What if we told you there was a real estate tax loophole that would help you write off most of your income without becoming a real estate professional or going through some precarious property scheme? If you’ve heard stories of wealthy investors making MASSIVE profits through rental properties and walking away with a near-zero tax liability, this could be the strategy that they were using. But, if you want to know what it is and how to use it to your advantage, you’ll have to tune in.
We’ve brought on not one but two financial powerhouses to explain the ins and outs of this rental property tax loophole. Brandon Hall, CPA, and Kyle Mast, CFP, have used this exact loophole to shave their tax liabilities down dramatically. The requirements to take advantage aren’t complicated, but you must be a rental property investor of a specific type of property. And not all CPAs will know how to do this, which is why you must find the right one BEFORE you file!
In this episode, Brandon and Kyle will talk about how to unlock this tax loophole, the requirements you’ll need to hit, the logistics of using it, and the red flags you’ll need to keep an eye out for when giving it a go. In a few simple steps, you could eliminate your income taxes in a completely legal way, BUT you’ll want to make sure you follow Brandon and Kyle’s suggestions to a tee.
Listen to the Podcast Here
Read the Transcript Here
Hey everyone. Welcome to On The Market. I’m your host, Dave Meyer, and today, we have a very special new co-host, Mr. Kyle Mast is joining us. Kyle, thanks for joining us today.
Oh, it’s so awesome to be here. It’s a real honor. I just love this podcast. When it pops up in my feed, I listen to it right away. So I’m thankful that I can be on here and talk about a few things with our guest, Brandon, that we’ve got to come on today and it’s going to be a lot of fun, I think.
Awesome. Well, if you don’t know Kyle already, Kyle is a CFP, a certified financial planner and is a regular contributor to the BiggerPockets Money Podcast. If you don’t listen to that show regularly, you should check it out. And we thought, because he is knowledgeable on this subject, we thought we’d bring him in today to co-host, to help me talk about tax strategies.
If you listen to the show, you know that taxes are not really my strong suit. So we thought that having you, Kyle, on to help our listeners understand what’s going on with this cool strategy that we’re going to talk about with Brandon would be a good idea. So you know anything about this tax strategy, tax loophole we’re going to be talking about?
Oh, a little bit. We’re having Brandon Hall on, and this last year, people that listened to the other show know that I sold a firm last year and I’ve worked through this strategy to try to offset some income from that in 2022. It’s kind of where we were going with our real estate investing anyways, but it’s just a great strategy and I like to tell people. I’m a CFP, not a CPA.
Brandon is a CPA, the person we’re bringing on here. And CFPs, our job is to know quite a bit about a lot of different things. Insurance, estate planning, investments, real estate, depending on the specialty. But then when it gets real technical and real detailed, we will pass it off to a specific estate planning attorney or a specific CPA that works specifically in real estate.
And in this case, someone who is an expert in this short-term, quote, “loophole strategy.” And he just does a real good job. His firm that he’s built does a real good job. So I’m excited for this interview. It’ll be great.
Yeah, absolutely. And just for a little preview, so everyone out there knows what we’re talking about. We’re talking about, they called the short-term rental loophole. It’s not illegal or anything, but you’ll learn a little bit about why it’s called the loophole in the course of this show.
But it is a really popular and intriguing strategy because it allows investors who are not, quote, unquote, “real estate professionals.” And that basically means, people who are working essentially full-time as an investor or real estate agent, loan officer, something like that. It allows people who are not real estate professionals to take advantage of some of the tax advantages that real estate professionals do get.
So this is a strategy you can consider. It is the day before Tax Day, this is coming out. So you have 24 hours to implement everything Brandon said. But no, realistically, you’re not going to probably be able to do this for last year, but because people are thinking about taxes right now, we thought it was a good time to share this information with you, so that you can be proactive and plan for next year and maybe take advantage of some of the strategies Brandon and Kyle are going to talk about today.
So we are going to bring on Brandon Hall in just a second, but first, we’re going to take a quick break and hear from our sponsor.
Brandon Hall, welcome to On The Market. Thanks for being here.
Thanks for having me on. I’m excited for this.
Brandon, could you tell us a little bit about yourself? I know you’ve been sort of part of the BP universe for a long time, but can you introduce yourself to those of our listeners who don’t know you yet?
Sure, sure. So my name is Brandon. I am a CPA. I am the CEO of Hall CPA, which is a national accounting firm. We’ve got about, I think we have a team of about 40 or so, and we work with 700 or so real estate investors across the United States. So we are niched in real estate. It’s only, the only thing that we do.
We provide tax planning, tax compliance, and monthly accounting services to real estate investors, small and also extremely large. So we do some fund accounting for some really large real estate funds. So it’s been really cool to watch the business grow and be a big part of driving people’s careers.
But I started the business in 2016. Prior to that I did a few years at the big four accounting firms. I did PwC and EY before I jumped ship and started my own thing. And I’ve just been a very big advocate of creating content and getting education into people’s hands, which I think has been a major driver in growing the firm.
Awesome. Congratulations. I know the firm has been hugely successful and I appreciate all your content contributions to BiggerPockets over the years as well.
