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Tax Smart Real Estate Investors Podcast
305. Passive or Non-Passive: What’s New for Short-Term Rentals in 2025
00:29:51
In this episode, Thomas and Ryan walk you through…
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- [00:00]
Tom
You're now listening to the Tax Smart REI Podcast, the number one tax podcast for real estate investors, your source for.
- [00:07]
Ryan
All things real estate accounting and tax. Here we reveal our secrets that can save you thousands in taxes, streamline your accounting process and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors and current clients on what strategies they use to grow their business and how they steer clear of Uncle Sam.
- [00:33]
Tom
Thanks for tuning into this week's episode of the Tax Smart REI Podcast. If you're tuning in, this is probably the first episode you're going to be hearing in 2025, despite the fact we're releasing it on the last day of the year. And today we'll be talking about everybody's favorite topic, short term rentals. All right, we're going to be going through the short term rental blueprint, how to maximize your short term rentals for tax savings in 2025. We're going to cover the rules, why you need the short term rental loophole mistakes to avoid what we're seeing on the audit front, what changes to expect in 2025, how to maximize your short term rental tax savings in 2025. So let's just go ahead and kick it right off with why do we even need to use this short term rental strategy to begin with? And that's all thanks to the past activity rules. Ryan, do you want to kind of kick us off with what passive activity rules are and why they're so important to real estate tax planning in general?
- [01:22]
Ryan
Yeah, so some of the history in context first. So these really became relevant for real estate investors back with the Tax Reform act of 1986. So been around for nearly 40 years, so it's been quite a while. And so basically what happened is we've got two categories in our income. We've got non passive. Think your W2. If you're an employee, you've got business profits. If you're running a business, you've got portfolio income like dividends, interest, you know, capital gains from stocks. That's all non passive. But part of this reform act was then we've got this passive activity and by default rental properties, rental real estate fell into the passive bucket. You also could have passive businesses if you're not materially participating, things like that. That's not going to be the focus of our time here. But basically what happened was the difficulty that came out with this law was okay, if I'm a high income earner, which is who they're trying to impact, I can't Just go invest into real estate and have that offset my physician income, let's say, or I'm a high income attorney or something like that. Right. Can't just have these rental losses offset my income there. They made it more difficult and that was on purpose. They made it more difficult so that you would have to meet certain requirements which we're about to get into in order to have your rental real estate losses offset the income that you have from W2 or business profits. So how do we do that? Now it is real estate professional status or the short term rental strategy. So basically we have to meet one of those to move now rental losses which are by default passive and now move them to the non passive bucket. So I'll kick it back to you for maybe the basics of real estate professional status if you want to talk about that.
- [02:59]
Tom
Right. So like Ryan just said, if you're a high income earner, basically your losses from your rental real estate trapped in traffic passive bucket, unless you qualify as a real estate professional. Right now, to qualify as a real estate professional, you spend 750 hours and and more than half your total working time in a real property trade or business. Now this was introduced in 1994. Since then there's been hundreds of tax court cases on this and it's one of the most audited and most litigated areas of tax code. And what we found is that it's virtually impossible to meet these requirements if you have a full time job where you're running a full time business. Just virtually impossible. The reason for this is because this was intended for people who are working full time. Predominantly real estate is their occupation, for lack of a better word. So this is painful for a lot of real estate investors who are icon owners to find out. Now there's a strategy to get around this. If you're married, you could have one spouse qualifying. We'll go through the real estate professional status in depth in another episode for everybody who might be in that category. But what if you're not in that? What if you can't qualify as a real estate professional? What if your spouse can't qualify as a real estate professional? Then you're stuck, right? Then all your loss can be passive. And yes, there's a 25k allowance, but we're presuming