YFP REI 113: Short Term Rental Tax Loophole

Amanda Han and Matt MacFarland, Founders and managers of Keystone CPA, Inc. share short term rental tax tips and implications.

Episode Summary

In this episode of Your Financial Pharmacist Real Estate Investing Podcast, we talk about vacation homes and what they could mean for you and your taxes. We decided to go all-in and dive into the tax implications relating to short-term rentals, and we couldn’t think of a better pair to join us for this conversation than the vastly experienced and widely knowledgeable CPA duo, Amanda Han and Matt MacFarland! Amanda and Matt are the founders and managing directors of Keystone CPA, Inc., a financial advisory firm centered on the tax strategies of real estate investing. Join us as we define “depreciation” and “short-term rental,” compare the tax benefits of short-term and long-term, find out how holiday homes fit into the picture, tell you everything you need to know about material participation, and discuss the benefits of doing your tax planning and research before the end of the year. We also learn about the implications of changing your property from short- to mid- to long-term rentals, and after honing in on the strategies for maximizing tax benefits in investment partnerships, Amanda and Matt still have some tricks up their sleeve as they share more valuable tax-saving advice!  

About Today’s Guests

Amanda Han & Matt MacFarland are CPAs and tax strategists who specialize in helping people use real estate to save massive amounts in taxes and keep their hard earned money. They help educate investors on how to maximize tax write-offs, legal entity strategies, tax-efficient ways to access profit, how to use 401K money for real estate, and much more.

They are authors of the highly rated book Tax Strategies for the Savvy Real Estate Investor and they have been featured in prominent publications including the Forbes Finance Council,  Money Magazine, Talks at Google,  CNBC’s Smart Money Talk Radio as well as the BiggerPockets podcasts.

Today, Amanda & Matt have helped thousands of investors nationwide to save on taxes with proactive tax planning. 

Key Points from the Episode

• Why we’ve chosen to talk about the tax implications of short-term rentals. 
• Defining depreciation and why it’s a tax planner’s best friend.  
• Our guests share their definition of “short-term rental.” 
• Assessing the tax benefits of short-term rentals versus long-term rentals. 
• Rules surrounding holiday homes and other short-term rental nuances and exemptions.
• Understanding material participation and honing in on the importance of tax advisors. 
• Delaying tax: what it is and practical examples of how it works.  
• How to embrace and maximize depreciation on a short-term rental. 
• The benefits of doing your research before year-end and/or tax-filing season. 
• Exploring the implications of changing a property from short-term to mid-term to long-term. 
• Taking a look at investment partnerships and the strategies for maximizing tax benefits.
• More tips, tricks, and tax-saving advice from Amanda and Matt!

Episode Highlights

“From a tax planning perspective, depreciation is our best friend.” — Matt MacFarland [05:30]

“[A] short-term rental, contrary to popular belief, is not every single property that’s listed on Airbnb or Vrbo.” — Amanda Han [07:20]

“Our goal when we take depreciation is – we’re trying to accelerate our expense, save our taxes now, use [those] savings, reinvest, go buy more income-producing assets, build our wealth faster, and kick the tax can down the road.” — Matt MacFarland [19:18]

“Oftentimes, we hear CPAs say not to invest in real estate because you don’t get the tax benefits. When you hear that, it’s important to understand that that CPA is only looking from a tunnel-vision perspective.” — AmandaHan [32:15]

“There’s always tax benefits to investing in real estate, it’s just a matter of when.” — Amanda Han [33:09]

Links Mentioned in Today’s Episode

• Amanda Han
• Amanda Han on LinkedIn
• Amanda Han on Instagram
• Amanda Han on X
• Matt McFarland LinkedIn
• Keystone CPA, Inc. 
• The Book on Tax Strategies for the Savvy Real Estate Investor
• ‘Episode 109: How Two Pharmacists Pay No Income Tax through Real Estate’ 
• ‘Episode 18: Tax Strategies for Real Estate Investing’ 
• Animals for Armed Forces 
• Airbnb
• Vrbo 
• ‘Episode 54: Using Cost Segregation to Optimize Real Estate Tax Benefits’
• Nate Hedrick on Instagram
• David Bright on Instagram
• Your Financial Pharmacist
• YFP Real Estate Investing Facebook Group

Episode Transcript

[INTRODUCTION]

[00:00:08] NH: Welcome to the YFP Real Estate Investing Podcast. I’m Nate Hedrick.

[0:00:09] DB: And I’m David Bright. We’re both pharmacists and real estate investors that believe that real estate investing does not have to distract from a meaningful career in pharmacy.

[0:00:18] NH: Each episode we share stories that educate and inspire pharmacists to leverage real estate investing as a part of your financial plan. Hey, David. How’s it going?

[0:00:27] DB: Good, thanks. How’re you doing, man?

