8/29/2021
Disclaimer: Please remember that I’m not a tax professional, so please consult with one before you make any big decisions, thanks!
If you’re an employed physician like me, you pay some of the highest marginal tax rates in the US. We have little ability to shelter income from federal and state income taxes. This is especially true when you live in a high tax state like California.
This is one of the main reasons why I invest in real estate. As a real estate investor, you’re creating a business. The US government likes to encourage businesses, because you’re generating employment and stimulating the economy. In the business of real estate, you’re also providing an essential service: housing.
General tax deductions of real estate investing
To review, these are some of the deductions/expenses of real estate investing that everyone can expect to deduct from your operating income.
- Depreciation
- Mortgage and mortgage interest
- Property management costs
- Repairs and upkeep
- Insurance
- Legal and professional services
- State and local real estate taxes
Read more: Tax benefits | Why I’m investing in real estate over stocks – Part 2
But even though I can deduct expenses and depreciation, there’s a limit to these deductions. The IRS usually classifies real estate investing as a passive business. If expenses exceed my rental income, deductions just stack up to be deducted against future gains in later years. Unfortunately, I can’t deduct against the income from my job as a physician.
The exception to this rule is if you’re a “real estate professional.”
I discussed this special status before in this post: Real estate professional status: a tax shelter for your day job.
If I were a real estate professional, I’d pay very little income tax at all. With the amount of real estate I’ve purchased and renovated over the last year, the associated deductions could easily eclipse my income.
But I work full time as a physician. Therefore, I am by definition not a real estate professional.
The exception to the rule
Even if you have a day job, there’s one exception that you should know about. It’s a specific type of real estate investing that mimics the deductions you can get as a real estate professional.
It’s short term rental (also known as vacation rentals).
This strategy is fully legal, supported by the tax code, and can lead to massive deductions come tax time.
It’s also a little complicated, so here’s the basic strategy in bullet points:
- Buy a short term rental
- Meet the criteria to classify it as an active business
- Perform a cost segregation study
- Accelerate depreciation into the first year
- Legally claim paper losses from your business
- Use the tax deductions from your short term rental and apply it to your active income
How it works: Time limits
First, you should buy a short-term rental property, and ensure that the average guest stay is 7 days or less. (See IRS Section 469.) You also have to limit your “personal use days.” Specifically, you have to abide by the 14-day rule, which limits you to 14 days of personal use a year.
If you exceed 14 days of personal use a year, the IRS will reclassify the property as a personal property, not a business.
How it works: Material participation
Secondly, you have to “materially participate” in the short term rental business to ensure you can apply the tax deductions against your ordinary income.
There are a number of ways that you can show material participation. Take your pick, as you only need to fulfil one of these criteria to show material participation for the tax year (paraphrased from IRS Publication 925).
- You participated in the activity for more than 500 hours
- Your participation was substantially all the participation in the activity
- Your participation was greater than 100 hours and no one else participated in the business more than you
- Your participation was significant participation and more than 500 hours, and you don’t qualify via the other tests
- You materially participated in the activity for 5 of the last 10 years
- The activity is a personal service activity, and you materially participated in it for any 3 preceding tax years
- You participated for more than 100 hours in a regular, continuous, and substantial basis during the year.
Some of these rules are clear as mud, and also depend on definitions of words like significant participation. The definitions can change based on recent case law, so please consult your tax advisor to check if you’re materially participating or not in the business.
The most common ways to show material participation are via the hours rules (criteria 1 or 3). If you go this route, make sure you are keeping contemporaneous (real-time) detailed records in case you get audited.
Why would I want to do this?
At this point, you might be saying, “This is complicated. Is this worth the hassle?”
The short answer is absolutely! For an employed professional, a short term rental can lead to massive tax deductions. Especially if you have a high income and usually pay a lot of taxes, you should definitely look into this.
As an employed surgeon, I fall into this category. In fact, the desire for more tax deductions is one of the main reasons why I got into real estate investing.
The follow up question might then be, “Why would I want to show a loss ? Isn’t the purpose of business to have income?”
You’re right of course — I want to make money from any business activity. But the more I learn about real estate, the more I realize that the skillful use of tax deductions is a hidden wealth accelerant. And paper losses are one way to access tax deductions.
An example from my portfolio
Let’s take this example:
![](https://thedarwiniandoctor.com/wp-content/uploads/2021/06/Camino-exterior-1024x880.jpeg)
This 1940s classic Spanish home has 5 bedrooms and 3 bathrooms, and I purchased it for $1.08 million earlier this year. My family just loves the idea of having a place in Palm Springs for vacations with friends and family. It might also be a wonderful place to retire later on.
We also love that Palm Springs is a hot market for short term rental, which can offer an opportunity to defray the costs of ownership.