if you're high income earner, you're above this threshold and you're not able to use this, at least in any meaningful way. So this is where the short term rental exception or loophole, it's been dubbed or strategy Whatever you want to call it came about, right? Or, or comes into play. Now these rules for the short term rentals that we're about to break down here were originally designed for hotels and motels and similar businesses back in the 1980s, right? Now the problem with that is back in the 1980s we didn't have the Internet, we didn't have Airbnb, we didn't have vrbo. You couldn't just go buy a property, throw it up on those websites. So that's what part of the reason why it's called a loophole. Now as you'll see, this is intended for hotels and motels and back then it was a lot harder to run those businesses than it is today. Right. And apply these rules. So what is the short term rental loophole? It is if you have a property with an average period of customer use of seven days or less, then it's not a rental activity. Remember what Ryan said before, all rental activities are passed by default. We could also have passive business instead. It's a business now. So now we're putting in this business category. Okay? The other exception that might be relevant to some taxpayers or some short term rental owners is 30 days or less and you're providing substantial services which are hotel like services like daily meals, cleaning, so on and so forth. We don't see that too often, but it does exist. Seven days or less is the more common exception, right? So now that it's in this business bucket, you don't need to qualify as a real estate professional. So take that 750 hours and more than half your total work time. Toss it out the window. Now we're dealing with a more simplified test which is just the material participation test. There's seven tests and out of those seven tests there's three of them that are going to be most applicable to most people listening to this podcast here today. First one's going to be 500 hours or more, so between you and your spouse. So now if you're married, both you and your spouse combine these hours, you spend 500 hours or more on your short term rental. Second one is you do substantially everything, virtually no outside help. You're a one person show, you and your spouse are two person band or then the third one is you spend more than 100 hours again combined with your spouse and no one else spends more time than you. Those are the three tests Ron, do you want to take off with which one of them is the most popular of the three and why?
- [06:31]
Ryan
The most popular one is the 100 hours and more than anyone else, test simply because the barrier is lower. Right. 500 hours compared to 100 hours. Right. The barrier to entry is much lower here. And for example, for a lot of the people who work with us, it's I'm buying my first one, help me do this. I'm buying my third one, help me make sure I'm doing this and the documentation and things like that. Right. And they're trying to maximize their tax savings. Right. That's why people usually come to work with us. So it is the 100 hour one. The issue with that one is that you have to record other people's time. It can't just be your own time. You have to document other people's time like a cleaner, a handyman, a manager, whoever is working or performing services for your short term rental. Okay. If you don't do that and you get audited and you're not able to provide that like that, there's just a risk that the IRS says you can't prove that you have more time than anyone else. I see you got a minimum of a hundred. That's half the equation here. The other half is you have to show you have more time than anyone else. So you've got to have other people's time. Now maybe a pro tip here is you can do that multiple different ways. You could just ask. But you could also look at like a security camera if you've got a smart lock and people are entering your property, that's another way to get some of that information to help you. Right. The point is, yeah, the second one is the most common. And just to back up, just to say it one more time, I know I've said this a couple times, but why this is so powerful, specifically the short term rental strategy is it can now be considered non passive. And now it's in the same bucket as your W2. Right. High income earner, a business owner. Right. High income profit. Right. It's all in the same bucket. And so with some exceptions, we're not getting to excess business losses or net operating losses today, but basically that now loss from your short term rental because it's in the same bucket, they can offset one another. And we could always do an equation, we've done other equations on here, but the savings can be massive. Right. And the higher your income, the higher bracket that you're in, the more of those tax savings can just kind of multiply. Right. But yeah, the second one there, the hundred hours is the most common that we've seen.
