Unlocking Tax Secrets: How Short-Term Rentals Maximize Depreciation!

Join Diana Tung and Stephen Morris, real estate tax advisors from AdviseRE, as they dive deep into the world of real estate depreciation with a twist—using short-term rentals! Learn why your typical rental is difficult to use for maximum tax savings and discover the loophole that could save you big bucks. Whether you're a seasoned investor or just curious about real estate strategies, this video will give you the insights you need to start saving on your tax bill today. Tap into the secrets of short-term rental strategies below!

Transcript

Hey everybody, this is AdviseRE and I’m Diana Tung.

• I’m Stephen Morris.

This one's for the real estate investors out there. Here at AdviseRE, we love taking advantage of depreciation, but unfortunately, there are some limitations on how much depreciation you can take. So today, we're going to talk about how short-term rentals can help you maximize depreciation.

We get this question a lot: "Hey, I want to use depreciation to lower my taxable income because I don't want to pay anything to the IRS." We love that goal, but unfortunately, it's not available to everybody. Let's briefly discuss the dynamics of what it takes to be able to use depreciation against your income. We have an article below that goes into more detail about the mechanics and the code, but I'm going to give you a high-level overview of how it works.

Normally, under the tax code, all real estate is considered passive. We have these pesky passive activity rules, which under Code Section 469, limit the ability of a taxpayer to take passive losses against their income unless they have other types of passive income. Now, you might be thinking, "Well, then what we can do is turn this into ordinary losses." You might have heard of the real estate professional designation under Code Section 469(c)(7). Unfortunately, to qualify for this designation and take those juicy depreciation losses against your full-time job, where you're earning big bucks as a W-2 earner, you have to meet a certain hour threshold.

To quickly review, we're talking about 750 hours a year in real estate trades or businesses, which doesn't seem problematic by itself, but there's an additional modifier: more than half of your time during the year must be in those real estate trades and businesses. What does that mean? In essence, if you're working a full-time job (assuming 40 hours a week and 52 weeks a year, which totals 2,080 hours), you would have to work well over 4,000 hours a year—2,000 towards your job and over 2,000 towards your real estate—in order to qualify. That's not reasonable. You'd have to be working 80 hours a week throughout the entire year. Very few people have that type of superhuman capability to do that.

Generally speaking, when you're trying to take depreciation losses from your normal passive rentals against your active W-2 income at your high-earning job, the IRS might say, "Sorry, we don't believe you." You probably won't meet this hour threshold. So, are we totally out of luck? Is there no other opportunity for us to take depreciation from real estate holdings against our W-2 income?

Well, there is another option: the short-term rental hack. Everyone's trying to take advantage of this, and Airbnb is a prime example. Typically, if you have a rental property, it's considered passive income or loss. However, if you have a short-term rental (less than 30 days), you're actively participating and renting it out. Instead of reporting this on your Schedule E as a passive rental activity, you get to report it on your Schedule C, turning it into ordinary income or loss on your tax return.

This is an important distinction because, while we both view this operation as real estate, in the tax code, it rises to a different level. It looks more like a regular ordinary trade or business. Generally speaking, it falls under the hotel category. Hotels are certainly not passive; as we all know, it's not like you let the guests check in and your obligations are done. You've got to provide housekeeping, services, respond to guest needs, and maybe even offer food services, tour guides, and other amenities. These are things you're unlikely to see in a typical apartment rental, for example.

The distinction here is the amount of services you are providing in this activity, allowing it to move out of the real estate bucket into an ordinary trade or business, which is something we love. This is a huge, huge advantage. I wouldn’t call it a loophole because you still have to work. I don’t know anyone who's an active Airbnb operator who just lets the property run itself. You have to respond to tenants' needs, be available for emergencies, and manage tasks like scheduling cleaning.

So, when someone buys an Airbnb property, what's the typical tax outcome? Are we then able to use bonus depreciation, and how does that work? Are there any limitations?

It’s great that you mentioned bonus depreciation, which we love to utilize. However, it’s potentially sunsetting in the next couple of years. For tax year 2024, we're at 60%, going down to 40% in 2025, and it's set to sunset to nothing after that—unless the government brings it back, which often happens. We’re really hoping for that. If you're making any improvements, like setting up an Airbnb with furniture and decor, you can take a large portion of depreciation in the first year and offset your other ordinary income.

Not to mention the good old-fashioned cost segregation study that we would do on the entire property. The depreciable life of a home normally as rental would be 27.5 years, but now we're talking about 39 years. This gives us even bigger incentives to do a cost segregation study to move assets like land improvements, shelving, and cabinets into much shorter depreciation periods. That’s where we get a lot of our benefits from as well.

Today, we talked about how depreciation can truly lower your tax bill but is subject to limitations. For you high-earning W-2 earners out there, there is one little loophole you can utilize, and that’s short-term rentals. If short-term rentals sound like something you might be interested in, feel free to reach out to us, and we can help you apply this strategy to start saving on your taxes. Thank you so much for joining us, and we look forward to seeing you in our next video.