[0:00]If you own rentals or want to, today I'm going to show you how short-term rentals can legally unlock big deductions this year and how to avoid the traps that get people audited. Stick around to the end and I'll give you a simple seven-step checklist you can screenshot. And if you want help at any time, and you have questions, type consult in the comments, or click the schedule a consult link in the show notes for a free consult where you can talk to an expert. All right, you've probably heard buy an Airbnb, do a cost seg, take bonus depreciation, and boom, you wipe out your W2 taxes. Well, parts of that are true, parts are internet fiction. So today we're going to cover, number one, how short-term rentals become non-passive so losses can offset ordinary income. Number two, what bonus depreciation actually applies to. Three, I'm going to give clear examples with numbers. Number four, the seven biggest gotchas that sink an otherwise good plan, and number five, a quick action checklist. Look, I'm a tax attorney who's seen the good, the bad and the, why did you do that? So let's keep your wealth preserve, protect and prosper. In that fight to keep your hard earned dollars in your pocket and out of Uncle Sam's, few strategies appeal to wage earners more than the short-term rental loophole. Why? Because it can allow for the offset of your W2 taxes, no matter how much you make. While at the same time, investing in valuable real estate. I'm investing in real, real estate. Not single family homes you'll never want to live in, but places you may want to make your home someday. Maybe that you're going to buy a an Airbnb in your favorite vacation spot. Maybe a town where you'd like to retire, right? Like Hawaii, for example. But before we get there, let's explore the mechanics of this loophole. Think of short-term rental tax benefits as two separate lanes. Lane A is your deduction. I am creating deductions in Lane A. I'll get to Lane B in just a second. So when we create deductions, that's when we use cost segregation and bonus depreciation, on the short life pieces of a property. Think furniture, appliances, flooring, land improvements actually work, but buildings themselves, which if you walk into a typical home, might be 27 and a half year or 39 year for commercial or Airbnbs technically, if they qualify, if it's uh hotel. You get a bonus on the short term, and the rest of it you're writing off over a longer period of time. So you don't get a bonus on the 27 or 39, 27 and a half or 39, but the components do. So we have to break them down and quantify each of those pieces. This is also where bonus depreciation, the new 100% deduction under the one big beautiful bill comes in. More on that in just a second. So this is where we create our deduction. Lane B. What do you do with it? What does that mean? All right. Lane B, what do you do with those big deductions? Do you just keep from paying tax on the income you made from your Airbnb? Or do you use those deductions against your W2 or other active income? That's where the short-term rental rules under the passive activity laws kick in. You see, rental activity, is generally thought of as a passive activity, and passive activities create passive income and passive losses. Now here's the problem. Passive losses can only be used to offset passive income with very few exceptions. So passive losses cannot be used against your active income like W2 wages, for the most part. But the regs say if your average stay is seven days or less, then your activity is not a rental activity. It's a trade or business. No different than if you opened up a pizza shop. This makes it non-rental business activity, and if you materially participate, your short-term activity is non-passive.