Well, I’ve worked with Brandon over, the last few years I actually took a tax course that he put online. I’m a CFP, Brandon’s a CPA. CFPs, we kind of know enough to just be a little bit dangerous and get people in trouble, and then when we need a real expert, we call in someone like Brandon.
And I took a real estate tax course that he put together at his firm, it’s very good. And then this last year I actually had some consulting with his firm, specifically for what, on the internet is kind of called the short-term rental loophole. Don’t love that word. And Dave, if you can think of a better one, we can throw in here, that’d be awesome. But Brandon and his team do a really good job with all of their tax planning.
One of the things I like a lot about them, is that they actually know a lot of court cases that back up some of the strategies that they take, and that really is basically what it comes down to. If you take a strategy that might be conservatively aggressive, if you might want to put it that way, you need to be able to back it up and show that the IRS is okay with it. And that’s one of the things that Brandon and his team do really well.
I’m super excited to have him on, because his strategy was phenomenal for me. And I think a lot of real estate investors don’t understand it completely the way they should. The internet has a lot of inaccurate information on this strategy, so this should be good.
A lot of inaccurate information. Yeah. We’ve been working hard to create content to kind of combat that stuff. But I missed saying in my introduction, that I’m also a real estate investor. I have 25 of my own units. One of those, which is a short-term rental. And a lot of the people on my team too, they have investment real estate.
We’ve got a couple of people, couple CPAs on the team that have short-term rentals as well. So it’s one of those things where, we’re telling people about it, but we’re also doing it ourselves.
All right, great. Well, let me take a stab at trying to explain briefly what the context for the short-term rental loophole is, and then you can laugh at how uninformed I am. But from my understanding, if for real estate investors there is a limit to how much depreciation you can take, unless you are a, quote, unquote, “real estate professional.” Is that correct?
Were close. Yeah. So you can always take all the depreciation you want. You can take that deduction on your tax returns. But what happens is depreciation, the deduction for depreciation often creates a tax loss, when I compare it to my rental income and the other expenses that I have related to that rental property. And the question becomes, “Can I claim that tax loss?”
Because the passive activity loss rules say, that in general, you cannot. That tax loss is going to be suspended and carried forward on my tax return, unless I have other activities that are passive, like rentals that are producing income, or a gain on sale of a rental property, then I can use these tax losses.
So if I can’t use the tax losses because I have to qualify as a real estate professional, they just become suspended, and that’s where people get a little peeved, I guess. Annoyed, because they want to fully optimize.
If I have a $20,000 tax loss, I want to be able to use that to offset my W-2 income or my other business income, because it’s just full optimization. I don’t have to wait to use that at some later point and get the benefit at some later point.
And what is the limit?
So the passive activity loss rules state, that there’s two types of passive activities. And most people don’t realize that these rules even exist until they get into real estate, which is the interesting thing about it. Everybody is subject to these rules, but we learn about it once we get into real estate because we get that first tax return and we see the loss that we can’t claim, and then we start asking questions.
So the passive activity loss rules state, that there’s two types of passive activities. The first is all rentals, unless you qualify as a real estate professional. The second is, any trader business that you do not materially participate in. So what does that mean? That means that I could invest a hundred thousand dollars into a hair salon and I don’t materially participate. I’m not on the board, I don’t make decisions, they just pass profits back to me. That’s passive income, that’s a passive activity.
So there’s no limit per se. What the rules say is that passive income can be offset by passive losses. I could have a hundred thousand dollars of passive income, and a hundred thousand dollars of passive losses and they will net out. But where the trouble starts, is when I have a hundred thousand dollars of passive losses, but I have no passive income, that is where I start tripping these rules and I can’t claim those losses. They become suspended and they carry forward.
There’s a few exceptions to the rules. So if I earn less than a hundred thousand dollars, I can claim up to 25K of the passive losses without having to jump through any big hoops. I just have to own 10% of the activity and I have to make decisions, management decisions. If I do that, then I can claim up to 25K without having to jump through any additional hoops.
So people that are getting started in real estate are often able to qualify for something like that, because they’re in their mid-twenties and they’re kind of at the beginning of their career. But as you start to earn more income, that $25,000 allowance starts to phase out and it’s completely phased out once you reach $150,000 in income.
So when I reach 150K, I don’t get this freebie allowance anymore. And so people start going, “Well wait a second, how do I use these losses?” That’s when they see real estate professional status. But one of the rules to qualify as a real estate professional is you have to spend more time working in real estate than you do anywhere else. And so then people go, “Well crap, I have a full-time job. I can’t outwork myself. I can’t spend an additional 2000 hours in real estate and even if I did, the IRS is not going to buy it and neither will the tax court.”
So if I have a full-time job, I can’t qualify as a real estate professional, which just means all of my losses for my rentals are going to be suspended and carried forward. And that’s where the short-term rental thing comes in. Because short-term rentals are not considered rental activities, I’m doing air quotes, but they’re not considered rental activities under Section 469, as long as the average period of customer use is seven days or less, which is most Airbnbs and Vrbos.
