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Vacation Rental Tax Shelters

Picture of a log cabin that works as a vacation rental tax shelterPotentially, a vacation rental tax shelter generates extremely large tax deductions for an investor.

Even better, almost anybody can use a vacation rental tax shelter.

Accordingly, this long-ish blog post explains how this tactic works.

To start, though, a quick review of how real estate tax shelters work.

How Rental Properties Reduce Taxes

Let’s say you own a beautiful log cabin in Montana. Say you can rent the property for $2,000 a month, an amount that covers your operating expenses, taxes and an interest-only mortgage.

Specifically, assume that “cash out” equals “cash in” as shown in the table below:

Cash flows from Vacation Rental
Rents Received $24,000
Less: Mortgage $14,000
Less: Property taxes $3,000
Less: Maintenance $5,000
Less: Insurance $2,000
Net Cash Flow $-0-

You might logically guess that this investment has zero tax effect. But tax laws let you depreciate the non-land part of the property. And that might mean you also get to deduct $10,000 a year of depreciation expense for the wear and tear on the property. (Yes, even though the property might actually be appreciating.)

That tax accounting, in fact, might show you losing $10,000 on the real estate investment for the year as calculated below:

Taxable Loss from Vacation Rental
Rents Received $24,000
Less: Mortgage $14,000
Less: Property taxes $3,000
Less: Maintenance $5,000
Less: Insurance $2,000
Less: Depreciation $10,000
Taxable loss reported on return -$10,000

Potentially, that $10,000 real estate loss shelters from taxes $10,000 of other income from W-2 wages or investments.

And that’s the real estate tax shelter. You’re not necessarily losing money. You may even be making money because the property appreciates.

But the tax accounting, mostly from depreciation, puts a ” loss deduction” on your tax return that shelters other income.

Once you understand the basic tax accounting, you want to know about a couple of other wrinkles, too…

When Real Estate Gets Really Interesting to Tax Accountants

Typically, real estate gets depreciated over roughly three or four decades. You depreciate residential property over 27.5 years, for example. And you usually depreciate nonresidential property over 39 years.

Say, for example, that you purchase a cabin for $350,000. Further say that $275,000 of the price represents the building while $75,000 represents the land. In this situation, you deduct $10,000 in annual depreciation.

Why? The $275,000 building component divided by 27.5 years equals $10,000 a year.

However, you can also often break apart the building into the “building” stuff that gets depreciated over decades. And then the “non-building” stuff which gets depreciated more quickly and maybe even immediately.

A $275,000 building, for example, might also be looked at as a $220,000 building with $55,000 of personal property (cabinetry, appliances and furniture).

In this case, the $220,000 building still gets depreciated over 27.5 years. And that produces $8,000 a year of depreciation.

But then the other $55,000 of personal stuff maybe gets immediately written off because it counts as personal property with a short life.

With $220,000 of building and $55,000 of personal property, the first-year depreciation deduction could equal $63,000 (the $8,000 of deprecation on the building plus the entire $55,000 of personal property.)

That might shelter $63,000 in income the first year.

Done right, then, you might buy a cabin or condo, rent it, and then drop a $63,000 tax deduction onto your tax return.

Note: After the first year, note that the annual depreciation deduction drops to $8,000. That $8,000 will probably just shelter the rental income and not any of the taxpayer’s other income from a job or investments.

How Passive Loss Limitations Work

Sounds pretty good, right? Almost too good? Yeah, Congress agrees.

Accordingly, Congress created the  Section 469 “passive loss limitation” rule. It says most people don’t get to deduct these sorts of passive losses unless they have offsetting passive income—such as from another rental property. Or until they sell the property generating the passive losses.

In effect, then, folks can’t necessarily use giant “paper” rental property losses to shelter the income they earn in their regular job or from other investments.

Every Rule Has Exceptions

Exceptions exist to this passive loss limitation rule, however.

I want to briefly describe and identify these exceptions. You want to know what they are.

And then we’re going to focus most of the rest of the discussion on the vacation rental tax shelter.

Exception #1: The Active Real Estate Investment Participant

Okay, a first thing to know. One exception creates a decent-sized loophole for middle-class and many upper-class rental investors.

The Section 469 passive loss limitation rules allow these folks t0 write off up to $25,000 of real estate investment losses as long as they own at least 10 percent of the property and actively participate in the management of the property.

The Tax Adviser has a good detailed discussion here: Maximizing the Use of the Special $25,000 Rental Real Estate Loss Allowance.

But note the taxpayer’s income needs to fall under $100,000 to get the full $25,000 deduction. If someone’s income falls between $100,000 and $150,000, the $25,000 write off amount gets phased out on a sliding scale.

