of your non-passive losses.
How to account for the expenses that are incurred when purchasing the property. In general, the cost of a residential rental building, regardless of whether it is a brand-new purchase or a conversion of a property that was previously used for personal use, is amortized over a period of 27.5 years. Even if the property is a condo, the cost of the structure and the land should be considered separately and priced accordingly. In most cases, the expenses of substantial renovations are capitalized and depreciated over the same period of 27.5 years as the remaining life of the building.
The question “Which rental property expenses are tax deductible?” is one that we get asked quite frequently. When paid, expenses like normal repairs and maintenance, HOA fees, utility payments, insurance premiums, and property taxes are completely deductible (subject to the passive activity limitations). Depending on the size of the property and the amount that was invested, a cost segregation study may be warranted in order to determine whether or not certain parts of the property can be separated and depreciated over shorter lives (five, seven, or fifteen years), which would also qualify for special “bonus” depreciation (a depreciation expense of one hundred percent immediately in 2022).
What is the typical length of time that a tenant stays in your home? If the average lease length of your short-term rental property is seven days or less, you may be eligible for a tax and depreciation break that is not available to owners of other types of properties. If you participate in the activity to a significant degree, the passive activity constraints that were explained previously do not typically apply to the net income you get from the activity.
Whether you own apartments with short-term leases, a condominium, or a lodge in the woods, the tax laws for the treatment of short-term rentals are difficult to understand and follow.
Let us know if we can help you?
Contact Surya Padhi at Sure Financials for any questions and clarification. Surya Padhi is an expert who keeps current on tax law changes as well as a member of the National Association of Tax Professionals National Association of Tax Professionals (NATP) and New Homepage – National Association of Enrolled Agents (naea.org). Visit Welcome | Sure Financials & Tax Services, LLC (surefintaxsvs.com) for more information and contact us by calling +1908.955.0696.