So if I have the short-term rental and it’s not a rental activity, then what I’m doing, is I’m getting around that first piece to the passive activity loss rules that I explained, which was all rentals are passive unless you qualify as real estate professional. But if I don’t have a rental under the code section, I know it sounds weird, you do physically have a rental but not under these regulations, then I don’t have to worry about qualifying as a real estate professional.
And if I don’t have to worry about qualifying as a real estate professional, then I don’t have to worry about spending more time in real estate than anywhere else, because that’s a real estate professional status rule.
So with short-term rentals, I can be working full-time, I can buy short-term rentals, I can create losses through depreciation, accelerating depreciation, and I can use those tax losses to offset my W-2 income, or my business income and any other type of income, as long as I’ve materially participate in those rentals, those short-term rentals.
So when it comes to this short-term rental piece of the tax code, you’re talking around here when you have a rental, but you don’t have a rental, I think I’ve heard you talk about this before, is the reason this is in the tax code, is it kind of fits into more of the small hotel or isn’t that kind of piece… So it’s not skirting a rule here, this is actual a rule that fits a specific type of business.
It’s just now that we have this thing called Airbnb that fits into this tax code rule that was made for a motel on the corner or something like that.
Right. Well, you’re right on it, because what’s really going on is the passive activity loss rules were written in 1986. And so all the draft regulations came out as well and then they kept tweaking them and adding to them over time. They added real estate professional status in 93 or 94.
So I mean these rules are old, and technology enabled us. Enabled everybody to have short-term rentals all of a sudden. So these rules were not written with Airbnb or Vrbo in mind, and that is why we refer to it as a loophole. Generally, don’t like that word, but I believe it is actually a loophole. Not the intent of congress, which also means that at some point it will probably be closed, it will probably be litigated harder over the coming years because everybody’s getting into this and doing this now.
So the whole dot your t’s, cross your i’s, I did that backwards. But you want to do that in reverse and make sure that you can really substantiate taking this deduction, which we help our clients do. And I’m happy to talk about how to do that type of stuff.
So, let’s get into that. How do you take advantage of this loophole deduction?
Well, first you have to understand the concept of material participation. There are seven tests to material participation. The three that we see most commonly used across all real estate investors, are spending 500 hours in your activity, your rental. Spending 100 hours in more than anyone else, or your time is substantially all the time. Meaning that, you spent 50 hours but nobody else did any work. It was just you. You did all the repairs, all the cleaning, all the turnover, everything.
So if you can meet one of those three tests, you are considered to be materially participating. And when you materially participate, you effectively move the activity into the nonpassive territory. Actually, I like to refer to them as buckets, when I’m kind of giving this presentation.
So the passive activity loss rules back in 1986 created two buckets of income, the passive income bucket and the nonpassive income bucket. And in your passive bucket goes all rentals in any business that you don’t materially participate in. In my nonpassive bucket, goes my W-2, my business income, interest, dividends, capital gain, all that type of stuff goes into my nonpassive bucket.
So if I can materially participate in my short-term rental by meeting one of those three tests, 500 hours, 100 hours, more than anyone else or substantially all of my time, or my time is substantially all the time, then I move the short-term rental out of my passive bucket and into my nonpassive bucket. And what that means, is I can now net out all the income in the losses in my nonpassive bucket. So I can use my short-term rentals to offset my W-2 income, offset business, offset gain on business sales, business income, that type of stuff.
So it’s really just understanding the concept of material participation and really the hours that go into it too. When we start talking about this, people go, “Okay. A hundred hours.” Most people with short-term rentals use the 100 hours and more than anyone else, test for material participation. So they want to spend 100 hours in the activity and they want to outwork anybody else in the activity.
So if I have a cleaner that spends two hours a week and I’m turning it every single week, well, that cleaner spending 104 hours. So I need to spend 100 hours and more than the cleaner, I need to spend 105 hours in order to materially participate.
And so people will typically use that test, but they’ll start asking, “Well what counts? What type of time counts for material participation? What type of time doesn’t count for material participation?” And that’s when people either get really excited or really bummed out because it’s a little harder. You have to actually spend real time. We can’t just listen to podcasts.
You can’t just think about it.
Can’t just think about it. Can’t sit here on Zillow all day.
What about complaining about my property manager? Does that count as time spent?
I guess, yeah. Maybe it depends on who you’re complaining to. Yeah, yeah, we got to actually go and swing the hammer.
I’m in the process of firing my property manager. Does that count?
You fired your property manager?
Yeah, for short-term rental.
Does that count?
Yeah, yeah. Well, the time that you spend working on the property or managing the property.
Yeah. Well, yeah.
Searching time is a little tough, because there have been tax court cases where searchers have not, they haven’t allowed the time to count, like researching activities. There was a case where a guy was researching, I believe it was self-storage facilities, and you spent a significant amount of time doing it and they threw all the time out.
So you really got to be working on the rental that you own and you got to spend a good amount of time. You got to outwork everybody else. And the thing too, is that you have to track everybody else’s hours. If you’re going to use a hundred hours and more than anyone else, you got to track everyone else’s hours.
So there’s a tax court case, Lucero versus commissioners back in 2020. I think, it was 2020. Where he was trying to claim 100 hours or more than anyone else. And the tax court basically was just in their written opinion was like, “Even if you did qualify, you didn’t produce any evidence as to what anyone else worked on your property.” They had a property manager. So they didn’t produce any evidence as to how much time the PM company actually spent.