[0:00:28] NH: Great. I’m doing really well. We just got done with Thanksgiving here as we’re recording, and it’s starting to get snowy outside. Of course, I’m thinking vacation, vacation rental homes. Right? We’ve talked about this a bunch on the podcast before, but this season makes me extra think about it.

[0:00:42] DB: Yes, it’s a super enticing investment strategy. You’re creating memories, you’re using that short-term vacation destination for yourself, but then also as an investment. Back on Episode 109, we both had one of those, what I think is probably one of our top 10 most jaw-dropping moment on the podcast so far. Where we heard Julia and Brad describe how they bought a short-term rental, they leveraged the tax benefits of it, and they paid no federal income tax for their two-pharmacist income family. It was just mind-blowing.

[0:01:13] NH: Yes, absolutely. We got a lot of questions about that, and people that were interested as well. So we figured, why not bring back two experts to really dive into this, talk about short-term rentals, talk about the tax advantages. So we pulled some pros from way back in episode 18, Amanda Han and Matt MacFarland, two tax professionals that just really know this stuff inside and out. They’ve authored some fantastic books. We mentioned that on the show. We want to make sure we dive through this stuff to really talk about how this might be a key strategy that would let a full-time pharmacist delay their income taxes, and leverage those tax advantages that come from promoting a short-term rental. 

[0:01:50] DB: Yes. When I first read Amanda and Matt’s textbook, I think that that helped me to understand more and more, I need to work with a CPA that understands real estate really well. That helped me to have a much more informed and productive conversation about tax strategy. Today’s interview for me was on that similar path, where if I decide a short-term rental is a good thing for me at some point, then, now, I have a better idea of the tax concepts, and the guardrails, and the rules behind that, and when I need to bring a CPA into that discussion.

[0:02:20] NH: In that last part, I think is the most important thing. When to bring that CPA in and honestly, just making sure you are bringing a CPA into that discussion. Matt and Amanda I think were really helpful in this episode, and drilling down into the complexity. I mean, I feel like we’ve just scratched the surface in some of the complexities. Knowing that, knowing that you need to be able to have a proactive conversation with your professional, it’s just critical. I mean, you have to make sure you’re not going to mess yourself up by going down this road in the wrong way. Then you get the tax season, and you can’t fix it. It’s good to highlight that upfront, and we hit on that a couple of times in the episode, I think.

[0:02:53] DB: I think that’s just really helpful. Even those considerations of, it’s not that you’re paying no taxes ever, is that you’re paying no taxes this year, and you’re delaying those taxes into the future. Even concepts like that, I think are really critical. Even just the concept of talking with your tax professional. I thought, when I first started out in real estate investing, that talking with your tax professional was something you do once a year in January or February when you deliver your stack of papers and all those things to your CPA.

I didn’t realize until I read their book that there was so much more about strategy, and there’s proactive conversations that go into this. Particularly, if you’re thinking about something that is as complex as the short-term rental loophole, I think this is a perfect opportunity to have those proactive conversations multiple times around when you’re purchasing. When you’re putting into service, when you’re doing a cost seg analysis, like all those kinds of things to make sure that you are dotting your I’s and crossing your T’s and getting the benefits that you expect from the real estate investment.

[0:03:53] NH: Yes. I think Matt and Amanda in this episode really kind of – they do it in an entertaining way too. It’s rapid fire, they go over some stuff quickly, a couple of jokes that are in. It keeps it anything but a dry tax lecture, which is I think what we’re trying to avoid. Hope you guys enjoy the episode as much as we enjoyed recording it, and maybe take a few tips away with you into 2024. Enjoy.

[EPISODE] 

[0:04:15] NH: Hey, Amanda and Matt. Welcome to the show.

[0:04:16] AH: Yes, thanks for having us again.

[0:04:18] MM: Thanks, guys. It’s good to be back.

[0:04:20] NH: We last had you guys on nearly, it’s almost 100 episodes back, I just looked. You’re on episode 18. Here, recording for Episode 113. Just really excited to have you guys back on. If anybody missed that episode really encourage you to go back and take a listen. Matt and Amanda go through a bunch of great information. They’ve published several books through BiggerPockets Publishing, like The Books on Tax Strategies and The Savvy Real Estate Investor. Those books and your previous appearance really just set this awesome foundation for some of the tax considerations and questions that investors should be aware of, that they should be talking to their CPA to.

Really wanted to have you guys back in season two, just to talk more about different pieces of the tax piece, and that is the short-term rental investing. To kind of start off, we want to lay the foundation here with a few definitions, and then we can dive into kind of the meat. Why don’t we start with depreciation, something we talked a lot about on the show in the past, but maybe define that for us. What is depreciation and how does tax depreciation apply, especially if my property is going up in value that feels counterintuitive?

