Tax benefits are one of the primary reasons many doctors invest in real estate. The U.S. government incentivizes real estate ownership as it is considered starting a business, which creates jobs and increases tax revenue. One way to achieve significant tax savings is by becoming a real estate professional, but this is impossible for those working full-time. An alternative option for these individuals is short-term rental properties.
A short-term rental (STR) is a property that is rented out for less than seven days on average. With the rise of platforms like Airbnb, it is now easy for individuals to rent out their vacation or second homes on a short-term basis.
The short-term rental tax loophole can be found in the tax code under Reg. Section 1.469-1T(e)(3)(ii)(A) and defines exceptions to the definition of “rental activity.” According to TheRealEstateCPA.com, six ways that income from a rental property can be excluded from the definition of a rental activity are:
1. Customers utilize the property for no more than seven days.
2. The typical length of time a customer uses the property is 30 days or less, and the owner of the property, or someone acting on their behalf, performs substantial personal activities to make the property available for customer use. This could include amenities like daily housekeeping or meals, which hotels offer.
3. To make the property available for use, extraordinary personal services are rendered by or on behalf of the property owner (without regard to the average period of customer use).
4. The rental of such property is treated as incidental to a non-rental activity of the taxpayer.
5. The taxpayer usually lets different customers use the property during set business hours, but not exclusively.
6. The provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not a rental activity.
A physician may find it challenging to become a real estate professional because they cannot devote half of their working hours to real estate. This is where the short-term rental tax loophole can be helpful. However, it is important to note that to claim the tax deductions against ordinary/active income, you must “materially participate” in the short-term rental business.
There are seven ways to accomplish this, but only one of them is required to establish meaningful participation for the tax year.
The seven material participation tests are:
1. You worked in the short-term rental business for more than 500 hours.
2. Your activity constituted all participation substantially for the short-term rental business.
3. Your participation was greater than 100 hours and equal to that of any other individual.
4. You must have more than 100 hours of substantial involvement activity and a total of 500 hours of significant participation activity.
5. You participated in the activity in five of the last ten years.
6. Personal service activity (non-income-producing) for three of the previous taxable years.
7. You worked more than 100 hours on a regular, continuous, and considerable basis throughout the year.
Once you pass one of these tests, your short-term rental is no longer considered a rental activity and is no longer passive. Remember that the goal is to use a short-term rental for losses that are not passive, as these losses can be used to offset non-passive income.
If you can pass one of the seven material participation tests, you can now use a cost segregation study to generate losses on your short-term rental (STR) through depreciation. Keep in mind that the study’s objective is to identify all construction costs that can be depreciated over 5, 7, or 15 years instead of 39 years. This is a powerful strategy because a 5-year or 15-year property can usually be worth between 20 percent and 30 percent of the price of a property.
For example, if Dr. STR buys a beach home for $1.2 million, his CPA, who is knowledgeable about real estate, suggests that he use bonus depreciation which could shield between $250,000 and $300,000 of his hospital income. Even though he makes about $300,000 in W2 income, he might not have to pay much or any taxes due to this one rental. For example, if you did a cost segregation study on a $1 million property, anywhere from 20 to 30 percent could be fully depreciated, giving you a $250,000 tax deduction.
In summary, using the short-term rental tax loophole is a good way for physicians to pay less tax overall. The key to making this strategy work is to get help from a real estate CPA or lawyer who can guide you through the process. One of the few ways to save 5–6 figures on your taxes without working full-time in real estate is to invest in short-term rental (STR) properties and use the STR loophole. And because some parts of this strategy will begin to phase out over the next few years, now is the time to act.