So that’s kind of interesting. Right? Because now you have to go and track time for all your contractors, your property managers. Which smart locks today kind of enable you to do. You can export entry times and exit times with a lot of that stuff. But you got to think about it, that’s the thing.
Yeah. I mean there’s a couple pieces here too, and I don’t know how detailed we want to get into this. What people are going to start realizing as we talk about this, is there’s a lot of little moving parts that you need to make sure are lining up correctly. You kind of glossed over the seven days or less as the average stay for the property and you got to make sure you hit that sort of thing.
There’s another thing, and I’m going to let you correct me if I get this wrong, but as far as like you and a spouse can put in hours and they can both count towards it, but you got to make sure you’re doing separate things.
I’ll take for an example this last year, people on the other show, the money show, know that I sold my financial firm last year. So I sold on July 1st. So the rest of the year I was purchasing some short-term rentals to help offset some of the gain from that and some income as well. And me and my wife went to the property and did a lot of work on two different properties for about two weeks to get them ready. And the idea with that was to really front load a lot of time for 2022, which was our big year that we really wanted to take care of this in.
So there’s a bunch of different pieces here and I guess maybe what I’m trying to say here, is that I want to make sure people are aware that we’re giving them a taste of this strategy and there’s a lot of more information that you need before you really go for it. It’s a very good strategy, it can be very good.
But Brandon, we’re probably, maybe the next thing we should touch on is kind of the depreciation piece of it and how that works. Okay. So we qualify for the short-term rental stuff. That sounds great, but what if I don’t have any losses in my short-term rental? What if it’s making money or what if I depreciate it at 27 and a half years or do I depreciate it at 30 some years because it’s commercial? And then how, what’s this bonus depreciation thing and why is 2022 special?
So maybe I’ll just throw you a whole bunch of things at you and let you have fun with that. But those are some more pieces that you need to know in this situation.
Yeah, yeah. So all really great questions. Most short-term rentals produce a significant amount of cash flow, and they also produce taxable income even after straight line depreciation. At least that’s been our experience working with our clients.
Depreciation for short-term rentals. You’re looking at a 39-year life, not a 27 and a half year life, that is from former reg. section. I’m not going to go into the section, but there is guidance on that. There is a 2011 CCA that talked about it as well.
So 39-year life for short-term rentals, which puts it into and what the IRS considers non-residential property, even though it’s residential. And again, this stuff all sounds weird because it’s like, “Wait, but it is residential.” I know, but the way that the code is written and the way that the regs are written, it’s treated as non-residential property. So that’s one thing to be aware of.
It’s not your regular 27 and a half years, but when you have a 39-year property, you can also, immediately expense qualified improvement property. And you can use Section 179 on roofs, HVACs and fire protection system. Section 179 is what people typically use, to deduct the entire cost of their cars or their trucks that they buy for their businesses.
So if I put a new roof on a 39-year building, now I can immediately deduct that cost of the roof with Section 179. And there’s nuances there, like, “I have to have positive income in order to do it.” So explore that with your CPA. But the point is, is that it’s not as black and white or it’s not as straightforward as just reporting a regular rental property. You’ve got all these additional things that you can be stepping through, when it comes to creating accelerated losses or accelerated deductions.
So on the depreciation side, 39-year property, but when I buy any property I have to, first I have to allocate the cost of the property between the building and the land, because the land does not depreciate over time. It’s just dirt, it doesn’t fall apart.
But my building does fall apart over time, and that’s why we all get this depreciation deduction on our tax returns. It’s meant to track that deterioration of your building over time. Even though the market value’s increasing, it’s also true that the roof is literally falling apart, the windows are literally falling apart, the doors, all that stuff, it all falls apart. So that’s what depreciation is meant, to track over time.
But the thing that you have to kind of consider is if I buy a million dollar beach home, and it comes with a bunch of furniture, because that’s what these beach homes normally do. They just include all the furniture and it just all conveys. So I buy million dollar beach home, it comes with all the furniture, the appliances, all sorts of other personal property. Any rational person would agree that the furniture is not going to last 39 years.
So what I have to do is I have to segregate the cost of that furniture and all the appliances in any other personal property or land improvements. I segregate that cost, out and away from the actual purchase price. And you do this through something called a cost segregation study. That’s where these come in.
It’s basically a look at your building and an understanding that the carpet in your property is not going to last 39 years, it’s going to last five years. So let’s assign a value to that carpet and we will take that value away from the building value, that is being depreciated over 39 years. And so we’ll depreciate this carpet over five years instead of 39 years. Which, if we’re talking about $10,000, that’s $2,000 a year of carpet and it’s not exactly that.
If we have any accountants’ listening to that, they’re probably going, “Oh, that’s not true.” That’s right. It’s not exactly that, but just to keep it simple. $2,000 a year for five years, or I can depreciate $10,000 divided by 39 years, which is, I have no idea what that is, a couple hundred bucks a year? So that’s why you do the cost segregation study to front load the depreciation expense.