[4:56]So the losses are no longer trapped as passive losses. They can be used against your W2 income. This is where the short-term rental loophole shines. Lane A makes the deductions big. Lane B lets you actually use them. So, how do I use it? So, first off, you need a property that you place into service as a short-term rental. Airbnb, VRBO, whatever it might be. For each calendar year, you take the total days rented. Hey, I rented it for 200 days, and I divide it by the unique rentals. I did 50 rentals, and that tells you, so 200 divided by 50 is four, right? So did I meet the seven day or less test? Is it less, is it seven days or less? If the answer's yes, then it is a trader business. So let me give you another example. Let's say that you rent your home for six months to one tenant. And then you turn it into an Airbnb and rent it 50 times over the next six months. You add up the total number of days rented, so you take the 180 days in the first six months and say 100 days in the next six months. And you divide that by the number of rentals. So 180 days, plus 100 days is 280 days. Divided by, hey, there was one rental in the first six months, but 50 in the second, so it's 51 rentals. This equates to 5.1 days. So you would qualify. Now, for depreciation and bonus, you start with when the property is placed in service. And what does that mean? Ready and available for rent. So I want you to think about this. It needs to be furnished, cleaned, photographed, advertised, calendar open. It's, it's not the day you close on the property. I bought it, and now I get to start writing off. Hey, that's today it's in service. No, it's the day a real guest could stay. That's when it's placed in service. So if you buy a property in September, say September 10th, and you furnish it and it's finally ready for rent, ready to be rented on October 1st, then it is the October 1st date that is it's placed in service date and the date used for calculating depreciation. So, okay, let's say we meet the seven days or less test, and we know our placed in service date. Well, what next? Well, just because your business is open, it doesn't mean that you are materially participating for purposes of the passive activity rules. You're going to be shaking your head like, what did he just say, right? Just because you have a business, does not mean that you are materially participating. So let me, let me give it to you like this. Let's say I open a pizza, uh, pizza shop, with my buddy Elliot. So we open up our own little pizza, uh, corner, pizza place. I don't do squat, but Elliot is in there day and night, slaving away, making pie. I'm passive, I'm not doing everything. Even though it's a business, right? I'm still a passive participant. Elliot would be considered active because he is materially participating in the business. So for short-term rental loophole to work, I need to materially participate. Otherwise, it's still a passive activity. I won't be able to log those big juicy deductions against my wages. I won't be able to use this. So what does it take to materially participate? Glad you asked, right? Because there's seven tests. All you have to do is meet one of them, and you qualify. You don't have to hit every single one of them, just pick one that fits your life. The common one used for short-term rental loopholes are the big mammoth, the the that beats all others, is if you and a spouse spend 500 hours between the two of you, like you get to add up both of your times. If you're married, if you're single, it's still 500 hours, but you have to do it. But if you're married, you could each do 250 hours. You meet the 500 hour test, you automatically participate. If that's too much, then you can meet a a different one, which is the most common is 100 hours. And you, and again, this is 100 hours between you and a spouse, and it is more than any other individual. That's another one. So, and it's individual, not the company, the management company, it's an individual working for the management company. As long as you do 100 hours, you and a spouse and it's more than anybody else, then you're good. Or, you did substantially all the participation. And yes, on a joint return, you're still looking at at at your spouses. So, I'll give you an example, doctor, doctor working 60 hours a week, working their off. Their spouse cleans and takes care of an Airbnb. The spouse is is materially participating on that. It meets the test for both, right? Because together they met a test. They did 100 hours, or they did substantially all the activity. Or maybe they worked so much that together they did over 500 hours, whatever the case. So if you can meet the material participation test by doing everything yourself or a spouse, cleaning, all that stuff. Or you and your spouse can do 100 hours and more than anyone else, or if you and your spouse do 500 hours of material participation, that automatically qualifies you. Even even if someone else did more, it doesn't matter when anybody else does. Hitting that 500 hours is materially participating. Now, here's a quick warning. That 100 hour rule fails if one cleaner or manager logs more time than you. So you got to track everyone's hours, not just yours. Now, let's move on to bonus depreciation under the one big beautiful bill, because this is huge. Bonus depreciation lets you expense qualifying 5715 year property right away. So you get 100% deduction for 5, 7, 15 year prop, right?
