On Tuesdays, for at least the next few weeks, we will blog about tax strategies that high-income investors and business owners may be able to use to reduce their taxes.
This blog post starts that series by talking about a first strategy that many taxpayers can use: vacation rental property.
Vacation Rental Tax Strategy in Nutshell
The vacation rental property tax strategy works like this. You buy a vacation property. So, a cabin in the Rocky Mountains. Or a Florida beach house. Maybe a condo in Hawaii.
You then put the property into a rental pool. Maybe a local property management company. Maybe one of the big international web-based services like HomeAway.com or AirBnB.
You then do your tax accounting in a way that puts large paper losses on the tax returns you file in the early years of your ownership.
Example: You make a $50,000 down payment on a $500,000 vacation rental. On your first year’s tax return, you use depreciation to calculate a $100,000 loss. That $100,000 loss shelters $100,000 of other income showing on your return, including wages.
Tricks that Make Vacation Rental Tax Strategy Work
Tax laws typically limit the business loss deductions a taxpayer claims on a tax return.
And tax law really limits real estate business loss deductions because depreciation tricks allow taxpayers to show paper losses even for properties appreciating in value.
The general rule for real estate related losses? A taxpayer can’t use those losses to shelter ordinary income, such as from job.
However, this limitation doesn’t apply in special situations. And short-term rental property counts as a special situation.
The precise rule? If the average rental period equals seven days or less, the losses on the property don’t get limited automatically.
Example: Two vacation rental property owners hold Florida beach condos. One rented her property for ten times for a week each time. She qualifies for the short-term rental loophole. Her average rental period equals seven days. The other owner rents his condo for twenty times. Nineteen times, he rented the condo for a single week. The twentieth time, however? He rented the unit for two weeks. His average rental period therefore equals 7.35 days. He fails to qualify.
One other rule to be alert to? Even an investor who averages seven days or less for rental periods needs to meet the material participation rules. For example, an investor needs to spend more than 500 hours a year on the vacation rental business. Or an investor needs to spend more than 100 hours a year and no other party can spend more time than that. Other material participation rules exist too. And you’ll want to review those with your tax advisor.
Possible Tax Savings from Vacation Rental Tax Strategy
The depreciation deduction on a vacation rental creates the loss deduction that shelters other income a taxpayer receives.
Example: Married taxpayers use the vacation rental strategy to put a $15,000 loss deduction onto their tax return. If their combined federal and state marginal tax rate equals 40 percent, that deduction lowers their current year tax expense by $6,000.
Typically, residential rental depreciation annually equals 1/27.5th of the building cost. Take the example of a $500,000 property that represents $100,000 of land and $400,000 of building. It probably generates at least an annual depreciation deduction equal to $400,000/27.5, or nearly $15,000 annually.
Turbocharging the Vacation Rental Strategy
Some investors use a technique called cost segregation to break down the building part of the rental cost—so that $400,000 mentioned in the preceding paragraph—into real property and personal property.
Personal property includes appliances and furniture. It can also be depreciated very quickly. Sometimes mostly or entirely on the first year’s tax return.
A $400,000 building for example might be cost segregated into $300,000 of real property that the investor depreciates over 27.5 years and $100,000 of personal property that she or he depreciates in one year or in a very few years.
Note that an investor might execute this strategy each year to enjoy larger tax deductions. An investor might also buy larger properties or multiple properties to increase the size of any vacation rental losses.
Limits to Vacation Rental Strategy
Starting in 2021, however, tax laws limit business losses to the amount of trade or business income a taxpayer generates plus another $262,000 if unmarried or $524,000 if married. (The IRS adjusts these amounts each year for inflation.)
Example: A married couple where one spouse earns $1,000,000 and the other spouse earns $100,000 in a trade or business (like a sole proprietor) would only be able to use $624,000 of vacation rental loss deductions in a single year.
How This Tax Strategy Can Blow Up
While a vacation rental tax strategy generates big tax savings through large loss deductions, taxpayers bear risks using the strategy.
First, and at a practical level, investors need to understand the material participation rules to safely take the loss deduction. Investors also need to do good record-keeping of their participation and the average rental periods in case the IRS audits a tax return.
Second, the depreciation-generated losses created by the vacation rental tax strategy reverse themselves eventually. Usually. That reversal means taxable income when the taxpayer later sells the property. Accordingly, a vacation rental investor wants to be able to delay sale of the depreciated property until she or he sees their income drop.
The Vacation Rental Tax Strategy Works Best for These Taxpayers
The vacation rental tax gambit makes most sense for taxpayers who already maximize their contributions to retirement savings plans (like 401(k)s) yet still want to save additional money.
For example, many high-income professionals (doctors, attorneys, and other professionals), business owners, and even high-earning employees (like professional athletes) may want to make use of the technique. Essentially, using the vacation rental tax strategy allows a taxpayer a large increase in the amounts saved using pre-tax money.
Example: A family includes one spouse who earns $1,000,000 in a W-2 job and another spouse who manages the family’s short-term rental properties and loses (on paper) $400,000 annually. The family adjusted gross income, assuming no other income or adjustments, equals $600,000. And one way to look at these numbers is, that $400,000 of the W-2 income is getting invested, pre-tax, into the family’s rental portfolio if that money pays down mortgages or goes toward down payments or property improvements.
Other Information Sources
The passive loss limitation rules appear in Section 469 of the Internal Revenue Code and get elaborated on in the Treasury Regulations for Section 469. Taxpayers or their advisors need to become familiar with these details to safely execute the vacation rental strategy.
As always, you’ll get great context by discussing a strategy like this in detail with your tax advisor since she or he knows your specific situation. And, finally, if you don’t have a tax advisor who can help, please consider contacting our firm: Nelson CPA.