But last year, 2022, if you placed a property into service in 2022, you also get to qualify for 100% bonus depreciation, and you can use bonus depreciation on any component with a useful life of less than 20 years. So if carpet has a useful life of five years, then I can 100% expense the $10,000 in the year that I place the property into service. I don’t have to depreciate $2,000 a year for five years, I just immediately write it off. Thanks to bonus depreciation.
In 2023, that 100% bonus depreciation drops to 80%. 2024 it goes to 60 and it keeps dropping 20% a year until it reaches zero, I believe in 2027. So bonus depreciation’s getting phased out, but it’s just a way to accelerate the deduction that you can claim for all the components that are inside of your property. And you typically want to do this even though, you have to pay depreciation recapture at some later point, when you sell the property, you typically still want to do this cost segregation study. Accelerate the bonus depreciation or accelerate the depreciation, take it as much as you can, because of the time value of money.
If I don’t do that, then I’m effectively leaving my cash, my tax benefit, my tax savings, inside of my property for 39 years. And over time the tax benefit’s going to disappear because inflation is going to erode it. We all know we wouldn’t get $500,000 and just park into a savings account. Maybe you would right now, literally right now because the T-bills are four and a half percent, but we’re not going to do that typically. We’re going to just immediately, we want to deploy that cash to guard against inflation.
Yeah. That’s a great point, Brandon. I just want to reinforce what you just said. And I think it’s true not just for the deduction we’re talking about, but just in general, want to stress the importance of deferring taxes even if you have to pay them in the long run due to the time value money, as Brandon said.
And I just want to make sure everyone understands that, what Brandon is saying is, if you do this and you actually defer your taxes, you get to take that money in today’s dollars and you have the potential to invest it into another property, into an index fund, into whatever you want to invest it, instead of basically letting the government hold onto that money indefinitely.
And I know that sounds, may sound like a trivial difference, but it can make a huge difference, especially if it’s a big property. As Kyle was saying, if he’s offsetting a huge amount from a sale of a business, that could make a huge difference in the performance of your portfolio over the long run.
Yeah. Depreciation recapture is rightfully something to understand, but in my experience, not something to fear, as long as you are a good steward of your money. So if you receive a hundred thousand dollars back in tax savings, don’t go buy an Audi R8. Right? Go and invest it in index funds or buy more property.
If you grow the capital, you will typically be fine even when you have that depreciation recapture hit at the end of the day. But the people that buy literal depreciating assets, those are the folks that get crushed with depreciation recapture at some later point.
Maybe to help put some numbers on it. And this is something when I was talking with someone at Brandon’s firm, kind of a general rule, and it can be higher or lower, but just if you bought a million dollar property, just a nice round number in general, what would be the deduction that you would get on that?
As to offset income or in my case a sale of a business, but that doesn’t happen every year, but just say income and you bought a million dollar property and you’re doing this bonus depreciation and you’ve explained that 2022, that bonus depreciation is slowly going away, but typically, what would that give in a deductible savings if you meet all the rules that you need to meet?
Yeah. That’s a great question. I will say as a caveat, I’m not a cost seg engineer, but what we see from the cost seg is that our clients do, is typically anywhere between 12 to 18% of the purchase price on a single-family rental can be allocated to components with five or 15 year lives. Which means that, they would qualify for a hundred percent bonus depreciation.
So million dollar purchase price, call it $150,000. That’s my bonus depreciation deduction. So even if my property cash flows 20,000 bucks, I’m still getting a 130K tax loss, which I can then use to offset my W-2, my business income, royalties, whatever other type of income that I have coming in. I’ve got 130K freed up to do that, assuming that I materially participate in my property.
If you buy multifamily property, that range that I just gave shifts up a couple points. We’ve seen multifamily be anywhere between 20 to 30% of the purchase price. So that’s typically that first year deduction coming out, thanks to depreciation. And that range will tick down over the coming years as bonus depreciation phases out, because the hundred percent bonus depreciation was what creates that large tax deduction.
Yeah. Something else to consider too is when you buy a property, if you’re putting leverage on it, if you’re putting 20% down on a property and then you’re getting 15 to almost 20% back in this tax savings, think about that. That’s a pretty neat strategy. And the depreciation recapture is something to be aware of down the road for sure.
But if you’re being wise with your money and you’re buying a good property, that is going to be an investment for you, for your family down the road. That’s just a huge incentive to go that route.
But you also need to, let’s make sure we don’t let the tax tail wag the dog here because this is a cool strategy, but if you buy a really dog of a property, it’s going to eat that away real fast, especially at the mortgage rates we have now. You can lose that money real fast, real quick and you will have a real deduction. That’s not a fun one.
Well, I mean you just hit a big unlock because if I buy a million dollar property and I put 200K down, but then that million dollar property gives me 150K tax deduction and maybe a cash flow 20K. So I’ve got $130,000 tax loss. If I’m in, I don’t know, California, I’m in 37% tax bracket plus 13% state, I’m talking about a 50% dollar, 50% savings on my 130K. So we’re talking almost $70,000 in tax savings that I’m pulling right back out.
