Summary: For those who follow us, you’ve probably learned about Real Estate Professional Status as a way to shelter income and reduce your tax burden. But for many, getting REPS is simply not an option because of the hours requirements needed to achieve the tax benefit. If that’s you, there’s another potential option: short term rentals. If you’re a high wage earner and not looking to cut back at work (or can’t afford to right now), short term rentals can be a potential option to shelter income. They can provide tax benefits, allowing you to keep more of your hard earned money.
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Advantages of Short-Term Rentals
Like many in our Semi-Retired MD community, you might be aiming to work smarter, not harder.
Instead of handing your entire paycheck to the government for the first four months of the year, you may want to to keep more of that money for yourself. As a result, you are probably exploring the tax benefits associated with real estate.
Some of our students harvest the tax benefits of cashflowing rentals by pursuing Real Estate Professional Status.
However, REPS isn’t always an option because the time requirements make it difficult, if not impossible, to achieve the tax status while working full time as a doctor.
Therefore, many in our community turn to a different option: harvesting the tax benefits of short term rentals.
With short term rentals, you can create large tax shelters just like you can with long term rentals.
For example, if you buy a $1 million vacation rental, using something called bonus depreciation (explained later), you may be able to shelter as much as $250,000 to $300,000 of your income. So, if you make $250,000 of W2 or 1099 income, you’ll report zero income and pay zero taxes as a result of just one rental!
This is a great option to take advantage of tax benefits for those who are single and working full time or a married couple, where both spouses work full time.
We have one doctor, for example, who we interviewed in our student spotlight series who works full time as a GI doctor and has used short term rentals to shelter a large proportion of her and her spouse’s income.
So How Do you Shelter Income?
I’ll break it down into four easy steps.
- The first step is to buy a short term rental.
- The second step is to materially participate in that rental.
- The third is to generate losses, ideally paper losses.
- The fourth is to find a savvy tax accountant who understands how to use these losses to shelter W2 or 1099 income.
Let’s look at each step in more detail.
Buy a Cashflowing Short Term Rental
This may sound straightforward, but the trick is to ensure that you must buy an asset. According to Robert Kiyosaki of Rich Dad, Poor Dad, an asset is something that puts money in your pocket.
This may sound relatively straightforward, but most newbie investors get this wrong. They just don’t know how to analyze deals properly or they don’t know how to buy a property the right way. So what happens is that they overpay for a property or after they buy it, they realize that it doesn’t cashflow.
In our course, Accelerating Wealth: Short-Term Rental Blueprint, we teach you how to buy a property the right way. You learn how to consistently acquire assets, not liabilities. You do that by thinking through the consequences of every major decision you make.
With short term rentals, this is especially important because of the risk that you can no longer use your property as a short term rental.
We regularly hear stories of doctors who buy properties and later are hit with the news that the City shut down short term rentals. In an instant, your short term rental business is shut down, and you’ve got a big liability on your hands. And it’s not just governments, you can also run into an unfriendly homeowner’s association that votes to shut you down as well.
So the key is, learn how to buy your short term rental the right way. Always ensure that you are buying an asset. Use our Short-Term Rental Cash-on-Cash calculator to be sure your investment will be an asset.
Materially Participate in Your Short Term Rental
What the heck is material participation?
Material participation for tax purposes are the rules the IRS uses to determine if you worked on your short term rental business “on a regular, continuous, and substantial basis during the year.”
There are seven different tests, which you can read about HERE but the ones that most accountants use are the first three and these are:
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
What is the Most Common Test Used to Shelter Income?
For the doctors in our community, most go for test number 3.
They buy a short term rental and aim to work on it more than 100 hours. Also, they ensure that they spent more hours on the property than anyone else.
So for example, if you rent a house 40 times in a year and you hired house cleaners who spent 3 hours each time cleaning your house, they will have spent 120 hours cleaning your house. You would need to ensure that you spent more than 120 hours. You should do the same with all other people you employ. Ensure that you spend more time on the property than they do.
This essentially means that you have to self-manage your short term rental that calendar year. Maybe also even do some of the cleaning yourself if the hours are close.
One strategy we’ve seen doctors use is to aim to rent their property about 50-60% of the time. They achieve this by setting a high nightly rate. This allows them to maintain revenue and profits while decreasing the wear and tear on their property. Their cleaners and anybody else they employ, such as handymen, also aren’t going to be required as much as if it’s occupied 100% of the time.
Generate Losses, Ideally Paper Losses
The next step is to generate losses from your short term rental.
Ideally these losses are phantom or paper losses. Therefore, the losses don’t result from money out of your pocket.
For example, a repair or renovation is real money out of your pocket.
If you use a home office for your short term rental, this can be treated as an expense. However, it doesn’t take any extra money out of your pocket because you are already paying for your house.
Another example of a paper loss is depreciation.
Depreciation is the value your property loses in value over time (even though it’s probably appreciating).
The IRS allows you to treat depreciation as an expense. Then there is bonus depreciation. This allows you to generate massive paper losses on your property using something called cost segregation. To read more about how this works, read our article on cost segregation and bonus depreciation.
We showed you an example earlier of how you can use bonus depreciation to create a $250,000 loss on a short term rental that you buy for $1 million, sheltering $250,000 of your income from taxes.
This is how you work smarter, not harder.
Find a Savvy Real Estate Tax Accountant to Maximize Tax Benefits
Some might argue this is the first step, however, we think you need to fully understand how the first three steps work in detail before choosing your tax accountant.
The reason is that there are many accountants out there who don’t know about short term rental tax loopholes. Others don’t know the rules well enough. Consequently, they may not give you the full tax benefits that you are entitled to when filing your taxes.
You can dig deeper and educate yourself before interviewing accountants and choosing one who will help you achieve your goals.
Now you know the first four steps to sheltering income using short term rentals!
So is a short term rental your next investment? Be sure to join our waitlist to enroll in the next Accelerating Wealth course. We’ll teach you how to use cashflowing rentals to work smarter, not harder. Learn how to put more of your hard earned money in your pocket using the tax benefits of real estate investing!
Have you found a way to creatively fund your real estate portfolio and achieve financial freedom? Join the conversation! Follow our Semi-Retired MD Facebook page and join our Doctors or Professionals group!
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