Are you stressed about filing taxes for your Airbnb investment? Do you worry that you might miss out on deductions and exemptions you don’t know about? Do you wish you had expert advice on exactly what to do as an Airbnb investor?
If this sounds familiar, you need to listen to Episode 55 of the Host Coach Airbnb Investing Podcast where CPA, Tom Castelli, unpacks the short-term rental exemption and where to look on your tax forms to see if you’re receiving the full benefit of depreciation due!
After listening to this episode you will know why a tax segregation analysis is essential for most STR investors.and how the STR tax exemption can save you money in taxes now and in the future.
Read on to learn the two questions you can use to qualify a CPA, and where to find the ultimate reference for understanding the Short-Term Rental Tax Loophole!
Topics discussed in this episode:
- How depreciation works on Airbnb investment property taxes
- The passive activity loss rules for short term rental investments
- How the STR Tax Loophole works for investors (legally)
- What a cost segregation analysis is and why it is essential for Airbnb investors
- Why NOT to DIY your short-term rental taxes
- The ultimate resource for the short-term rental exemption
Host Coach Airbnb Podcast Episode 55 Show Notes:
Tom, how did you get into the accounting industry specifically related to Airbnb investments?
I've been an accountant since 2014, but then I switched over to the tax side in 2017, with Hall CPA, also known as the real estate CPA. We're a firm that works primarily with real estate investors. Around 2020, there was a tremendous amount of interest in short term rentals and Airbnb's and VRBOs. I think it was driven primarily by the pandemic demand of people hopping around. Through that, we ended up taking on a bunch of short term rental clients. From there, we've drilled really far down into the short term rental tax niche. Basically the long story short, the pandemic is how we got involved.
How Airbnb Depreciation Works & Its Tax Advantages
Okay. We talk a lot on the show about gross incomes and expenses, and there's deductions that go into operating a short term rental. We haven't talked much on the tax side specifically about depreciation. Could you illuminate how depreciation works and the tax advantage that brings to real estate investors?
Absolutely. So, the IRS allows you to deduct a portion of your building each year - basically a portion of the purchase price in the form of depreciation, , it's a non cash expense. And what this is meant to do is actually help you kind of recoup the costs of the actual physical deterioration of the building.
So your property may be appreciating a value, as tends to be the case with real estate, but your property - year by year - it's deteriorating. You have to replace all these different components. So the IRS allows you to recoup that cost through depreciation. The biggest thing I think to point out here in terms of the tax benefits of depreciation is it's a non-cash expense. So that means that it only shows up on paper, meaning when you take your depreciation expense, you're not necessarily giving money away.
The Two Things Depreciation Allows Airbnb Investors to Do
First, it reduces your taxable rental income. So say you have a short term rental property - you're going to have rental income, you're going to have all these different expenses that it takes to actually operate the property. Now these expenses generally leave your pocket or your bank account and go to a third party, but with depreciation, again, it just shows up on your tax return.
So, you might have a property where you're cashflow positive, meaning you're putting money in your pocket, everything's gone well... but you're telling the IRS that you lost money. And this is very common in real estate, not just short term rentals, but you basically just tell the IRS, Hey, I lost money, which means A: You're not paying taxes on your rental income or that cashflow that you're generating, butB: in certain instances, you can actually use that loss to offset other forms of income to reduce your taxes.
Passive Activity Loss Rules Demystified
So can everybody take those, depreciation losses? Are there some sort of restrictions there?
There are restrictions put in a place under the tax reform act of 1986. Prior to that point, if you had losses from a rental property, it would just offset your other income, such as income from a job or a business. There really weren't many stipulations around that. But in the 80s, it became very controversial. So they introduced the Passive Activity Loss Rules. And that said that all rental activities are passive by default, which means that the losses are considered passive losses and can only offset other passive income. Unless you meet certain requirements like qualifying as a real estate professional, the special loss allowance, or certain things with short term rentals.
So to answer your question very succinctly, no, not everybody can use these tax benefits immediately. If you're not able to qualify for one of these exceptions to this rule, your losses will be suspended and carried forward to future years in which they can be used to offset other passive income. So, you will eventually use them, but not right away in all cases.