[0:05:18] MM: Right. It’s totally true. We like to refer to depreciation as, why I call it the ninth wonder of the world, somebody told me there’s only seven wonders, so it should be the eighth wonder, but regardless. Point taken is that, from a tax planning perspective, depreciation is our best friend. When you buy rental properties, a lot of people know, we get to take a ride off every year for a portion of our purchase price. We don’t get to do that when we buy stock. We don’t run out of stock until we sell it down the road. That’s why we love investing in rental properties, is that to your point, you buy a building, you get to write off, you take a deduction for our part of the purchase price of the building every year against your income from that property. So a goal being that we got cash in our pocket, we got depreciation expense that we didn’t have to pay for, necessarily, and now we got to write off. That’s why we love it so much.

[0:06:02] AH: Depreciation is just one of those things in the tax world, that you can get really creative with. Generally, the IRS allows you to write off if it’s a regular rental property, you write it off over 27 and a half years. For commercial real estate or short-term rentals, typically, it’s over 39 years. That’s kind of the standard rule they give you. But as an investor, we have options. We can choose whether to write them off faster. Meaning, taking more of that tax benefit upfront using strategies like accelerated depreciation, bonus depreciation. 

As a real estate investor, I think it’s really important for all of us to get at least a general understanding of what depreciation is. Because like Matt said, it’s really powerful when we can say, “Hey, we bought a rental property, maybe we’ll have $3,000 to write off on depreciation this year, or I might have $30,000 of depreciation this year.” That’s the strategy behind which one makes the most sense and how you kind of get the optimal tax savings.

[0:06:57] NH: Yes, it’s great. It’s something that I think a lot of people overlook the first time they’re diving into investing. They’ll look at like cashflow, they’ll look at the potential depreciation, but they don’t look at the other side, which is the tax savings. That’s huge. The other thing I want to make sure we define before we dive again deeper is short-term rental. I know that that is a pretty important definition from the IRS perspective. Maybe you can give us what is actually considered a short-term rental, how do you define that?

[0:07:20] AH: Short-term rental, contrary to popular belief is not every single property that’s listed on Airbnb or Vrbo. IRS actually doesn’t care where you list your property. What they look at is the average number of guests stays during the year. When we talk about defining a short-term rental for tax purposes, it’s a property where the average guests stay during the year is seven days or less. That year is January 1 to December 31. So you can have a property on Main Street, that’s a short-term rental this year, but a long-term rental next year, just depending on what the average guest stay is. 

I’m sure we’re going to dig into this a little bit. But for one investor, it could be very favorable for you to have this as a short-term rental, versus for another investor. It might be more favorable for you to not have it be considered a short-term rental for tax purposes. Everyone’s situation is going to be a little bit different.

[0:08:12] MM: I mean, the only other situation where you might see people having short-term roles, where the average customer stays 30 days or less, and they’re providing what we call hotel-type services. So they’re doing daily cleaning, they’re providing room service, concierge service, and stuff in a hotel would provide. If you’re doing that, then even if it’s eight to 30 days, it can still be considered a short-term rental for tax purposes. But other than that, the typical one you see most often is the seven days or less.

[0:08:41] DB: Then, as you mentioned, putting those two concepts together, and particularly short-term rental with depreciation, it sounds like there’s kind of a power play to be made here. But I really like the nuance that you shared of sometimes there’s benefit in short-term, sometimes there’s a benefit in a long-term rental. Could you expand on that a little bit, and why as a broad concept, this is something that investors should pay attention to?

[0:09:00] AH: Yes. I mean, for people who are investing in long-term rentals, or I guess, people who invest in all types of rental real estate, we can always use rental losses to offset taxes from rental income or other passive income we can have. That’s just kind of the standard benefit for everyone. But for those people who are investing in long-term rental properties and have higher income, typically, this is defined as someone making over $150,000, which I think is a lot of the listeners that’s with us today. If you’re investing in long-term rentals, you’re making $150,000 or more of your W-2 or other income, then the default rule is that your rental losses cannot offset W-2 income, unless you or a spouse is a real estate professional.

There’s a lot of different rules to qualify. One of which that’s the hardest for people who have a full-time job, is that you have to – you or your spouse have to spend more time in real estate than your job to qualify. What we see in practice is that you have these people who have high income investing in long-term rentals, although we can get tax-free rental income with the right strategies, but it’s difficult and oftentimes impossible to use the rentals to offset taxes from the W-2 income side.

Now, conversely, for short-term rental real estate, you can potentially use the losses against W-2 income, even though you’re still working full time, and short-term rental is just your side hustle. This is why it’s like a great strategy. A lot of people start calling it the short-term rental loophole because it’s really advantageous for people who have a W-2 job that’s high income, but also investing in short-term rentals, and trying to put those two together in the same bucket to significantly reduce taxes. 