So you can look at that in a number of different ways, but you can kind of look at it like I paid 200K but got 70 back, so I’m only 130 into this property, which is powerful. But you’re definitely right on the, I do want to pause there and just kind of emphasize what you just said about not letting the tax tail wag the dog.
Don’t get me wrong, I love this stuff and I also, I’ve built my business on this stuff, but you absolutely have to understand that you are buying a property that you are going to have to operate. This is not something that I can buy and hand it to a property manager and walk away. You’re not going to benefit from this strategy if you do that.
You have to materially participate, which also means, that you have to have at least a sliver of an understanding about hospitality because we see so many… Some of our clients are guilty of this too, but we see these people just push back on their tenants and be just not good hosts. You have to be a great host, otherwise you’re not going to actually make money. You have to get five star reviews or you’re not going to make money and we’re all in this to make money at the end of the day. We want to build wealth and build income streams.
So if you’re going to get into this, just remember you have to be good at hospitality. And this is the type of thing too, I have one short-term rental. I would love to buy 10 more from a financial perspective because it’s amazing, but I always stop myself when I see another perspective short-term rental because my current one is, I spend, what? Maybe an hour a week managing this thing. It’s really simple to do when you set up all your technology and get all your team in place and everything. Once it’s all set up, it’s relatively easy. So why not buy 10 more?
Well, the one hour occurs at 10:30 at night on a Sunday, when I’m trying to watch Succession. And now, I got to go and troubleshoot with this tenant that can’t get in because the code doesn’t work or the HVAC’s not working or there’s some emergency. It’s not like I can bunch all the time into a Friday afternoon and just knock it all out then. If I could do that, I would buy a hundred more of these things.
So just understand that you’re getting into the hospitality business, the customer service business, and if you don’t feel like you’re good at that, don’t buy a short-term rental, even if the tax savings are amazing.
Yeah. That’s such a good point. It’s a very different business model than rental properties in general. I’ve found, I, like you Brandon, just own one, and I think that’s enough for me right now.
But I have a question about the logistics of this because now I’m scheming in my head, how you can pull this off. It’s basically these tests for material participation, they only have to be passed in the year in which you’re taking the deduction. Right?
Yep, yep. I knew where you’re going. Yep.
Okay, so if theoretically, I wanted to buy a property and I have done this in the past with my short-term rental. I did all the furnishing, I did a ton of renovations myself.
If I did that, let’s say, I bought it in the second half of this year. Did all the work to get it up and running, took the deductions in 2023 and then handed it off to a property manager in 2024. I’m seeing you nodding. Would that work?
It would be a nonpassive activity in 2023 and it would be passive in 2024.
Okay. So you get a hit one year and then it would go away, but okay, just curious.
Yep. That’s a good… Yep. You’re on it. What are you doing the rest of the year? You want to come join our team as an advisor?
You definitely don’t want that.
That’s a good place to go. Brandon, I’ve heard you talk before. The strategy of doing it towards the end of the year and it’s a great way to do it because you can beat the hours of other people pretty easily. But you also want to make sure, I’m going to come on the devil’s advocate side of it, and you want to make sure that you show that you’re running it as a business.
You got, well, I don’t know, you probably have an opinion of how many bookings, but I’d say, three to five bookings that are not your neighbor Joe and your uncle Tom booking the place. You want to make sure that, that is a business that you’ve logged hours and that you can show all of that to be able to deduct those things. But that’s a great strategy to be able to do it in the second half of the year.
And then maybe along with that too, as you’re looking these properties, if this is looking at a very short-term strategy, initially as a tax savings and may, it could be long-term, you could do it year after year, but what are the pitfalls that people should watch out for down the road with this large amount of depreciation that’s in this property?
What if someone wanted to 1031 exchange that property to another short-term rental, another long-term rental? Is there anything that people need to be paying attention to? Because it’s not always about the short-term. You got this wealth building thing, you got to think of what the impact is of your decisions now, years down the road.
100%. Yep. So buying at the end of the year is doable as long as you are going to run it legitimately and get bookings. Three to five is a good range. There’s no bright line tests, there’s nothing that says you have to book it a certain amount of times. I mean, we’ve had people say, “Well, I didn’t book it at all. But the intent was to make it a short-term rental.” And in those cases we’ll just say, “Too bad there’s nothing that proves that this was actually a short-term rental. Your intent, in our opinion doesn’t really matter.”
So you have to actually get bookings. The more bookings, the more that you’re going to be able to substantiate your case, that this is a real business, that you do have real participation. I would just say, get as many as you can. If you’re purchasing last week of December, don’t count on it. Maybe just don’t even put it into service, just wait until the next year to put it into service, so that you can really log your hours and get this work in the right way.
And don’t… There’s a lot of these online groups. There’s ton, in real estate, we love groups, we love entrepreneurship groups that are all talking about wealth building and how to help each other. We have a group actually, so I’m guilty of it too. But in these online groups, it’s very, very easy to get FOMO. It’s extremely easy to get FOMO. Right?
Yeah. “Dave is getting this massive tax deduction. Well, I’m going to go do it too and I’m going to tell my CPA to…” I just want let you know that it doesn’t work like that. And a lot of times too, if you’re hearing me say one thing, and then you’re going to your tax advisor and they’re saying something totally different. One of us is probably correct and one of us is probably wrong, and your job is to figure out who is right and who is wrong. And the one of us that typically comes with citations and tax court cases and reg cites, authority, were the right ones.