The Short Term Rental Loop Hole Explained
That makes sense. Can you explained the short term rental loophole?
Under the Tax Reform Act of 1986, they made all rental activities passive by default. Basically, certain businesses would either be passive or non passive depending on your level of material participation. If you materially participated in your business, it would be non passive. If you didn't, it would be passive.
What the short term rental loophole does is the regulations, intended originally in the eighties, for hotels and motels and similar establishments that operated more like businesses than they did rental properties. So, the exception here is if you have a property with an average stay of seven days or less for the year or 30 days or less for the year. And you're providing substantial services, which are services you'd find in a hotel, like daily cleaning, daily breakfast, concierge, vouchers, things of that nature. Then you're not a rental activity under the tax code, you're now in the business category. So the ability to take these losses becomes much easier because the thresholds and the requirements you have to meet to actually make them non passive are a lot lower than other. Which makes a lot of sense, right?
A Tax Exception, Not a Loophole
I hate thinking of it as a loophole. It's really an exception. And it's a logical exception, right? All of us who operate short term rentals know that it's not passive. It's not set it and forget it. We don't sign a one year lease and just collect those monthly rent checks, right? And in short term rentals, we're turning over every two to three days. We're dealing with guests. I really like to think of it that they've carved out this logical exception and we're not doing anything shady here, right? It's not a loophole that we're going to get caught on. It's the code has actually done something very logical.
Yeah, absolutely. Now, I will say the reason why some people have dubbed it a "loophole" is because of something called the real estate professional status. So the real estate professional status allows you to claim losses from your rental properties. If you spend more than 750 hours and more than half your total working time in a real property charter business. However, the passive activity rules were put in place to prevent people from buying a single family home or condo or whatever the case is dnd just taking their losses.
The real estate professional stats is a pretty high bar to get over. When the framers of this law back in the eighties, created it - they presumably didn't see Airbnb and VRBO coming to the point where you'd be able to take a single family residence or a condo and list it on Airbnb for seven days or less.
So that's why many people consider it a loophole because of the way it's used and kind of going around these passive activity rules. Despite the fact, to your point, it's a logical exception. And it's not really a loophole. It's right there in the regulations for anybody who looks for it.
The IRS and the STR Loophole
Is the IRS is still happy with that arrangement?
Yeah, I don't see it going away. We've not seen anything in any recent legislation suggest that they'd be changing the rules. Where we are seeing the rules being changed is more at the local level. I'm sure you guys are seeing this too, throughout certain markets - like New York, it's getting banned or restricted.
There's permits and taxes that some markets charge on short term rentals. So it's mainly being regulated through the local and state governments. I don't see them taking that rule out.
We're seeing in some of our markets, an increase in the occupancy tax charged at the county level. But I would much rather pay taxes than be banned. So, you know, silver linings and everything.
Where to Look for Airbnb Depreciation on Your Tax Return
For our listeners that have already filed a tax return for their Airbnb property. Where would they look on their actual return to see if they're getting the full benefit of their depreciation?
Schedule E is going to be the first place. So on schedule E of your tax return, if you pull it up, there's going to be a few different columns. Column A, B, C, so on and so forth. And there's gonna be properties listed in each column and down at the bottom of it, you're going to see the net income or loss per property. That's the first place you're going to see it is on schedule one of your form 1040, and there will be a loss, and I believe it's box five of your form 1040 schedule one. So those are the two places you'll typically see it.
So if our listeners go pull out those tax returns, to make sure they're getting a full use of that depreciation afforded to us by the the tax code. On the issue of depreciation, not all depreciation is created equally, right? Are ther different strategies for looking at depreciation and accelerating that through cost segregations.?
Cost Segregation Studys
So when you have a short term rental property, the depreciation life of that property is going to be 39 years because short term rentals are typically considered commercial - so not the 27 that we think about?