Also, we’re talking about a limited real estate loss deduction here. Not about giant deductions to shelter great gobs of income.

Exception #2: Real Estate Professional

The most well-known exception for real estate investors? Real estate professionals don’t get limited.

In other words, if you’re “in” the real estate business—as an agent, broker, property manager, developer or some other real estate job—and you spend more than half your time and at least 750 hours on real estate? Hey, the Section 469 passive loss limitation rules don’t apply to you.

You can probably deduct your losses. All of them.

Example: You make $100,000 a year as a real estate broker. You lose “on paper” $100,000 on your real estate investing. Your taxable income equals zero. You owe no income taxes.

Interestingly, a married couple gets to deduct losses even if only one person qualifies as a real estate professional.

Example: Your spouse earns a boatload of money annually. Say $500,000 a year. You’re a real estate professional due to your management of the family’s rental properties and “lose” $200,000 a year. The total income reported on your tax return, however, equals $300,000. That’s the number that plugs into the tax calculations.

We talk in other posts here at the blog about the real estate professional loophole. (See Real Estate Professional Audit Troubles and the Real Estate Professional Loophole.) But know that it’s a tricky one to make work. You need to have really good documentation to prove you hit the 750 hours number.

Which is why a third tactic, the short-term vacation rental, makes so much sense to consider…

Exception #3: The Short-term Rental

The short-term rental exception (see 1.469-1T(e)(3)(ii)) says if your average rental period equals seven days or less, tax law doesn’t limit your losses.

Example: You buy a Montana log cabin late in the year, get it furnished, and then sign up for a couple of the short-term rental websites. During November and December, you rent the property for a week three different times. Your rental activity averages 7 days and therefore isn’t limited by the passive loss limitation rules.

If you do your depreciation in a way that puts a $63,000 deduction on your tax return? Bingo. You may shelter $63,000 of income without needing to worry about having passive income or middle-class income or qualifying as a “real estate professional.”

Just to play with the numbers so you see how powerful this is, you could use the vacation rental tax shelter to put a big deduction on your tax return every year.

Recycling the example presented earlier, if you purchased a vacation rental every year, you would drop a $63,000 deduction onto your tax return every year.

And by the way? If you wanted to really jack your depreciation deductions? Sure, you can scale. Ten vacation rentals might produce a $630,000 deduction. A hundred vacation rentals? Well, you do the math…

Achieving Material Participation

One other important wrinkle you need to know about.

You can also lose your ability to deduct losses–even losses on short-term rentals–when you lack material participation in the activity.  Accordingly, you need to materially participate in the short-term vacation rental activity.

You can achieve material participation in a variety of ways. But typically, you have three practical options:

  • You or your spouse spend more than 500 hours a year.
  • You or your spouse spend more than 100 hours a year and no one else spends more hours.
  • You or your spouse is the only person who substantially participates in the activity.

Let me provide examples so you see how this works.

Example 1: You do all the marketing, housekeeping and landscape maintenance. All totaled, this activity only adds up to 40 or 50 hours a year. However, because no one else does more work than you do, your participation counts as “material” even though the total hours over the year are modest.

Example 2: Your spouse spends about a 120 hours over the course of the year renting or trying to rent a vacation home. You guys use two housekeepers: Mary and Margaret. Mary spends about 80 hours over the course of the year. Margaret spends about 100 hours. Nevertheless, your participation counts as “material” because your spouse spends more than 100 hours a year and no one else (neither Mary nor Margaret for example) spends more hours.

Example 3: Same facts as example two except Margaret retires and Mary picks up all of the housekeeping. This means your spouse spends 120 hours a year while Mary spends 180 hours a year. In this case, your participation does not count as “material.” With Mary spending 180 hours a year, you or your spouse would need to spend more than 180 hours a year.

Example 4: Your property is rented nonstop through the year. As a result, your housekeeper, reliable Mary, spends about 1000 hours a year cleaning and washing. The heavy rental use also requires you to hire another worker who does repairs and landscape maintenance—work that he also spends about 1000 hours a year doing. In this case, you need to spend more than 500 hours a year in order to participate on a material basis.

Final Comments and Caveats

Let’s wrap up this discussion…

The main point discussed above? You can use the short-term vacation rental rules to sidestep the passive loss limitation rules and shelter other income.

You can, therefore, use real estate investing not just to build wealth but to shelter from taxes income from jobs, investments, and even retirement plan withdrawals.

And the only two “tricks” to all this? Well, first, one needs to keep the average rental period equal to or less than 7 days.

And then, second, one needs to establish and superbly document material participation.

It’s all something to think about, right?

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