[0:10:42] MM: Yes. Because different than long-term rentals, the threshold to – basically, it’s a kind of a similar strategy. If we can create losses through depreciation, can we use those losses to offset W-2 or other income. With a short-term rental, it’s a lower threshold, maybe an easier threshold to meet in order to do that. Because with a short-term rental, there’s really only – you need to meet one of the, what they call the material participation requirements. There’s ways for people who are, as Amanda said, working full time, she can self-manage her own short-term rentals and be able to use that, meet one of those requirements. And we can dive into those if you guys want to or when you’re ready. But that’s kind of it in a nutshell, if that makes sense. 

[0:11:17] DB: Yes. I think that there’s something really powerful there, as you mentioned, for that high W-2 earner, 150 or more, and then thinking about ways to capture those tax savings. Again, this isn’t necessarily losing money, but it’s harvesting that depreciation, to make it appear on paper that you’re losing money, even though the property is going up in value. Putting that together then, I know one thing that a lot of pharmacists may do is buy a second home, use it as their own vacation home. Can this even be applied to kind of like a second home loan where someone’s buying that, and then choosing to rent that out a little bit? Or are there rules about how long or how many times those have to be available?

[0:11:55] AH: That’s a great question, we get that quite a bit. The first thing I’ll say is, the type of loan you have is not the leading indicator of whether a property is a short-term rental. Again, we said, what is the short-term rental for tax purposes is strictly looking at the average guest stay. So yes, it’s possible that you’ve told the bank, this is your second home. But in reality, if it is truly just a short-term rental for the year, then it’s going to be treated as a short-term rental property. If it’s a property where it’s like your second home, but you’re also renting it out, then the tax benefits will really differ, depending on kind of how the year pans out. So if your personal use of the property is less than 10%, the short-term rental days, like the days occupied by the guests, then generally, you’re fine. You still quite get the bulk of those tax benefits.

Now, conversely, if your personal use is greater than 10%, of the short-term rental days, then it’s treated mostly like a second home, which just means that you can’t create a huge loss and claim all of that loss to be business related. There’s a lot of fun planning that we do with clients around that, in terms of how do we maximize our personal use versus business use between the different years to make sure we get the most benefit from a specific property.

[0:13:07] DB: Okay. That’s a really good tip then, to make sure that if you’re planning to use it personally, you’re talking with your CPA, and you’re figuring out what those guardrails are, to make sure you don’t go past that. You also mentioned material participation. I think that sounds like a definition that people should be paying attention to. Particularly, you also mentioned things about potentially one or both spouses being able to. Is this something where if there’s a married couple, both spouses need to materially participate, or one or the other? How does all that work?

[0:13:35] MM: Yeah, it’s a great question. There is a lot of opportunities to kind of use it to your advantage, and to some extent. Material participation for your short-term rentals, there’s technically seven tests somebody could make, but 99% of people, they’re looking at three different tests. First one is, they’re spending at least 500 hours a year in the right type of work on their short-term rentals. Short-term rental or short-term rentals. So it can be on one single property, or you can look at it as a whole, if you have multiple properties. That’s one test. Five hundred hours, great, you get there, you’re good to go. We can create losses, use those to offset our W-2.

If you can’t get the 500 hours, the next year down is, did you spend at least 100 of this right type of hours, and it’s more time than any other single person or businesses spend on your short-term rentals? So meaning, you spent 120, you look around, and your cleaning crew spent 110. As long as it was more than the next highest person, you’ve met the material participation requirement. If you don’t get to 100 hours for some reason, then the third test someone could use is, any number of material participation hours as long as that is more than everyone else’s time to spend time on your properties combined, then you’ve met the test. There’s pros and cons of each test, obviously.

Your second question. For material participation, you can combine spouse’s time. So if you’re trying to get to a 500-hour requirement for some reason, and husband got 300, wife could get 200, and you’ve met the test. It could be 400 or 100, or it could be 500 to. You don’t need to combine the time, but it is an opportunity. You can use that if both spouses are working on the property.

[0:15:06] AH: Yes. The only one thing I would add is like, when we say spouses’ time counts, it’s under the assumption that both people are actually working on the property. So it could be like, I don’t know, Matt is like building the furniture, but I’m doing the other part of the staging.

[0:15:21] MM: She always makes me build the furniture.

[0:15:23] AH: Like in my scenario, and not just like, oh, he’s building furniture. I’m like on the couch watching TV for moral support, then my hours wouldn’t count. Also, I think, as we are getting closer to the end of the year, for investors who are closing on the property in the third quarter, or the fourth quarter of the year. Oftentimes, these are the times where we see like that 100-hour rule come in more handy, because odds are, you’re not going to have 500 hours in the last few months. But it’s also very likely that you will spend more time than the cleaning crew or the gardeners, because they’re only coming here maybe a couple of times before year end. 