- [08:35]
Tom
Right? Absolutely. And Just to add to Ryan's point, why it's so powerful is that this can save you between five to six figures in taxes. We've seen this happen over and over again depending on the size of your rental. We're not go through all these equations today, but basically you buy a short term rental, you rent it out for seven days or less on average. You materially participate, use a cost segregation study. Now you have this massive loss that's generated by the cost segregation study because it breaks down the various components that are eligible for bonus depreciation. Use the bonus depreciation to create this loss. It'll offset your W2 or business income. That's why this is so powerful. Okay. Now, and that's the third part of this I should say that, okay, once you get seven days or less, you materially participate. You run the cost segregation study. And what the cost segregation study does is it breaks down the components of the property into their useful class size. Right. If you buy a short term rental, it's typically depreciated over 39 years because it's considered a commercial property. But it's not just the building that you're buying. You're going to have things like faucets, appliances, so on and so forth. And these things, pools and decks and sheds that are able to be depreciated over five and 15 years, not 39 years. And you add bonus depreciation and you're massively accelerating it. So that's kind of the strategy in a nutshell. Once you do all this, it's massive. Okay, so now the big question on everybody's mind is, well, great, we have this powerful strategy. What's going on in 2025? Is it still viable? Right. People have been using this strategy since at least 2020. That's really when it started to become popular during COVID and in 2020, from 2020 to 2022, it was a hundred percent bonus depreciation, which made this massively powerful. And then in 2023, we saw it decrease down to 80% in 2024, we're at 60% this year or the tail end of 2024. And then as we move into 2025, under current law, we're at 40%, which makes this still the most powerful strategy available for real estate investors, in my opinion. From a. If your goal is to offset your W2 or your active business income. But we're getting into the territory where now we have to start looking at what might be coming up the pipeline in 2025 with the end of 2024, right around the corner. Now's the perfect time to start planning what moves you're going to make to optimize your tax situation before the year ends and get a head start on 2025. Whether you're looking to use the real estate professional status, the short term rental loophole, cost segregation studies, 1031 exchanges or anything in between, our team is here to help you through pro proactive tax strategy and planning, painless tax filing and streamlined bookkeeping services. After helping thousands of investors save millions of dollars in taxes, we want to help you. So whether you're looking to finish the year strong or get a head start on 2025, what are you waiting for? Head on over to www.therealcpa.com podcast to request a free 30 minute discovery call today. We're looking forward to learning more about your situation and how we can help. Again, that's www.therealcpa.com podcast to request a free 30 minute discovery call. We look forward to hearing from you. But for now, right back into today's episode.
- [11:35]
Ryan
Yeah, and so there's no changes to the actual regulations. There's nothing from the irs. They haven't come out with a new law. There's no changes legally from them at that kind of level of government. Now the things that you do have to be careful of is any sort of state, local, HOA regulations that might be changing. Right. So New York City, for example. Right. They changed pretty recently. Hey, you've got to essentially, from my understanding, Tom, you've got to like live there at the property in order to have a Airbnb. Right. In a short term rental. That didn't used to be the case. But point is, is that these regulations at kind of the state, local level could be changing, but they're not changing at the IRS's federal level. So that's kind of the comment there. So you have to be careful there. And obviously before you go and look for one of these properties, you need to determine, am I going into a market that this could be a contention and a change in the future, or is this kind of an economy and a market where it's been vacation rental for years and decades? Right, right. So you just need to kind of assess, is that an issue? Is that a risk that you might be taking on as a business owner and as someone who might acquire a short term rental? Now the other thing too, Tom mentioned 40%. Who knows what will happen here with 2025? And we've got a change In a lot of our political system. Right. They're going to be thinking about, and we've had episodes on this, but they're going to be thinking about changes to our tax situation. One of the levers that they could pull is changing bonus depreciation. So stay tuned for that. We obviously don't know, but that is a potential thing that could change here and a strategy that people want to be knowing about for 2025.
- [13:13]
Tom
Yeah, absolutely. They do want to make bonus depreciation go back to a hundred. That's been talked about. What we see actually happening is like Ryan said, is yet to be seen. But if it does go back to a hundred or does get extended in any meaningful way, we are looking at this still being one of the most powerful real estate tax strategies, you know, going into 2025 and hopefully into the future. So that's kind of what we're looking at in terms of changes. If you do want an in depth tear down of the short term rental loophole, we have a lot of resources on that. We just released our short term rental Tax secrets book not too long ago. It's available on Amazon, Kindle paperback. If you do want to check that out. We go through plenty of examples. We go through everything really in depth. We answer a lot of frequently asked questions in there. And also we're going to have a boot camp dedicated to this in 2025. Might be in January, it's going to be in Q1 and you'll hear about it. As soon as we have the information, you'll hear about it. But before we kind of wrap up this episode on short term rentals, we did want to touch on a few other things we did want to leave people with. Again, we've been consulting on this since at least 2020 and we've gotten a million one questions and common mistakes that we've seen and miss. So we just want to touch on those. And then also, also there's been some audits that have came our way from third parties. People have been knocking on our proverbial door. Hey, can you help us with the audit? We're getting audited by the IRS that we've actually been able to help win audits on this. So this is by far a bona fide strategy at this point. We've won audits, there's task court cases on it. So let's go ahead and just dive into some of the common mistakes. Okay, I'll just take the first one here. When you're dealing with short term rentals. Okay. It is A business. And make no mistake about it, it's not your passive long term rental where you're going to go ahead and you're going to get a long term tenant, you're going to do all your vetting and your, and your, your qualifying of your potential tenant. You're going to sign a 12 month lease and if you do it right, hopefully there's not that many things you have to worry about going forward. This is a business where you're going to have tenants turning every seven days or less on average is how most people do it. Or within a very short period of time you're going to have cleaners you're going to have to coordinate with, you might have to have repair folks come in and repair the place a little bit more than normal because again, you're going to have this active wheel of turning. So it is a business. You're going to have to be mindful of pricing and stay on top of pricing. Systems and automation can help you, but it's not always the best idea to automate your pricing. You might want to keep a pulse on your specific market if you want to maximize the revenue to your property. So I don't know if you have anything you want to add in there, but this is a business. This is not a passive investment. It's a little bit more intensive than a long term rental.
