Airbnb or Real Estate Professional Status: Which is the Best Fit?
Real estate investors have many tax strategies at their disposal to help them build wealth.
Two popular tax strategies are operating short-term rentals and qualifying as a real estate professional. Both of these strategies offer significant tax benefits by allowing rental property losses to be characterized as non-passive.
Owning rental properties is a great way for real estate investors to build wealth for themselves and their families. The tax code provides several opportunities for real estate investors to capitalize on, making it easier for them to achieve their goals.
One popular tax strategy is operating short-term rentals, which can be done through platforms like Airbnb or VRBO.
With this strategy, investors can have income and losses from rental properties treated as non-passive. However, this strategy may not be suitable for all investors, and it is important to weigh the benefits and drawbacks of this approach before committing to it.
Operating rental properties as short-term rentals is an exception to the general rule that income from rental properties is considered passive income by the IRS.
This can be done by renting properties for periods of seven days or less or renting properties for less than 30 days while also providing substantial services to guests.
Most investors prefer to rent properties out for an average of seven days or less to take advantage of this strategy.
Providing substantial services can be a significant commitment, essentially meaning the short-term rental must function like a hotel. Moreover, taxpayers who provide substantial services may be subject to the 15.3% self-employment tax.
The short-term rental tax loophole is ideal for real estate investors who do not meet the criteria to qualify as a real estate professional.
This includes W-2 employees with high incomes and business owners who often lack the time to satisfy the requirements to qualify for real estate professional status.
Investing in short-term rental properties can produce significant tax savings for these taxpayers. For example, a successful Podiatrist who was a client of Bright Hill Advisors, a specialized real estate accounting firm, reduced his federal income tax liability by approximately $145,000 by acquiring two short-term rental properties.
As with any tax strategy, there are trade-offs investors must consider before committing to it.
Some of the advantages of operating short-term rental properties include non-passive characterization of income and losses, increased profits, and deductible expenses such as advertising, mortgage interest, and repairs.
However, the disadvantages include the time demands of managing a short-term rental property, the unpredictability of income, and the fact that it may not be a fit for every property.
Qualifying as a real estate professional (REPS) is another tax strategy that allows real estate investors to have the income and losses from their long-term rental properties taxed as non-passive income.
To qualify for REPS, investors must meet certain requirements, such as spending over half of all personal service hours in a year in a real property trade or business in which they materially participate and spending over 750 hours working in a real property trade or business.
However, this designation is more difficult to qualify for than using the short-term rental tax loophole and may not be a great fit for many investors.
In summary, real estate investors have access to many tax strategies to accelerate their wealth-building journey.
Operating short-term rentals and qualifying as a real estate professional are two popular strategies that offer significant tax benefits.
However, it is essential to weigh the pros and cons of each strategy before committing to them.
Seeking advice from a specialized real estate accounting firm, such as Bright Hill Advisors, can also be beneficial in designing and executing a tax strategy that fits an investor’s unique situation.