The two secondary rules that Matt said, 100 hours and more time than anyone else, or the third one, which is you spend more time than everybody else combined, are ones that we see a lot in when people invest in like the fourth quarter.

[0:16:16] NH: That’s a great tip. I think it reminds me that we should mention to our audience, this is a pretty litigated part of the tax code. These are not things to be doing without a pro like you guys on the team, right? I mean, this is something where you’re sitting down with clients in advance and saying, “Okay, for 2024, here’s our plan.” Am I missing something there? 

[0:16:34] AH: Yes, for sure. We still do that as part of year-end planning as well. But as we get closer and closer to the end of the year, there’s not that many days with holidays and stuff. But definitely, I would encourage everyone to start out the year with kind of a meeting with the tax advisors. “Okay, here’s what I’m trying to accomplish.” And so, you can make sure you’re doing the right things. I think, it’s no secret. The IRS got $80 billion of additional funding, and they’re hiring a lot more people. 

So the expectation is that, audits will increase. But for most of our clients, and us, we’re not super concerned with it. Because you’re always leading with, what are the things that I’m going to do to make sure I have the right facts. So that if I’m audited, I have a way to substantiate the position that I’m claiming to take. Like doing the actual work, buying the right properties where I could spend the amount of time. That’s going to go a long way in terms of legitimately saving in taxes, or like, “I heard on a podcast I can scheduled it myself. Not sure how, but I’ll do that.”

[0:17:35] NH: Right. That’s what I’m worried about. It sounds easy. I saw a TikTok video how I can basically spend nothing on taxes. I don’t want that to seem like that, because it’s not that easy. So good, I appreciate you guys saying that.

[0:17:44] AH: Yes. It’s so good that I think that we’re talking about the short-term rental loophole, because I post a lot of stuff on social media, whether it’s like Instagram or LinkedIn. That’s I think – over the last year, this is the one topic that I’ll get the most DMs from people, who tell me like, “Oh, my CPA said, I can’t do it. My CPA said I have to be a real estate professional, or because I have a full-time job.” So it’s really important, because there’s not that many people who specialize in real estate tax, and the short-term rental loophole is even more niched within real estate tax. So just make sure you’re working with someone who understands that loophole, because this is an area we’re seeing the huge number of mistakes from tax advisors.

[0:18:25] MM: I think you were saying, you need to be on TikTok doing dance videos where you’re talking about tax.

[0:18:29] AH: Yes, to be more legit.

[0:18:31] NH: Absolutely, yes. That’s how you know you’re credible. That’s good.

[0:18:33] MM: Right.

[0:18:34] AH: That’s how you know you’re credible, yes.

[0:18:35] NH: One of the things I want to make sure we hit on too, that I think gets lost in a lot of this discussion is that you’re not necessarily avoiding tax. We’re not skipping tax, we’re delaying tax. Because eventually, there’s going to be a depreciation recapture. Can you walk us through that a little bit? Just tell us a little bit about how it is and what delaying tax actually looks like.

[0:18:52] MM: For tax purposes, you’re kind of referring to, when we go and sell a property down the road, we’ve got potentially gain on sale. Some of that might be depreciation recapture. The reason that happens is, you buy a property for $500,000, and since they allow you to take depreciation expense every year, your basis might go from 500 down to 400 or 350. First $100 $150,000 game on the back end is now going to be depreciation recapture.

Our goal when we take depreciation is, we’re going to get the same amount of depreciation expense over the life of the property, whether it’s 27 and a half years, 39 years. We’re just trying to take more of it sooner, right? We’re trying to accelerate our expense, save our taxes now, use that savings, reinvest, go buy more income-producing assets, build our wealth faster, and kick the tax can down the road. It does come up obviously when you go and sell a property so it is something to factor in when you are selling depreciation recapture as tax a little bit higher than normal capital gains. But I think with proper planning, and planning ahead in terms of, hey, having that conversation open dialogue, and sell the property in year five. As we get closer that, we were nailing that down and planning ahead, “Okay. What’s the gain going to be? What other things are we going to do? Are you going to reinvest the money and other real estate? Can we offset it with that?”

So there’s definitely things you can do. So I would just encourage people, definitely try and maximize your depreciation expense. Don’t be worried. Think about the depreciation, we’re going to plan ahead for it, but don’t totally concerned about it.

[0:20:18] AH: There are a lot of people, unfortunately, even CPAs who share this message that, “Hey, because you have to recapture depreciation when you sell, don’t take depreciation.” That is terrible advice, because depreciation is a requirement. It’s not like I choose to do it, or I choose not to do it. In other words, if you own a rental property, and you chose not to claim depreciation, if you sell it in year five, or six, or seven, and you’re audited, and you say, “Oh, I’m not going to recapture anything.” The IRS will force you to recapture it as if it was taken. So really, want to make sure you’re getting the right advice that you have to – you don’t have to take accelerated depreciation, but you have to take at least a minimum depreciation every single year.

