Here’s a wild loophole for short term rentals…

Step 1: Buy a $500k house with a $100k downpayment.

Step 2: Write off ~$150k year one on your taxes and have it offset your W2 income.

Wait, what? How? Let’s talk about it…

This is an expansion on my friend Mitchell Baldridge's thread, here.

This message piggybacks on the earlier email on DEPRECIATION. Read that first here if you missed it.

Short term rentals are defined by the IRS as properties with an average stay of less than 7 days. They buck the passive rules for Section 469 (of IRS tax code), and are considered active.

As you know - most depreciation deductions are considered "passive" and can't offset W2 income or active income from your business if you're not a "real estate professional".

BUT - as with any other business, to deduct the losses the owner must materially participate. That involves time requirements (annually) that can be met if you work with your CPA to track them correctly:

Time Requirements

Material participation is achieved by:

1. Spending more than 500 hours in the business

or

2. Spending more than 100 hours and more than anyone else, or substantially all the time in the business.

If you own an STR and meet the test, you can set up a tax deduction machine.

A couple of issues to consider first:

• You have to count your time and the time other people work in the business (cleaning, maintenance, etc..)
• If you use the property more than 15 days or 10% of the time it becomes a residence.

Don’t try to skip these steps or fudge the numbers. I’m not saying the IRS will come knocking, but you don’t want to give them a reason to start.

Active losses

The ability to defer taxes in your highest earning years without having to put money into qualified retirement accounts is a great way to build wealth.

So, if you own an STR:

1. Keep good accounting of your money and your time spent on the business.

2. Do not stay in the property for more than 15 days.

3. Complete a Cost Seg study - combined with leverage, it is feasible to deduct your entire equity contribution in year 1 because 20-30% of the total cost of the property is also eligible for bonus depreciation.

This is a huge advantage for non real estate professionals. And why buying short term rentals can be extremely lucrative from a tax savings perspective for high income earners.

How do I feel about the short term rental space in general?

As with anything - great operators and savvy buyers can do REALLY well in the space.

But rookies who are undercapitalized and just hire third party management could really struggle to hit the returns they need to be profitable. I own one property in Upsate NY that I stay in sometimes and rent out on Airbnb on the side. It is definitely not a profitable business and I got a GREAT deal on the property (I paid $380k fully furnished) and its right next to a Nascar race track with events weekly.

I did get a cost seg study on the property and got a $105k year 1 deduction, which was great. But the property did $28k in revenue last year and I had $27k in interest and costs related to the property. Counting principal payments, I was cashflow negative.

I think folks need to be careful about it - especially with high-end vacation homes. I also hate how an owner only sees 60% or so of the value created through the rental because of fees to Airbnb and management companies which charge upwards of 25% of revenue. I'd never pay a management company to oversee my property for that kind of expense.

Onward and upward,

Nick

P.S. I got all my cost seg studies done by RE Cost Seg. They're also the sponsor of this newsletter. They do virtual visits with quality engineering to get you maximum deductions at a great price - check them out.