Post-COVID demand for short-term rentals has skyrocketed on sites such as Airbnb and VRBO. Investors are attracted to these properties to generate passive income, and are jumping into the market. Listings are expected to grow another 20.5% in 2022. Since many short-term rental properties are owned as passive investments by non-real estate professionals, any investors should check with their CPAs to be aware of the depreciation rules that apply to the short-term rental market which vary from the traditional tax strategy.
The good news is that depreciation allows investors to realize significant tax savings. Completing cost segregation strategies to maximize these deductions can increase these savings even more. But first, investors should check with their Fuoco & TFG advisors to determine if they will be able to utilize any deductions because limitations on passive investments might reduce the amount of deductions they can utilize. However, if the owner is not subject to the passive limitations, or if they generate enough income, depreciation deductions can help to reduce the associated tax liability.
Typically, a short-term rental was a first or second home in which the owners use online rental services or rental agents to rent out the property. In the past, these properties were usually limited to beach houses or mountain homes, included personal use, and followed the “vacation home rules.” These “rules” assume the taxpayer is also using the property for personal purposes which exceeds the greater of:
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- 14 days per year
- 10% of the total days it was rented to others
- If you are going to dip a toe in the water, first, you must understand the IRS’s eligibility requirements for depreciation deduction properties. The IRS states that eligible properties must:
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- Be owned by you
- Be used in an income-producing or business activity
- Have a finite useful life – meaning it will wear out after a predictable period
- Have a lifespan of at least one year
- Cannot be classified as excepted property, for example, intangible property
If your property is eligible to use depreciation deductions per IRS criteria, you can consider short-term rental depreciation specifics. These can include determining deductions, whether you need to file self-employment taxes, and whether you earned passive or active activity. Each of these elements affects the tax strategy you use to file.
Determining passive versus non-passive activity also affects your depreciation deduction strategy. Most rental activity is considered passive, which means you can only deduct an amount up to your passive income level. There are exceptions to this rule when:
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- You qualify as a real estate professional per the IRS guidelines, and
- You demonstrate material participation
In some cases, the IRS does not consider the activity to be a rental activity, and you must only demonstrate material participation when:
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- The average rental is less than 7 days
- The average period of rental is 30 days or less, and you provide substantial personal services
To demonstrate material participation, the IRS holds several standards you must meet. These include:
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- You participate in the activity for over 500 hours during the year
- Your activity substantially makes up all of the participation in that activity
- You participate in over 100 hours during the tax year, and your activity is not less than any other person’s
If you do not meet exceptions to passive activity loss limitations, your passive rental losses can be deducted against non-passive income up to $25,000 when your modified adjusted gross income (MAGI) is less than $100,000.
- The second issue is to determine the amount of land associated with the property. When a property owner acquires a rental property for $500,000, the entire amount is not depreciable — the IRS requires the taxpayer to separate out the non-depreciable land from the depreciable building. Look at the tax assessment of the property and utilize the ratio of land to building. For example, if the assessment for a property lists the land at $100,000 and the building at $300,000, the IRS would consider the property 25% land. This means that with a purchase price of $500,000, the buyer can depreciate $375,000 of the purchase, with the other $125,000 attributed to the land. If a buyer considers the assessment ratio to be inaccurate, the land could be reappraised to determine its fair market value.
Don’t assume you do not have land because you own a rental in a condominium building. Each condominium owner also owns a share of the common elements, including land, lobbies, elevators, public spaces, etc. Condominium owners may pay dues to the condo association, but the assets are owned by the condominium owners.
- The third issue is that short-term rental owners need to consider is the correct depreciable life to utilize. Most owners assume their rental will be depreciated over 27.5 years as residential rental property. But, according to the IRS, 27.5-year assets are reserved for assets in which 80% or more of the income is being generated from dwelling units. To get the 27.5-year life, these dwelling units cannot be utilized on a “transient basis.” The IRS traditionally defines “transient” as stays of 30 days or less. This means most short-term rentals would be considered nonresidential and have a depreciable life of 39 years, similar to a hotel.
- The Tax Cuts and Jobs Act of 2017 created a new class of property — Qualified Improvement Property. QIP consists of nonstructural improvements to the interior of nonresidential property after the property is placed in service. If a short-term rental is considered nonresidential, this means any interior renovations may qualify as QIP, which is good news — QIP is currently eligible for 100% bonus depreciation and can be written off in the year the assets are placed in service!
- Owners of short-term rentals can look at other ways to maximize depreciation, such as cost segregation studies. Cost segregation allows you to take eligible depreciation deductions on your property assets that depreciate more quickly than the rest of the property like flooring, fixtures, cabinets, and fencing. These studies can help an owner maximize depreciation deductions, offsetting the income generated from the property. In the end, the owner maximizes cash flow, which can be used to pay down debt or acquire additional properties.
CONTACT US: The short-term rental market is heating up again, but before taking the plunge, investors should do their homework and understand the tax implications. Typically, a short-term rental is a first or second home in which the owners use online rental services or rental agents to rent out the property. In the past, these properties were usually limited to beach houses or mountain homes. Now, they may also include properties used as Airbnb or VRBO rentals. Let our experts assist you, depreciation is just one of the many items to consider when building out an investment portfolio. Email CPA@fuoco.com or call toll free: 855-542-7537.