[11:32]I break it down and I say, here's what it is. Recent law restored that 100% deduction. For property that was purchased and placed into service. This is really important, because for this one it is purchased and placed into service, after January 19th, 2025. Right, so you got to confirm the timing and eligibility with your CPA, your tax pro, when you're purchasing and placing items in service. As failing either one simply means that your bonus might not be 100% bonus depreciation. It might be something else. It might be reduced to a lesser percentage. Now, a key point for you. Furniture, appliances, window AC units, certain flooring, land improvements, generally qualify for that bonus. While the building does not. So, I want you to give you an example. I'm walking up to a white picket fenced house. It's a rail house, and I walk up, and I see the white picket fence. I see a big driveway. I see a walkway. I see all these new planted shrubberies. I see new grass out there. I walk in and, it was a beautiful house and it was freshly painted, smells great. I open it up. I walk inside, new carpeting, new cabinets, new appliances. I walk outside the back, and there's a new deck, there's a new fence. There's a bunch of, you know, new shrubs, some, some little trees and things. Now, most people look at that and say, okay, that's a single family residence. It's 27 and a half year property. I'm writing everything off over 27 and a half. No, when you are looking at doing bonus depreciation, you're going to do what's called a cost segregation on it. And you're going to break it into its pieces, the, the, the value. A person like me, walks up to that house. I see a fence. And I might say that's a land improvement. That's 15 year property. Driveway, 15 year property. Walkway, 15 year property. I walk up, I look at the new carpeting, five year property. I look at cabinets, five or seven year property. Appliances, five year property. The electrical that connects them, five year property. The the base, the the concrete base in which it stands, five year property. Um, I I start looking around. I go outside and I see a deck, 15 year property. I see shrubs, 15 year property. The new, the new pitch, 15 year property. The fence, 15 year property. And I break it into its 5, 7, 15 year components, which is usually about 30% to 40% of the value. So let me give you an example. Let's say that you bought a $600,000 short-term rental. The land value, because you can't depreciate the land. Let's just say it was 20%, and we can use the assessment or an appraisal, but just for my purposes, it's $120,000. That means that the depreciable basis is $480,000. You do a cost segregation. So you hire a cost segregation company. They come in there and they say, hey, $90,000 of this, furniture, appliances, carpeting, etcetera, is five-year property. So $90,000 is five-year. $30,000 is seven-year. $60,000 is 15-year land improvements. The balance is the 27 and a half year or 39 year building. What bonus allows you to do, is we added all that up, the 5, 7, and 15 year property. It's $180,000. What it allows you to do is deduct that immediately. If your average stays are seven days or less, and you materially participate, that $180,000 loss is non-passive and can offset wages, business income, gain on other capital assets, even stock. Let's just assume that you're at a marginal tax rate. I'm just going to say 35%. That saves you about $63,000 in federal taxes this year. Boom. So, what are the two steps to make this happen? Number one, you do a cost seg, and you do bonus depreciation to create the loss. Lane A, cost segregation, bonus. Cost segregation, bonus. Number two, you want to qualify under here. What do I do with it? Seven days or less.
[16:24]And materially participate. So I call them Lane A and B, but you hit them together,
[16:38]they are super powerful. To make this more powerful, you you need both. You need a cost seg, bonus, and the ability to unlock it to make it deductible. Your numbers are going to vary on all of your homes, so you want to talk to somebody who knows what they're doing. So talk to a tax pro, uh, tax pro. And this is why so many people love the strategy. You bought a $600,000 home in a great community that you're thinking, boy, I'd love to live there someday, or maybe I want to come visit there. I put 20% down, so I had $120,000 in it, but you saved cash in pocket $63,000. Your guests are paying for the house. You know, so they're paying off your mortgage, and eventually you're going to own it free and clear, which is pretty nice.