[0:21:02] NH: That’s a huge tip. I mean, I’ve heard that out there, where it’s like, “Oh, don’t worry about depreciation. It’s too much headache.” It’s like, “No, no. You can just skip the portions of the tax code you don’t find interesting.” Yes, this is not how it works, guys. Okay. So yes, really great tip. Again, something that everyone should go back and listen to again if you missed it. This is not an option, you have to do it the right way, and make sure you’re working with a pro that knows what they’re doing.

[0:21:23] AH: Yes, I think you were mentioning earlier, hey, this is just deferring taxes, and not really like eliminating tax.” But if we get in a little bit into the nitty gritties of it, for some people, it is certainly elimination of tax. We were talking earlier about an example of someone, a recent guest on the podcast that said, “Hey, they have two six figure incomes, using the short-term rental loophole, they’re going to pay no taxes.” If we assume they were at a 37% tax bracket, so they’re saving 37% in taxes. When they sell a couple years later, if they’re not working full-time anymore, and even if there’s recapture, maybe the recapture is at 20%, or 25% in taxes, depending on where they are. There oftentimes is a permanent tax savings where I’m saving at a higher tax rate now, but I’m recapturing at a lower tax rate way into the future too.

[0:22:14] MM: This is what tax nerds think about, and this is where they get excited about.

[0:22:17] NH: I love it. It’s a good distinction, though. It’s important.

[0:22:20] DB: Yes. One thing that I want to hit too is, now that you’ve made depreciation not sound like a boogeyman that we should be afraid of, but there’s something that we should embrace, right? There’s ways to really accelerate that depreciation like you mentioned, accelerate depreciation, bonus depreciation, cost segregation. Can you walk us through how all those kind of come into play if you’re really looking to maximize depreciation, particularly on a short-term rental? Because cost segregation has come up a few times in the past. We did spend Episode 54 talking to a cost segregation specialist about that. But if you could give us just the overview and how that might fit in?

[0:22:53] AH: Yes. I think it’s probably best to just go over like a real quick example. We had a client who’s a couple also in the medical profession. I think they were making a little over $300,000 of income together combined. First year of real estate investing, they bought two short-term rentals. I believe the purchase price is about $400,00 to $500,000 each, so about $800,000 in total purchase price. In that first year, they did all the right things, they have the right properties. I was close enough to them, where they had enough hours racked up to use the short-term rental loophole.

In that first year, I think their depreciation was like 245, or something like that from just those two single-family, short-term rental properties. You can see, their income went from over $300,000 down to $40,000, $50,000, $60,000 of income. So pretty significant in terms of tax savings.

[0:23:54] MM: What they did, they did take advantage of a cost segregation study. So, generally, for depreciation purposes, for the people who don’t know. when you buy a short-term rental and for depreciation, you take your purchase price, you’re supposed to split it between building and land, we’re not allowed to write off the land, but we can depreciate the building. The building itself gets written off over 39 years. That’s good. I mean, that is that paper write off we’re talking about. It’s not going to move the needle $245,000, necessarily.

So then, you could go and have a cost segregation study. Like an engineering study, company will come in to look at the property. They’ll say, “Hey, some of this stuff should really be depreciate over five years or 15 years.” That is by itself is better than 39, obviously. That can definitely help. But then you add to that, we’ve got bonus depreciation right now. So these five and 15-year assets, if you put them in service this year, you can write off 80%. At least 80% of those five and 15-year assets right away. That’s where you can kind of really start to see some significant tax savings when you can combine a cost segregation study and material participation with respect to that short-term rental loophole.

[0:24:58] DB: Yes. So the 80%, if I remember correctly from what we’ve talked previously, that’s something that’s kind of going down over the years. So that’s good this year, it’d be less good next year. So there is some advantage to it. Trying to squeeze things in by the end of the year. Particularly, cost segregation study, if you were to do this, would you have to have this study done before December 31 or just before you file your taxes? 

[0:25:20] AH: Yes, great question. So right, yes. Before last year, we had 100% bonus, 2023, we have 80% bonus. Next year is scheduled to go down to 60%.

[0:25:30] MM: Which is less good, as you said.

[0:25:31] AH: Less good. But things are always changing the tax world, there’s been proposals even as late as this year to bring back 100% bonus depreciation. So definitely something that we’re keeping our eye on. With respect to timing, the important thing that we need to understand as investors is what we call place in service date, which means, I’ve purchased the property and it is now in service. For short-term rentals, what does that mean? That means I want to have at least one guest turn. Somebody checks in, somebody checks out, so I can prove that the average guest stay is seven days or less.

If it’s placed in service in 2023, then I’m eligible for that 80% bonus depreciation. This is true, regardless of when I actually get the study done. For a lot of our clients, our focus right now at this time is make sure property is placed in service. Get it staged, get it furnished, get it rented out.