So if you’re going to work with somebody that is wrong, you just… Typically, people that are wrong are going to tell you what you want to hear. And we’ve had this happen. We had a whole bunch of people come to us at one point because this group recommended us, and they were like, “Well, I’m buying the property on December 30th and I want to make it a short-term rental.” We’re like, “Yeah, it doesn’t work like that. You can’t do that.” And like, “Well this other CPA said that we can.” “Okay, well go work with them.” If they want to take that chance, that’s fine.
But what’s really going on is if that CPA is telling you or tax accountant. If that tax accountant’s telling you that you can do whatever, they’re telling all their other clients that you can do whatever. And all it takes is just a couple of those folks in that client base to get audited before everybody gets audited. So just be really careful getting that FOMO.
Even though you might want to make it happen, you can’t will this stuff to happen. You actually have to follow the rules and check the boxes. But that end of the year stuff can work, as long as you’re doing it legitimately. You have real bookings. Not like another one that we noticed, it’s two years ago.
So our clients are pretty expansive at this point. We’ve got a large client base, they’re all in real estate and they’re all in these groups. Well, what we realized was people were buying these short-term rentals and they were renting them to each other in the groups.
Oh my god.
Yeah. Because we kept seeing the name, we were like, “Wait a second, that’s one of our clients.” We looked at theirs and they had rented the other ones, is they’re trading these rentals.
Thought you want to make money, why wouldn’t you just rent it out? It’s the easier to do the legal thing that makes you money. Why would… So stupid.
Dave, I wrote a POTUS post about that the other day. I was like, “All this energy that people put into tax savings,” And again, I’m saying this as a tax person, “all this energy that we put into tax savings, we could put into creating income streams.”
It’d be so great. Right? So just do it legitimately. It’s a great strategy if it aligns with what you’re actually trying to do, wealth building wise. And you should do it if you can do it, but if you’re feeling like you’re pushing it, that’s when you should press the brakes and really get more strategic, because you know might be able to do it later or something. You don’t push this stuff, it’s just too much risk.
So when you sell a property, you pay depreciation recapture, you pay a tax on your depreciation that you’ve claimed or could have claimed. Sometimes people go, “I just won’t claim depreciation.” You have to claim depreciation. The IRS is going to assess this tax on you whether or not you claim it. So it’s depreciation that I’ve claimed or could have claimed, plus the appreciation tax on appreciation capital gain.
A way to illustrate this is, let’s say that I bought a home, a rental property for a hundred thousand dollars. Five years goes by, I sell it for $105,000. Now, most people that haven’t gone through this process will automatically default to, I have a $5,000 gain. But accountants and investors that have gone through this process multiple times, ask what is my adjusted basis in the property? Your adjusted basis is basically your purchase price minus that appreciation that you’ve claimed.
So on this a hundred thousand dollars property, let’s say that I’ve claimed $15,000 in depreciation over the five years that I’ve held it. My adjusted basis is 85K. So when I sell it for $105,000, I have a total gain of $20,000 that I have to pay tax on. $15,000 of that 20 is coming from depreciation. That is depreciation recapture. $5,000 of the 20 is coming from appreciation and that’s where I’m going to get those capital gain rates.
It’s really important to understand because it can shock people that are not prepared for it. Oftentimes, people will accelerate depreciation and then forget that they did that, and the sale will shock them. We also see this with people that invest in syndications. So they’ll get a big tax loss and they’ll be like, “Oh my gosh, I love that GP. I love that sponsor group.” Five years goes by, then they cash out, they get a small distribution and a huge tax bill because they forgot about that depreciation recapture.
It’s just, it’s something to watch out for and keep in mind. But you can roll it forward, you can roll it forward through a 1031 exchange and you can keep doing that. And we call what we say, swap till you drop. So just exchange, exchange, die. Because when you die, you get to pass it down to your heirs and they get a stepped up basis, which wipes out all of that recapture and all of the appreciation. So they get started all over. So 1031 until you die.
Wow. Swap till you drop. The new-
Swap till you drop.
Title of the episode right there.
Yeah, it is a good, I like that Kyle. It was good name.
All right. Well, Brandon, this has been super helpful. Something I am going to very seriously consider sometime in the future. Is there anything else you think our audience should know about this really cool strategy before we let you get out of here?
Yeah. Sometimes accountants think that because the treasury regs say that this short-term rental is not a rental activity under Section 469, of the internal revenue code, they think that, that automatically means that the rental should be reported on Schedule C, and that’s not true. Most of these short-term rentals are going to be reported on Schedule E, which is where you report rental activities. Even though, Section 469 says it’s not a rental activity.
If you find that your accountant is reporting this on Schedule C, you should make sure that you’re not subjecting yourself to self-employment taxes. So you can make a workaround in your software to put it on Schedule C and then opt out of self-employment taxes.
But that’s really the key here is these rentals should not be subject to self-employment taxes, unless you are providing substantial services to your guests while they stay at your property. Which would be daily made services, daily room services.