[17:42]But there are some landmines, and there could be a nasty surprise. So, number one, this is what I was just talking about, is your personal use. If you or your family use that property more than 14 days or 10% of the rental days, whichever is greater, then your deductions are limited. You can't create a loss with that house because it's considered personal property, or a personal residence. You cannot create a loss when you stay there too much. So, in the year that you want to use that bonus depreciation, I, I know this, and I want to use it, then you want to make sure you do not violate this rule. Number two, hour tracking. You got to keep a contemporaneous log, the date, the task, the time that you spent on the house. Keep vendor invoices, so you can prove you exceeded any one vendor if you're using that that 100 hour test. For a lot of my clients, I say, you just do everything. If it's in your neighborhood, do everything. If it's out of your neighborhood, then you got to do the 100 hour. And you got to make sure you're documenting whoever's there. You could say to the property manager, document your time and don't let anybody spend more than 100 hours this year. Number three, wrong classification. Some properties look like hotels, services like daily cleaning, breakfast served, concierge. That can really screw you up, and that can push your income into schedule C and add a self-employment tax. It's not always bad, right? But just know that it could do it. Like some of you guys make so much money, you're talking about, you know, 2%, 3%. You're not too worried about it. But just know that if you're acting like a hotel, then not only is the income, actress trader, business income, it's just ordinary income, but now it is active ordinary income. It's self-employment income. Number four, state conformity. It's going to throw a loop at you guys. Some states don't follow this rule. Some states don't allow federal bonus rules. So, plan for state add-backs or, you know, lower deductions in your state return. Number five, there's something called equip, which is qualified improvement property. This is only for non-residential interiors. So, you open up a restaurant or something like that. You can write the whole thing off in the first year. Don't try to claim qualified improvement property on a residential short-term renter, uh, rentals interior build out. You don't need to do it. Just get your bonus depreciation, cost segregation done, and then do that. Number six, if you sell this thing, you got to deal with recapture. So when you do bonus on five, seven or 15 year assets, then that can come back to you as 1245 ordinary income if you sell. It's not evil. It just means that whatever the value of that, I have to recognize that as tax, as ordinary income. It's not typical recapture rules where it's capped at 25%. But there's something called a 1245 exchange too, where we can get that down really, really low, so it's just capital gains. But just know that it's out there. Now, what if I use a property manager? Toby, I want to do the short-term rental thing, but I, I got to use a property manager. That's totally fine. But if you want non-passive status, your hours are going to have to hit that 100 hour test. And you got to make sure that management doesn't do the participation for you. In other words, you don't hire somebody and then try to count that time. It is your time. It is you and your spouse.
[21:33]The individual time for each other person working for like the management company, not the management company itself. This is a third party management company. So I'm I'm using somebody else. Everybody that's working for them, you have to track their time. If it's really low, then you don't have to worry about it. But if it's getting anywhere near close, you want to know how much time they spend. So in that's that's if you use the material participation 100 hour test. If you hit the 500 hours material, you don't have to worry about it. You automatically, you don't care about anybody else. But if you're doing the 100 hour test, you're hiring another management company, you need to be cognizant of who is working on those properties. Now, by the way, when we're doing material participation, these hours do not include investor time, stuff that an owner does like bookkeeping. It is the time you spend on the business of operating your short-term rental. So this is like your guest messaging, supply runs, maintenance, vendor coordination, listing optimization, just document it all. Now I want to jump in and do some demystifying by address addressing some common myths around the short-term rental loophole, because it is one of those things that's it's it's running around all over the Internet, right? All of a sudden it's the, it's the it is a very powerful strategy, but it's misused and misstated a lot. So, here's a myth that's out there. Bonus depreciation only works if it's a short-term rental. That is not true. Reality, long-term rentals can use bonus too. The use of the loss, so they both get to use Lane A. Lane B is a little different. Right? In order to do Lane B and offset your W2 with long-term rentals, you might have to be a real estate pro. Or you could qualify under something called active participation if your adjust to gross income is below 150,000. Myth number two, if I hit 100 hours, I'm good. Reality, only if no one else exceeds your hours. So, if you do, you and a spouse and you hit 110 hours, it's great. But if somebody else did 120 hours, you're toast. You're not a material participant. That's how weird it gets. Now, I've never seen, since I've been doing this, I've been doing this close to 30 years. I've never seen a situation where that