Short-Term Rentals vs. Long-Term Rentals: Which One Is For you?
As a tax accountant with over 30 years of experience, I've seen firsthand how the tax implications of rental properties can have a significant impact on an investor's bottom line. When it comes to the choice between short-term rentals and long-term rentals, the tax code can play a pivotal role in determining the more beneficial option.
Short-Term Rentals: Maximizing Tax Deductions
Short-term rentals, defined as properties with an average rental period of 7 days or less, offer some unique tax advantages. The key benefit is that these rentals are considered non-passive activities if the investors can establish Material Participation, which means the paper losses generated by deprecation can be used to offset other active income sources, such as W-2 wages.
For short-term rentals with average stays between 7-30 days, providing substantial services like daily cleaning, meals, transportation, and other amenities can also qualify the income as non-passive. This further expands the opportunities to utilize rental losses to reduce an investor's overall tax liability.
Another tax perk of short-term rentals is the potential for accelerated depreciation deductions. Through the use of bonus depreciation and cost segregation studies, investors can maximize the deductions taken on the property's assets, leading to greater tax savings in the early years of ownership. Bonus Depreciation is sunsetting by the end of 2016. There is a bill in the Senate to restore 100% BD from 2023 to 2026. Many real estate investors are hoping this will pass in the summer. They are literally holding their breath.
However, it's important to note that the provision of substantial services in short-term rentals can subject the net income to the 15.3% self-employment tax. This is a potential drawback that must be carefully considered.
Also, due to aggressive bonus depreciation through cost segregation tend to leave much less depreciation to take in the future years. So, if you want to keep on using the same strategy, you need to purchase new properties every year to generate the paper losses to offset your W2 income.
Long-Term Rentals: Steady Income and Deductions
While short-term rentals offer some compelling tax advantages, long-term rentals also have their own set of benefits.
One of the primary advantages is the ability to deduct a wide range of operating expenses, including mortgage interest, property taxes, insurance, repairs, and maintenance, against the rental income. This can help to offset a significant portion of the rental income, reducing the overall tax burden.
Long-term rentals also benefit from the standard depreciation deductions, which allow investors to write off a portion of the property's cost over 27.5 or 39 years using the straight-line method. That tax deduction may just reverse your next income into a net loss on your tax return. What other investment can produce you cash flow but not tax liability?
For non-real estate professionals, long-term rentals offer the opportunity to utilize the $25,000 passive loss allowance. This means that up to $25,000 of rental losses can be deducted against other non-passive income, such as wages, as long as the investor's adjusted gross income is below $100,000. The limited loss amount will be completely phased out when the income hits $150,000. Now you see why Short-Term rental is a better tax strategy for high income earners.
Additionally, long-term rental income is not subject to the 15.3% self-employment tax, which can be a concern for short-term rental owners who provide substantial services. Also, you can hire people to manage your properties so you can save time and headache and you can actually manage your investment portfolio at a higher level.
Coupled with 1031 Exchange strategy, long term rental is still a great investment strategy for the long run for busy professionals.
Conclusion
In the world of rental properties, the choice between short-term rentals and long-term rentals can have significant tax implications. As a seasoned tax accountant, I've seen firsthand how the tax code can play a pivotal role in determining the more beneficial option.
Short-term rentals offer the potential for non-passive treatment, accelerated depreciation deductions, and the ability to offset rental losses against other active income sources. However, the time commitment involved in STR is not for the faint hearted.
Long-term rentals, on the other hand, provide a steady stream of passive income, the ability to deduct a wide range of operating expenses, and the potential to utilize the $25,000 passive loss allowance for non-real estate professionals.
Ultimately, the decision between short-term rentals and long-term rentals should be based on the investor's specific goals, risk tolerance, and tax situation. By understanding the tax implications of each option, investors can make informed decisions that maximize their returns and minimize their tax liabilities.
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Justine Zhou
Justine Zhou is the CEO of Zhou Agency. As a one-of-a-kind CPA who also excels in real estate investment, retirement planning and insurance, Justine was once given the nickname of "The Renaissance Woman", meaning " a woman who can do all things if she will." In spite of her seniority, Justine is a very approachable professional who genuinely cares about each individual and business' needs and finding them solutions that best fit their unique situation.
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This post is to be used for informational purpose only and does not constitute legal, business, or tax advice. Each person should consult his or her own accountant, attorney, or business advisor with respect to matters referenced in this post. Zhou Agency assumes no liability for actions taken in reliance upon the information contained herein.