Right. It's 39 because properties with transient use - so 30 days or less on average are considered in that commercial bucket or non residential property as the task code refers it to, which is 39 years. There's going to be components of your property, however, that have class lives of less than 30 years. To give an example of that: land improvements, things like pools, decks, and sheds. Then there's something called tangible, a personal property, which are things like appliances and fixtures and other elements of your property. Now when you buy the property, it's going to be depreciated over that 39 years by default.
What a cost segregation study does is an engineer or software looks at your property evaluates it and says, "okay, this is the breakdown of your 39 year property in this case." And that cost segregation study then gets reported on your tax return. Now, the 5 and 15 year property, which is what you're most likely see in addition to the 39 year, is depreciated over 5 and 15 years, right? Which is shorter and that in and of itself will increase your depreciation expense
There's something called bonus depreciation that's been in place since 2017 what it says is that from 2018 to 2022, it was at a hundred percent bonus depreciation, which means you were deducting the full amount of that five, and 15 year property on in the first year. That has since phased out 20% per year. And currently in 2024 we're at 60%. 2025 will be at 40%. But you're still accelerating or increasing your depreciation expense significantly in that first year.
Is that of the entire property or parts of the property after doing a segregation analysis?
That's a great question. So the 39 year property will always be depreciated over 39 years. The portion that's broken out into five, seven, or 15 year property through the cost segregation - that's going to be what's eligible for bonus depreciation.
The Costs and Benefits of Cost Segregation Studies for Airbnbs
Okay. In your experience, what would an investor expect to pay for a cost segregation analysis?
It depends. There are basically two different ways to go about it. One of them is a software study. Software studies are usually good for properties that are under $1, 000, 000 or so, and those cost approximately $1, 500, which is relatively cost effective for those less expensive Airbnbs.
So is that the investor actually using software and doing it themselves, or are you still hiring a professional?
Usually cost segregation companies will provide this software. There's a few of them that do it, and the investor will go and put information about their property into the software, and then the software will use their algorithms and data that they have as a company to basically create this cost segregation study report for you.
So this is largely driven by the investor in that case, but facilitated through a cost segregation company? Are there some big names out there, Who can our listeners contact?
There's one of them called ELB consulting. Their website is: DIYcostseg.com. They'll do the full study for you, but they also have the software component too. There's another one out there called KBKG that does cost analysis studies as well. Those are the two that I've seen a lot of our clients and investors use.
Okay. So under a million dollars, it's kind of a hybrid approach where you, the investor, are in the property picking out your cabinets and things like that, and then putting them into the software to be analyzed by the software and the software provider to give you that report back?
Right.
And then you just turn that report over to your CPA?
Yes. The other way to do is a more traditional cost segregation study. And this is where an engineer comes to your property and they actually survey the property and they go back and they do their own report.
Is there a timing component to this? Like, does it make sense to try to do a cost segregation analysis early in owning the property before you've already begun depreciating it?
Yeah. Most of the time, you're going to do the cost segregation study around the time of acquisition. And then sometimes they might come back and do a second one. It's a phase two. If their property underwent significant renovations, but I usually don't see that on short term rentals
Are Cost Segregation Surveys Worth the Money?
For the average investor with a $300,000 - $400, 000 short term rental, single family property does it pencil out? Does it make sense to do the DIY? Are they going to get more back in tax savings than the $1,500?
Yeah, I've seen it almost always makes sense to do if you have a property that is that size. I don't remember a time when it didn't make sense, but I'm not saying that doesn't exist. But generally speaking, if you have a property, that's $300,00 - $500,000 DIY cost segregation is probably going to be the way to go.
Okay. And again, this is a accepted practice by the IRS
Yes. Recently one of these survey companies went through an audit on their software cost segregation study and won the audit. That was the first step in the direction of, okay, this can be substantiated under audit. It is legit. Now, before that, what they would do if you were audited and it was in question, they would usually have a service actually do the physical study to make sure that everything was backed up. But, with this win with the software study it looks good for this type of thing.
I know exactly what Culin is doing as soon as this podcast is over. I've thought about it. It's been on my to-do list. And I think I assumed incorrectly, and I'm so glad to have talked to you about it, that it was just going to be cost prohibitive. I love this DIY hybrid model, it's super smart.