[0:26:26] MM: Get your hours, yes.

[0:26:27] AH: Yes, get your hours in. We’re going to wait to do the actual cost seg study. We can do it before we file the 2023 tax returns, and that could be next April. That could be next October. Or let’s say, you’re someone who put the property in service, but you don’t have enough hours yet. We’re going to try to earn all those hours in 2024. Well, then we would wait until we file the ’24 tax return to then do the cost segregation.

We come across investors who are like, “I bought a property. Got to do a cost seg.” We tell them, “No, don’t do the cost seg yet. You got to earn the hours first. Once we confirm we have the hours, we can use it, then we’ll do the pay for a cost segregation.”

[0:27:07] DB: That makes really good sense. Again, the value of planning, and having all these conversations in this level of detail to make sure that your tax professional is walking you through when to do all these steps. One more since you said that property could be short-term one year, long-term the next year, is there potential advantage to putting something into play, having a short-term guest or to bonus depreciating like crazy this year? Even if it becomes a long-term rental for the rest of time, does that walk back any of that value? Or does that just help you capitalize that value?

[0:27:39] AH: Yes. I mean, a great example would be, you have a pharmacist who’s working full-time. This year, they bought a short-term rental, right? So we’re going to keep it as average guest stay, seven days or less for this year. For the hours, do a cost segregation. Next year, this pharmacist says, “Wow, that was a lot of work. I don’t want to do that again.” So sometime in 2024, I wouldn’t recommend like January 1 immediately. Sometime in 2024, maybe that person says, “Well, let me turn it into a midterm rental. It’s already furnished, staged, and furnished. I’m not going to be like a long-term tenant. That doesn’t really make sense, practically. But I could certainly turn it into a midterm rental, where I’m renting to other traveling medical professionals or to insurance companies that need to relocate people. It’ll be 30 days or more, and that’s fine. I don’t really care as much, because in the first year, I kind of already utilized all of my tax benefits.” So yes, we do see that as a kind of a natural transition for some clients.

[0:28:33] MM: Another one that comes to mind too is a little bit similar to where you’ve got to – they bought the property, bought a short-term rental number one this year, they focus their time, they’ve self-managed, they meddle the rules, they use a loophole. They come into year two, it’s like, “Okay. Well, we’ve maximized the depreciation for that one.” That one, I don’t need to necessarily self-manage anymore. I’m going to kind of hire maybe a local property manager to kind of take care of that. But I’ve gone out and bought short-term rental number two, and three. Now, I’m self-managing and focusing my time on those, and doing the cost saving on those. And basically, rinse and repeat on the new properties. Because when you can look at the material participation requirements on a year-by-year basis, you can look at them on a property by property, or you can combine them all. There’s a lot of flexibility there to take advantage of what works best in someone’s situation for sure.

[0:29:18] NH: Yes, I like that a lot. It’s a great tip in terms of building that flexibility in, and adjusting based on what your needs are and what you’re trying to accomplish. That leads me to start thinking about partnerships, though. I’m a pharmacist, and I’ve got five other pharmacist friends or whatever, and we want to go in and buy a property together, let’s say. How does that start to change that view, especially if I’m someone that – I get to [inaudible 0:29:38] like this all the time, they want to invest in real estate, but they don’t want to be active at all. They just want to stay passive as part of that partnership. Are they excluded from that? Are they still able to participate? What does that look like?

[0:29:48] AH: Yes. I mean, when we see those kinds of scenarios. Out of the five people in that partnership, typically there’s going to be one person or two that is active, right? Because someone does have to deal with property-related things. Someone just have to be the decision-maker. Generally, you’ll kind of be that person who tries to meet the material participation. We have seen partnerships where it’s like, “Hey, we both want to get the tax benefit. But clearly, the two other rules – there’s three rules, but two of them, it’s like, nobody else can spend more time than me, and you are part of that other person.

So there’s kind of a potential issue of us trying to go for the same thing. But yes, there’s workarounds for that. We see all the time with clients that maybe, “Hey, within this partnership, you’re going to have 100 hours and more hours than everybody else, which includes me.” But I also have my other short-term rentals, kind of like what Matt was saying, well, so for me, I’m going to aggregate my hours amongst my other short-term rentals and I have 500. Now, you and I both can get the tax benefits. 

Yes, there’s a lot of strategy around partnerships as well, that are a little bit more complicated than just you, or you and your spouse, because you’re considered one unit. But definitely, could still be accomplished.

[0:30:57] MM: I’d say too. I’m just thinking out loud, maybe that person doesn’t want to be active in the partnership, but they’re looking for a good investment, they’ve looked in the marketplace, “A short-term rental, that makes sense. I got four friends who ae going to go out and buy one. We still want to maximize depreciation. Because maybe that pharmacist has other K-1, they’ve invested in somebody else’s pharmacy that’s kicking off out of K-1 with positive income. Now, they’re both passive income, passive loss. We can use that short-term rental loss to offset it. So that’s another way somebody could use it without necessarily having to be active per se.