- [15:54]
Ryan
Yeah. And I know oftentimes you'll hear, you know, social media, the news that real estate is passive and passive income. Yeah. It's like meant to be that, but it may not start as that, especially as you're starting any business. Right. It's definitely not going to be passive. You've got to set it up, you've got to learn this, especially if it's your first one. Right. And anyone who's been doing this for a while will say, yeah, even on your fifth and whatever, it's still business. It's still a lot of work to set up and figure all these things out. So it is a business, you need to think of it as a business. The common misconception is that it's not. Another one just to kind of transition is the personal use. Right. A lot of times people have heard of the 14 days or less test and they'll come to us and they'll say, hey, I've heard of this 14 days or 10% rule and they say, okay, cool, so I can stay at my property for 14 days and have zero tax impact, right? No, that's not the case. If you stay at your property personally so it's a true personal use day. And we've had other episodes kind of defining what that means. So go back and take a look at that. But basically, if you have any personal use days, it will have a negative tax implication. It could be small. Right. But it really depends on how much throughout the year you've also rented it. Right. Because there's kind of this ratio of the number of days used personally and the number of days used for rent. Right. And so if that use for personal is high, now we can't take as many deductions. So now we have to basically do this ratio, this pro rata split between your things like mortgage interest, property taxes, insurance, things like that, just listing a couple. But it also includes depreciation. Right. And we've been talking about a cost segregation study as part of this strategy. So if you're using this property even for one day, which, which is less than 14, you are going to miss out on some of the deductions and create it less of a loss. Okay. So 14 days is there. And the reason we've talked about that, again, we've talked about that on other episodes, but the reason it's there is because if you go over that threshold now, you can't use any of the losses to offset things like your W2, that high income earner that you are. That's the threshold. People think, though, that they can go to 14 and have no tax impact. And that's the common mistake that we want people to avoid listening to this.
- [18:06]
Tom
Right, Right. If you're going to use this strategy in the first year, you want to use it for 14 days or less to make sure you don't get into that issue. But like Ryan said, there's also some potentially minor tax implications that you'll have to face if you do use it personally. But bottom line is, avoid using it more than 14 days in your first year. Okay? That's basically the big takeaway there. The other one is using a property manager in the first year. So again, like we discussed kind of in the beginning of this episode, bonus depreciation is a major component of this. And basically you're going to take most of your tax benefits in that first year, and you need to materially participate by meeting one of those three tests we talked about. Now, the IRS automatically assumes that if you hire a property manager that you are not materially participating. And the reason for that is because the property manager is taking over your role, which would allow you to material participate. The bottom line is, first year you want to avoid using a property manager, you want to run it yourself between you and your spouse. Yes. If you're using the a hundred hour rule or you're using the 500 hour rule, you can get cleaners to come in and help you out and some additional help, but you don't want to delegate it completely to a property manager. That's a big no no there.