The house is pretty rough around the edges and will need some extensive remodeling and a pool to really bring it to life as a great Airbnb or VRBO. In fact, we budgeted up to $300k for the renovation.
We are also paying holding costs for the home during the renovation, such as the mortgage, property tax, and utilities. These all represent deductible business expenses once the house is put into service as a rental.
But the biggest deduction (by far) is going to be depreciation.
Depreciation
Depreciation is the concept that real estate degrades over time. The roof ages, the HVAC loses function, the cabinets get damaged, and even the toilets have a lifespan. In fact, for a single family home, the IRS will assume you’re deducting 3.6% of the cost of home every year as depreciation. This fixes the “lifespan” of a typical residential property at 27.5 years.
An important point is that land doesn’t depreciate. So when you depreciate your property, the land is being carved out of the calculations.
Also, you don’t have a choice when it comes to depreciation. Even if you forget to deduct it on your taxes, the IRS still assumes that you’ve done so. And when you sell the property, the IRS will try to get part of this back in something called “depreciation recapture.” (You can avoid this with a 1031 exchange.)
Accelerated depreciation
Since the 2017 Tax Cuts and Jobs Act, you can also perform “accelerated depreciation.” This is a tax strategy that allows you to take up to 15 years of depreciation and “accelerate” 100% of it into the first year of ownership.
So you get to take a massive amount of depreciation in year 1. In most cases, this will generate a big paper loss.
If you fulfil the criteria discussed above and are running an “active” real estate business, you can deduct the full amount of this loss from your active income.
Of note: the ability to take 100% accelerated bonus depreciation starts to sundown in 2023 when it moves to 80%. It then goes down by 20% every year until it hits 20% total acceleration potential.
Predicting the loss with a cost segregation study
How much will this equate to for an average short term rental home? You’ll need to do something called a “cost segregation study” to find out exactly.
A cost segregation study will analyze your property and assign a depreciation schedule to every component of the home. Everything from the cabinets to the roof will be evaluated and put on schedule over its assigned life span. The first 15 years of this life span can then be “accelerated” by your CPA into the first year of your business ownership.
But I’ve seen that a good rule of thumb is that you’ll be able to deduct 20-30% of the purchase price of a home in the first year via accelerated depreciation.
We’ve performed a cost segregation on the Palm Springs house, and it came back more aggressive than expected. With this study, we expect to deduct over 30% of the purchase price via accelerated depreciation.
That’s right — if we fulfil the criteria, we should be able to deduct over $300,000 from our taxes in April. This should lead to a tax refund of over $100,000.
I spoke to my tax professional last week and confirmed that my understanding of this is correct.
I use Engineered Tax Services for my cost segregation needs. My personal contact there is Kim Lochridge.
Additional deductions
If we can check all the boxes, there are also many more business expenses for the Palm Springs home that we will be deducting against our active income.
Here’s a short list:
- Cleaning services
- Insurance premiums
- Lodging taxes
- Security systems
- Renovation costs
- Furniture and supplies
- Various rental expenses
The cost of having a business
This all comes at a cost, of course. We are investing a tremendous amount of money and time into into this property, with a lot of uncertainty in the year(s) to come due to Covid-19. We have to manage the property ourselves to qualify as “active participants” in the business.
But since we cannot qualify for Real Estate Professional status, this is the best real estate related deductions we’re ever going to see while the Dr-ess and I still work our day jobs. The home office deduction pales in comparison to what we expect from this business venture.
In Year 1 of ownership, we expect a huge tax deduction against our tax return. In Year 2 and beyond, we expect the short-term rental income from this one property to rival the rest of our long term rental income combined.
A note about Schedules
Your CPA might ask if you want to file your real estate taxes on Schedule E vs Schedule C. I’m not going to address this topic today. This post is already pretty long!
But let’s just say for now that it depends if you’re providing “substantial services” for your guests or not. It’s my opinion that it’s much better for you to file the taxes on Schedule E.
Conclusion
If you’re a high income professional and want tax deductions, you should consider starting a short term rental business. My family loves Palm Springs — the community, the mountains, and the energy are all incredibly relaxing. We’re happy to have a vacation home there, and to inject hundreds of thousands of dollars into the local economy with our home renovation.
But as a short term rental business, the home also offers a chance to significantly reduce our taxes. To do this, you have to be prepared to manage the property yourself or invest a significant amount of time into the business. You have to be careful to fulfil the IRS criteria as noted above. But if you do, you’ve got until 2023 to take full advantage of the 100% bonus depreciation.
If you already have a second home or you just love vacation homes, this could be a great fit for you.
Because if you do it right, you might be able to gain a fantastic weekend getaway, a great source of extra income, and a truly amazing tax deduction, all at the same time.
–TDD