[0:31:26] NH: That’s a great point, because we’re not just – those losses don’t go away, they just can’t be converted to active losses. So you can still apply them to other passive. Yes, it makes a ton of sense. That’s great. This is great stuff, guys. Really appreciate all your insights. Ultimately, the themes I’m getting so far are the short-term rental loophole is a great opportunity for high-income earners. But make sure you talk to a professional first, because there’s a lot of nuance, and getting it wrong can be a bad thing. And so you want to make sure you’re doing it right. Anything I’m missing, any other tips or tricks that we haven’t discussed today.

[0:31:55] AH: I think, obviously, today, we talked a lot about the short-term rental loophole. I think it’s really important for people to understand that, just because you have a property that maybe the loss will be passive, like long-term rental properties, or if you’re investing in the syndication. There’s other types of investments that just result in passive income. I mean, passive losses.

Oftentimes, we hear CPAs say, not to invest in real estate, because you don’t get the tax benefits. I think when you hear that, it’s important to understand that that CPA is only looking at it from a tunnel vision perspective. All they’re saying is, today, you cannot use the loss against your W-2 income. But something you just mentioned is like, those losses don’t go away, they don’t expire. You will be able to get the benefit, it’s just a matter of when. You might get it next year, when you have a bunch of rental income. You might get it three years from now, when you have more rental income or when you sell a property.

In fact, let’s say in the worst-case scenario, you invested in real estate, it was passive loss, you lost money along the way, you sold the property at a loss, just losses all over the place. Well, when you sell the property, it becomes an ordinary loss, and you can use it to offset W-2 income. Regardless of whether you’re a real estate professional or spending any hours at all. There’s always tax benefit to investing in real estate. It’s just a matter of when do you get the benefit.

[0:33:14] DB: I love it. I know that I said it last time at the end of the show, but I got a copy of your book, The Book on Tax Strategies for the Savvy Real Estate Investor. I found that to be incredibly helpful to help me with just confidence and having conversations with my CPA. Knowing questions to ask, and knowing when to reach out. I think it helped me to learn that I’m not even remotely a tax professional, but I know when to phone a friend. That was just really, really helpful for me. 

For listeners that want that sort of support or those resources, where can people find out more about you and those resources that you’ve produced over the years?

[0:33:47] AH: Yes. I mean, keystonecpa.com is the best place to find us. We work with investors all over the nation. One of the most common questions we get is like, how do I know if I’m overpaying in taxes? On our website, we have a tool that you can download that’s basically a self-assessment, so you get an idea whether you might be – like what your risk percentage is in overpaying in taxes. If you’re just looking for daily tax tips, the best place to find me is on Instagram, @amanda_han_cpa.

[0:34:19] MM: Sometimes you can see me in the background of her videos on Instagram. 

[0:34:22] AH: Sometimes.

[0:34:23] MM: Sometimes.

[0:34:23] NH: I love it. Well guys, really appreciate you joining us on the show, Amanda and Matt. Just a wealth of knowledge and we really appreciate you coming back on to share it with us in the audience. So, thank you guys.

[0:34:31] AH: Yeah, thanks for having us.

[0:34:33] MM: Thanks again for having us. Appreciate it.

[0:34:34] DB: Thanks so much.

[OUTRO]

[0:34:35] DB: Thanks for listening to the YFP Real Estate Investing Podcast. If you liked what you heard on today’s show, please leave us a review, and subscribe to the show, so you never miss an episode. If you have a question, know someone that would make a good guest or want to connect with us, head in over to yfprealestate.com and join the growing YFP Real Estate Investing Facebook group.

[0:34:52] NH: As we conclude this week’s episode of the YFP Real Estate Investing Podcast, an important reminder that the content in this podcast is provided to you for informational purposes only and is not intended to provide and should not be relied on for investment or any other advice. Information in this podcast and corresponding material should not be construed as a solicitation, or offer to buy or sell any investment or related financial products. We urge listeners to consult with a financial advisor with respect to any investment.

Furthermore, the information contained in our archived newsletters, blog posts and podcast is not updated and therefore, may not be accurate at the time you listen to it. Opinions and analyses expressed herein are solely those of your financial pharmacist, unless otherwise noted and constitute judgments as of the dates publish. Such information may contain forward-looking statements which are not intended to be guarantees of future events. Actual results could differ materially from those anticipated in the forward-looking statements. For more information, please visit yourfinancialpharmacist.com/disclaimer.

[0:35:47] DB: Thank you for your support of the YFP Real Estate Investing Podcast. Have a great rest of your week.

[END]

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