came up. There but there are some cases, court cases, where it came up. Where the court just didn't believe somebody that was traveling to do, to their condo that was a short-term rental. They didn't believe that they were spending the amount of time. And they just used that as a convenient out. And they said, you didn't track the other people's hours, so I don't believe that you did more time than anybody else. Another myth, three. If it's listed, it's placed in service. No. Reality, it must be ready and available, which means furnished and rentable. Just listing it doesn't mean diddly squat. It has to be ready and available for rent. Myth. I can call it a short-term rental and still vacation there all summer. You can call it a short-term rental. But then using it personal will cause the personal residence caps to apply and limit your losses. So that's the reality. Myth. I will never pay tax on these losses. I'll create all this loss, and I'll never pay tax on it again. Reality, recapture exists. Plan exits like an adult. By the way, you can 1031 exchange this whole thing, and there's also business loss limitation rules. So if you do too much of this, you might have run into caps like, what do I do with the loss? If it's too great, and you don't have other businesses to offset, then it could be a problem. Now, let's discuss how this might fit into your planning. So, most of my audience holds stocks, bonds, cash flowing real estate. The short-term rental tax strategy can accelerate deductions in high income years. For example, my doctor clients love this. So, assume that a doctor is doing really well. Doctor's spouse has the ability to run a short-term rental. The tax savings can be huge for these types of people. Six figures per year easy. Plus, they are building high value real estate. You can create additional cash flows with short-term rentals when you pair it with conservative leverage, right? So, you get all of this. Plus, you can fund other investments with the tax savings. So, imagine that you saved that 60 some thousand, but you bought VOO shares, or you paid down debt, or you put it into, you were able to fund more retirement plans from your employer because you have this, this cash. Now, just remember, we don't chase loopholes. This is powerful, but we align the tax code with your life to keep more of what you earn. That's what it is. It's not about chasing and doing everything you can to get it if it's not for a benefit. What you do is align it and make sure it's something you can do and actually have success. All right. So, I told you I'd give you a checklist. It's kind of a bonus seven-step short-term rental plus bonus depreciation checklist. You ready? Number one, your average stay must be less than seven days, or seven days or less, or otherwise non-passive with another test you must meet.
[27:18]Two, material participation. Pick your test and track hours, yours and vendors'. If you're doing the 100 hour test, probably want to track your vendors as well, just to make sure that you don't run into a problem at some point in the future. Number three, placed in service means ready, available, and listed with the calendar open. Number four, cost segregation. Use a reputable firm. Make sure the components are clearly categorized. Do not use those software programs.
[27:51]Do not use somebody who doesn't know what they're doing, because this, number one, when you use software and you use somebody who doesn't know what they're doing, they're probably not getting you the benefit. My experience is that you get about an extra 10% deduction by using an actual company. Plus, the IRS audit guide tells us you need to use a reputable company. You need to do an engineering study, where they actually walk it. There's all these folks that might go, hey, I can do the cheap route. Your risk goes way up here. If you don't want that risk, use a reputable firm. Now, Anderson does not do it, but we have great partners that we work with, uh, cost seg, uh, CSA partners is one of them. I've done videos. I'll try to put a link or something to some of the videos I've done where we go over cost segregations and why you use someone who just specializes in that. But you want to make for sure those components are clearly categorized. Number five, bonus targets: furniture, appliances, flooring, land improvements. Number six, make sure that your personal use is under 14 days or 10% of the total time that is actually rented. Please. Otherwise, you're going to lose the loss. You're going to lose Lane B. You can always use Lane A, but you're not going to be able to take it over and use it as a loss. You won't have to pay tax on the short-term rental income it's generating, which for a lot of you guys might be enough. But for some of you guys, you're like, I really want to offset some of my W2. Number seven, remember state conformity. They don't all conform. Like, like California does not allow bonus depreciation. There's a bunch of states that don't follow the federal rule, and a lot of them don't have the 100% bonus depreciation. Right? So, be aware, and then your exit plan. Make sure that you're looking at recapture and state add-backs. That's it, right? This is the loophole people have been talking about. The short-term rental loophole. Maybe it's something you can use, maybe it's something that that's not really interesting to you. But now you know how it works and why people use it. If you know anybody who might benefit, share this with them. Please. And if you found this content helpful, please like and subscribe. Feel free to ask questions below, or put your comments. Again, I'm Toby Mathis. Be smart and let the tax code work for you and your family, not against you.