- [19:14]
Ryan
Yep. And just maybe to add one more thing there, because some people have asked, you know, what if I get a co host or something like that. If you just get a co host to help you respond to guests every once in a while, maybe that's not the worst thing. Okay. But even that is starting to get into, okay, is that like a manager? Kind of. But Tom's saying if you hire like a full blown property manager, you got a contract. They see management fees on your P and L. Okay, sounds like you've got a property manager. So just be careful there of how much you hire out. And the key there is that how does this number one look to the irs? Do they assume that you're passive? Well, yes, it's real estate, but even more so if you have a property manager. But the point is, is that you want to materially participate. That's what we started with, right? You have to materially participate. You're putting yourself at an even more steep uphill battle to try to prove if you've now got a property manager. So just don't do it the first year, maybe year two or three or whatever it is. But that first tax year, we're not saying 12 months. Right? Because, Tom, if we buy this in October 1st, we're not saying you got to use them through October 1st and next year. Right. It's really the first tax year that you want to be careful of using that property manager. So that's really what we're saying. Just be careful that first year. Absolutely.
- [20:27]
Tom
The last common mistake to what you want to avoid is not documenting your time again. Seven days or less on average. You'll be able to get that information usually from Airbnb or VRBO or whatever platform you're renting this out on, you're listing it on. That's usually not the big deal. Right. The other parts of material participation, you want to have clear records of not only your time, so how much time you and your spouse, if you're married, how much time you spend on the property, but also how much time other people spend, like cleaners, so on and so forth. And the reason for that is that if you're using the a hundred hour test, which the majority of people we've seen use the strategy do, the IRS wants to know not only how much time you spend, but how much time other people spend to make sure that they're not spending more time than you. Okay, so that's the last big mistake you want to avoid. Again, we do have other resources on this. The STR tax secrets book is out. We go a little bit more in depth in some of this stuff, but I just want to make sure you're aware of that. Now, common arguments from audits, that's going to be the final topic we're going to discuss here on today's episode. Now that people have been using this strategy and it's been widespread for over four years now, or coming up on four years, we've been seeing some audits and we want to just discuss some of the common arguments that we've been seeing and how you can avoid it. So let's kick us off with the first argument. And, and that is that the irs, their auditors sometimes are not trained to the degree you would think they are. And they'll tell you that you need to qualify as a real estate professional to take the losses from your short term rentals. And why do they think that? Why do they believe that? They believe that because they have a very cursory knowledge of the code section that governs this area and they think all rentals are passive by default. And when they see a short term rental, their brain automatically goes boom. Short term rental, it's passive. Right. So if you do get audited, you do want to work with a tax professional as soon as possible. Because once you start engaging with the auditor, providing them documentation or information, you might be giving them more information than they need. You might be shooting yourself in the foot. Right? So understand that you do not need to be a real estate professional to use this strategy. Right. And if the IRS tries to claim that you do, you need to be working with a tax professional who can help you argue and show them the regulations, the rules, and so on and so forth. That proves that you don't need to be a real estate professional.
- [22:45]
Ryan
Another one that's commonly misunderstood by these agents is you need to report a short term rental on schedule C. So the misunderstanding there is generally around substantial services. Substantial services we normally would think of like a hotel, a motel, kind of that. Daily cleaning, daily food, daily breakfast, those kind of like extra services. Right. Substantial services that some of these companies would provide. We have not found that to be the case for most Airbnbs, it's like, yeah, you do a clean and a turnover in between guests, but you're not showing up there every day to wash their linens, wash their clothes, make them breakfast, make them coffee, things like that. That's more of the substantial services. And again, most Airbnbs, most of you listening, that's not you, okay, so because of that, because you don't provide substantial services, it continues to go on to schedule E, just like any other long term rental or whatnot. So it doesn't go on Schedule C, it does go on Schedule E. And the distinction there is substantial services.