Tax Advice for First-Time Airbnb Investors
Tom, any advice for the first time Airbnb investor who's filing their very first set of returns?
We've had a bunch of people come to us, who self filed their return and ran into significant struggles trying to report the short term rental strategy on their tax return in the way we're speaking of. Because TurboTax Online, for example, does not offer the capability to make the right elections and check the right boxes, so to speak, to be able to actually use this strategy.
So the first thing I would say is you probably want to avoid DIY filing. You can do it on TurboTax Desktop, but it's kind of complicated. And secondly, you want to find a CPA who understands the strategy as well as how to file it on the tax return. Because there's been a ton of people we've advised on this. We give them everything they need, all the details, they do everything right. Then they go to their CPA and their CPA has no idea how to do it. So if you're going to be using the strategy, you definitely need to work with a tax preparer who understands not only the strategic component of it, just so that they're comfortable with it, but also know how to file it properly in a tax return.
How to Verify a CPA is STR Tax Savvy
What would be a good qualifying question to bring to your CPA to see if he/she has the knowledge and expertise necessary to implement the STR Loophole strategy.
There's two or three questions I would ask. The first one I ask is: are you familiar with the short term rental exception of seven days or less and materially participating? If you go to them and they have no idea what you're talking about, If they look at you like you're crazy - they're not the professional to help you file your Airbnb taxes. The point I'm trying to make is youneed to find somebody who understands the strategy of it.
The second thing I would ask is how many short term rental investors are you currently working with? Because that's going to give you an indication of, do they have experience actually doing this, or are they just telling you what you want to hear?
The Book of All Short Term Rental Tax Secrets
What inspired you to write your book: Short Term Rental Tax Secrets?
While the pandemic was still going on, we did a podcast series on the short term rental loophole going pretty in depth. And that's kind of what popularized the strategy and got it out there in the community. But we still found even to this day, there's a lot of short term rental investors who are unaware of this. Maybe they're not listening to podcasts. Maybe they're not on YouTube. Maybe they're not in these niche real estate communities. So we put it out on a book to get it out to more people.
The second reason is, I could tell you the short term rental loophole in a nutshell is an average stay have seven days or less and meet one of three material participation tests, 500 hours or more, or do everything yourself or a hundred hours or more and make sure no one else spends more time than you. That is the strategy in a nutshell. But when you actually go out and apply it, there's all these questions. What if I do this? What if I want to have my cousin stay at the property? What if I have a partner in the property? There's all these "what if" questions and nuances that we've came across working with clients on this, that we decided to put all that in the book. So itcould be a reference for people who've already using the strategy and have questions. So that's what inspired us to write the book.
With the Host Coach book, we had a system that worked and wanted to share it with the world to make everybody's life easier. And it's a great book, it's concise. Don't be apprehensive about buying a tax book. Taxes can be exciting when you understand the strategy is going to make you money!
Yeah. And we laid it out in a way to be accessible to somebody who's brand new to this world of taxes. We wanted to explain how the code works, how the U. S. tax system works, and then how specifically the strategy works step-by-step. So hopefully we achieve that!
Tom, how can our listeners get in contact with you if they have questions, want to use your services?
The best place to do that would be therealestatecpa.com/Thomas. That's my personal page there. If you want, you can request a free 30 minute discovery call. We'd be happy to learn more about what you have going on and if we're a good fit for your situation.
All right, guys, 30 minute consultation. Thank you so much. Really appreciate you sharing all of your knowledge on a very niche but very important part of taxes related to short term rentals.
So there you have it! You now know exactly how the STR tax exception can save you money in taxes now and in the future. You also learned Tom’s advice for first-time Airbnb investors filing taxes, as well as the two questions you can use to qualify a CPA. Don’t forget to order his book: Short Term Rental Tax Secrets to use as a reference!
If after listening to this episode, you feel the need for a short term rental support, we do offer Airbnb coaching packages so schedule a free 30 minute Airbnb coaching session to see how we can help lighten your load and get you to your goal faster!!