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Do You Materially Participate In Your Short-Term Rental?

short term rental tax

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One tax strategy high income W2 employees who do not qualify as real estate professionals can implement is utilizing depreciation on short term rental properties to create losses that can be offset against their W2 income.

When done right, this strategy can result in a taxpayer creating tax savings equaling a substantial portion of their upfront investment. 

To implement this strategy, two criteria must be met.

First, the property must qualify for an exemption from the typical rental property classification by the IRS

There are 6 exemptions that can be utilized with number 1 being the most common for this strategy. 

  1. The average rental period is 7 days or less. 
  2. The average rental period is 30 days or less, but significant services are provided. (Think hotels)
  3. Extraordinary personal services are provided. (Think nursing homes)
  4. The rental is incidental to a non-rental activity.
  5. The rental property is available during defined business hours. (Think golf courses, health clubs etc.)
  6. The rental is provided by taxpayer to their own business. 

The second criteria that must be met is material participation

The material participation test is looked at on a year-by-year basis. There are 7 tests for material participation. The first 4 tests are the ones most commonly used for this strategy.  

  1. The taxpayer must work 500 hours or more during the year on the activity.
  2. The taxpayer does substantially all of the work in the activity.
  3. The taxpayer works more than 100 hours in the activity and no one else works more. 
  4. The activity is a significant participation activity (SPA). The total of all hours worked in SPAs with 100-500 hours exceeds 500 hours for the year. 
  5. The taxpayer materially participates in any 5 of the last 10 years. 
  6. The activity is a personal service activity and the taxpayer materially participated in any 3 prior years. 
  7. The taxpayer participates on a regular, continuous, and substantial basis during the year. This applies if they also meet the 100 hour test, no one else worked more hours, and there was no property manager hired.  

What can you do to make sure that you meet material participation?

  • Time Log – keep a detailed time log that shows what work you did and what day you did it. The more detailed your log the better. Note that investor type activities generally don’t count and neither does travel time to or from your property.
  • Don’t hire a property manager – hiring a property manager makes it very hard to claim that you met the material participation test. 
  • Have enough time to manage to property away from other businesses/ your W2 – if you have multiple other businesses or a job that takes up a lot of your time, you may want to consider finding ways to free up your time so that you will have availability to manage your short-term rental.
  • Buy a property close to where you live – it is hard to justify that you materially participate when you live far away from your property. This is because the IRS requires you to be integral to the operation of the property and it is unlikely that you are integral if you live hundreds of miles away.
  • Be capable of managing the property – have the skills and physical ability to do any needed tasks.

Don't invest just for the tax savings

This should go without saying, but never let the tail wag the dog with tax planning. Think first “is this a good investment?” then start looking for ways to capitalize further through tax savings.

While we’ve got you here, why not take a look at our real estate CPA services.

Disclaimer

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.

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