- [23:45]
Tom
Yep, for the most part, your short term rental is going to go on Schedule E, not Schedule C. So just make sure the irs, if they audit you for that, you are not falling trapped to that argument. Now, the third and final one that we've been seeing, the big one, has been that each spouse needs to hit the material participation test on their own. Like we talked about before, when it comes to the material participation test, you and your spouse are effectively one person in the eyes of this area, the tax code. So that means that if, for example, you're going for that 100 hour test, say you spend 50 hours and your spouse spends 75 hours, okay, well, you just spent 125 hours, which is more than 100 hours. And as long as no other person outside of you and your spouse spend more time than 125, then you're good to go. But the IRS will make that argument because we didn't go through this today, but we'll go through in a future episode on reps for the real estate professional status to meet that 750 hour and more than half your total working time requirement, one individual spouse needs to meet that. So if you're looking to go for reps, you can't split the 750 between you and your spouse. Either you or your spouse need to do that. And I think that's where they're pulling it from. Again, they have a cursory level knowledge of this area. They don't know the regulations in depth enough to understand the nuance. And that's why sometimes when you're facing an audit, it helps to have a qualified tax professional on your side who knows all the regulations and where to point to and task court cases, so on and so forth, so that the IRS agent basically has to admit that they're wrong and you win the audit effectively. So these are just things that we're seeing. Okay, if you're going to be using the short term rental loophole in 2025. You've not done it before. You have questions, what if I do this, what if I do that? What if I rent out an adu? Does this time count? Does this time doesn't count? So on and so forth. There's two ways we can help. All right, you can join Tax Smart Insiders by going to www.taxsmartinvestors.com insiders become a member. You can ask all your questions in a private forum and myself and our tax advisors answer those questions. So go ahead, join that if you do want that as a resource. Or you can become a client. And we become a client. We'll do one on one tax planning with you, where one of our advisors will effectively meet with you and look at your situation, tell you exactly which strategies you need to use and how to use them to capture their benefits. So one option is you can get your questions answered in a forum. If you're just starting out, maybe you don't have your rental yet, you're just kind of piecing this together. Or if you have a short term rental or you're very close to closing on one and you want someone to hold your hand and make sure you're not making any mistakes and making sure you're taking full advantage or maximizing your tax savings and cutting out a whole bunch of your learning curve, you could become a client. All right, if you want to become a client, you can go to WWE therealestatecpa.com podcast, fill out the form on that page, and our team will follow up with next steps. And with 2025 just kicking off, this is like the best time to start planning and strategizing for this year. Okay. For 2025. So go ahead, check that out. Anything you wanted to leave the audience with before we wrap this up?
- [27:05]
Ryan
Please don't do this alone. Like we've talked about common mistakes, people we, we see or the questions we get, and then people trying to do audits themselves. Uh, it's anxiety provoking. There's a huge amount of stress that can come from getting a examination letter from the irs. So please get some help just like you would with anything else that is stressful or an issue. You hire a professional, you look for guidance. Right. Please don't try to do this yourself just to cut corners. Right. This is generally not something you want to diy depending on the dollar amount that we're talking about. Okay. And what's even better than reaching out to some sort of professional like us doesn't have to be us. We obviously think that we're, we're good at this and we are able to help. But you want to even do this sooner than once you receive an audit. At that point, it's like a lot of this is already done. Right. So this is a lot about being proactive and getting that plan in place. Right. To help you, then support you and partner with you to go and implement the process. So reach out to people proactively. We're here to help as people in need. But, yeah, don't do this alone. Be proactive in this. There can be a lot at stake, especially as audits continue to increase.
- [28:11]
Tom
Yeah, you want to set yourself up for success way before the audit ever comes. And that's the way we work with our clients. We end up looking at their situation. We give them what they need so that if an audit ever does come, it's a check the box audit. Like, boom, boom, boom, we win. Right. If you don't do it, you don't do things the right way, then you could be ending up in a whole lot of trouble. This is not a Tylenol solution. Right. This is not a strategy. You should go to your medicine cabinet, grab Tylenol. This is one of those things you call a doctor because you have a serious cold or something along those lines that you need to get, you need to get fixed. Okay? So again, if you're interested in having us help you one on one with this strategy and making sure that you're taking advantage of all the other strategies you might be able to use, whether it's on the real estate side, the personal side, or if you're running a small business, ww.real estatecpa.com podcast and we'd love to help you out over there, but that's it for this first episode. We'll be back next week when we'll be going through even more strategies and we'll see you then.
- [29:09]
Ryan
Thanks for listening to today's show. If you enjoyed the show, please find us on itunes and leave us a review. You can also email us at contact with any feedback or topic suggestions. We are always taking on new clients and with the new tax laws in play, you really don't want to navigate this alone. Let us help you save money on taxes with your accounting and CFO needs to become a client. Navigate to our client page@therealestatecpa.com and fill out a web form with as much detail about your situation as possible. Thanks so much for listening. Have a great rest of your weekend.