Massages. Yeah. I mean if you’re talking about hospitality, you’re really going to… “Five stars for Dave. The massage was amazing.”
I’ve never done that for the record, that this is getting out there. That was a joke.
Yeah. So if you’re just providing the lodging and then you’re kind of coordinating with the guests to check in, check out, and then you’re putting your cleaning crew in place after they leave, but before the next people check in, that’s a Schedule E activity, that’s a rental. You don’t have self-employment tax. So just be careful. In general, these things should not be on Schedule C.
One more quick thing for everybody too, is if you personally use your short-term rental, you could fall into a very bad trap. So personal use of these properties can limit the loss that you claim. It would limit your deductions to your income, so you wouldn’t be able to claim any loss.
And those rules, even though they probably warrant a much deeper discussion just at a high level, if you spend more than 14 days at the property or 10% of the total rented days. So if I rent it for 300 days, I can spend 30 days, then you trip these rules.
So just avoid personal use. If we want to kind of think about Dave’s strategy, avoid personal use in that year that you’re going to be materially participating, because you would not want those losses to be suspended or limited to the income.
Got it. Awesome. Well, it seems like we’re just cracking the tip of the iceberg here. So Brandon, if anyone wants to learn more from you, I know you’re always putting out great content, where can they find that?
So there are three different places. The first is if you want to check out our firm and our website, it’s therealestatecpa.com. The second is, if you want to get involved in our community, we’ve got a Facebook community called Tax Smart Real Estate Investors, which I think is facebook.com/groups/taxsmartinvestors.
And then the third way, is if you’re just kind of interested in different tax strategies and things, and you want to learn more about what you can do as a landlord with real estate and taxes, check out our podcast, Tax Smart Real Estate Investor Podcast.
We’ve got hundreds of episodes and we actually break the short-term rental strategy down into I think, six different episodes. So very deep dive, if you really want to get technical. You’ll be in one of the top 1% of people that understand this stuff if you listen to all that.
That should be everyone’s goal.
All right. Well Brandon, thank you so much for being here. We really appreciate your time.
Thank you guys. I appreciate it. I appreciate coming on.
So Kyle, what’d you think of Brandon’s advice for all of us?
Oh man, I love it. I love it. I think he just gave such a good primer on that strategy and it’s deeper than what we could cover today, but he just covered what we needed to cover.
And I mean, I’m partial to it because it has really helped me. It’s something that I literally implemented and did a whole bunch of research and I love that he cites things. I just think that brings a lot of clout to the strategy that he’s bringing to the table, and that way you feel like you can do something and not get in trouble for it, that the IRS is actually maybe incentivizing you to do this type of thing.
Yeah. I think it’s great that he is clearly a student of tax law. You would hope that every CPA is, but I think it’s just really fascinating and encouraging to know that he’s done his homework and research to make sure that he really understands this on the behalf of his clients, and on behalf of all of us listening to this.
I think it’s a really interesting strategy. Unfortunately, I don’t think I can do it based on the fact that I live overseas and hire a property manager, but for everyone else out there who owns a short-term rental, and as Kyle and Brandon said, are eager and committed to making that into a successful business, this could be a really interesting strategy for you.
Definitely. He mentioned it being a business too, and we should really emphasize that. My phone goes off, guests message me, the lock doesn’t work sometimes, the housekeeper needs something. You need to order some stuff. If you’re going to run it and be the one that’s materially participating in it, it is a business, but it’s a fun business. I enjoy it, but don’t think it’s not going to be some work.
Yeah. That’s good advice and true of all real estate investing.
I know everyone loves to call it passive, but it is a business and you need to work on it, and you’re, need to make sure that you’re offering a good product out there, whether it’s to tenants or guests or whomever.
So Kyle, it was awesome to have you, man. I appreciate you coming on and joining us.
That’s pleasure to be on. This is a lot of fun.
And just so everyone knows, just as a reminder, Kyle will be a frequent contributor to the BiggerPockets Money Podcast, and if people want to find you off of the podcast network here at BiggerPockets, where should they do that?
Two places the best to find me, kylemast.com. I do some writing there, or just @financialkyle on Twitter. If I’m thinking of something that I think is interesting, I’ll throw it up there.
All right, great. Thanks again, Kyle, and thank you all for listening. We’ll see you for the next episode of On The Market.
On The Market is created by me, Dave Meyer and Kailyn Bennett. Produced by Kailyn Bennett, editing by Joel Esparza and Onyx Media, researched by Pooja Jindal, and a big thanks to the entire BiggerPockets team.
The content on the show, On The Market are opinions only. All listeners should independently verify data points, opinions, and investment strategies.
Watch the Podcast Here
In This Episode We Cover
- The real estate tax “loophole” that allows you to write off a SIGNIFICANT portion of your income
- Real estate professional status and how those that don’t make the cut can still write off BIG deductions
- The requirements you’ll have to hit to realize this real estate tax deduction
- Bonus depreciation, cost segregation, and why NOW is the time to take advantage
- Depreciation recapture and what to do to avoid paying taxes in the future
- Red flags to watch out for when trying this strategy and whose advice you can actually trust
- And So Much More!
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.