The Tax Deductions & Tax Rates of Renting Out Your Property Short Term vs Long Term in 2023
Owning rental properties can be a profitable operation but it can also make or break your tax return based on the IRS rules for rental properties. When you purchase a property with the intent of renting, how do you decide between operating a short term versus a long term rental? This is a conversation we have with clients often. Let’s talk about how to evaluate your rental property activities and expenses to maximize your rental property tax deductions.
How does the IRS define short term versus long term rentals?
If the average stay of renters is 7 days or less, it’s considered a short term rental property. If the average stay of renters is more than 7 days, it’s considered a long term rental property.
What expenses from rental properties can be deducted?
Qualifying expenses are the expenses incurred in renting a property (either short or long term) and typically include: depreciation, mortgage interest, property taxes, utilities, insurance, repairs and maintenance, and operating expenses. Operating expenses of a rental property can include any expenses necessary for the operations of the rental which may include salaries and/or fees charged by independent contractors. Most property owners think to claim expenses from cleaning and maintenance, but you can also deduct bookkeeping, accounting, legal, and other services.
Which is better for your tax return, owning a short term rental (STR) or a long term rental (LTR)?
While the answer is ultimately “it depends,” a short term vacation rental can be better since it allows for active losses. STRs generate active rental income while LTRs can be considered passive if you are not a real-estate professional. Deducting passive losses will be limited to the extent of passive income or $25,000, based on your modified Adjusted Gross Income (AGI). The $25,000 maximum passive loss is only allowed for AGIs under $150,000 for married filers or $75,000 for single filers. STRs are especially recommended when the owner/taxpayer materially participates in the rental activity. To materially participate, the taxpayer must meet one of the following seven tests for each property, or you can look into grouping properties together so the test can be applied based on rental activity across the properties. Usually Test Three is the easiest test to pass for STRs.
- Test One: Participation for more than 500 hours.
- Test Two: Activity that constitutes all participation substantially.
- Test Three: Involvement for more than 100 hours and no less than the participation of any other individual.
- Test Four: The activity is a significant participation activity, combined with all significant participation activities, for more than 500 hours. A significant participation activity is a business in which the taxpayer participates, without qualifying for any of the other six tests, for more than 100 hours.
- Test Five: Participation during any five of the preceding ten taxable years.
- Test Six: The activity is a personal service activity you participated in for any three prior taxable years. Personal service activities are activities in which capital is not a material income-producing factor, such as health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
- Test Seven: Partaking for more than 100 hours and based on all the facts and circumstances, on a regular, continuous, and substantial basis.
If you file taxes as a real estate professional, will a STR or LTR have a lower tax rate?
If you qualify as a real estate professional or your rental activity is considered active (non-passive), owning a short term versus long term rental property will not matter when it comes to taxes. If you are not a real estate professional according to the IRS, we advise our clients to keep their average stay for guests to less than a week at a time in order to qualify as a short-term rental. As a STR, you can avoid the passive activity limitations and utilize losses as incurred (barring any basis limitations). In addition to the rental periods being 7 days or less, we advise our clients to spend more than 100 hours managing the rental, and no less hours than any other individual. For example, the cleaning crew cannot spend 150 hours on the property if the owner/taxpayer is only spending 100 hours.
What if you only want to rent part of your property, like a room or guest house, what expenses can be deducted?
You would need to determine the square footage of the rental space and divide that by the total square footage of the property. Once that percentage has been calculated, it is multiplied by each qualifying expense to determine how much can be deducted.
Check out these examples from two of our clients, one with a short term rental and one with a long term rental.
This is his first year (2022) of owning a short term rental. He had $29,000 of income and his expenses totaled $223,475, resulting in a net loss of $194,475. The loss was allowed to be deducted from his 2022 tax return because he materially participated in this short term rental. All qualifying expenses are listed below:
- Depreciation: $179,250
- Insurance: $1,121
- Mortgage Interest: $9,898
- Professional fees: $2,617
- Repairs & Maintenance: $9,465
- Taxes & Licenses: $266
- Property Taxes: $12,678
- Travel and Consumables: $1,820
- Utilities: $6,360
Owns a long term rental and had income of $15,300 and expenses totaling $19,014, resulting in a loss of $3,714. The loss was disallowed because: the long term rental is a passive activity, this taxpayer is not a real estate professional, and because his AGI exceeded the $150,000 limit. The loss will be carried over to next year when/if there’s passive income to offset the loss. All expenses are listed below:
- Mortgage Interest: $5,616
- Repairs: $2,462
- Supplies: $372
- Property Taxes: $4,426
- Depreciation: $5,313
- Small Appliances: $325
- Professional Fees: $500
When it comes to tax obligations, which states are most conducive to owning rental properties?
The states most conducive to owning rental properties require low or no income tax payments, for example Texas, Alaska and Florida. The less desirable states for owning rental properties typically have the highest income taxes, like California and New York. For short term rentals with a cost segregation study, it could be less advantageous for a taxpayer to own a short term rental if the state doesn’t allow bonus depreciation, like Illinois. Confirm your tax preparer knows when it’s necessary to take Section 179 depreciation instead of bonus depreciation; otherwise you could end up paying more state taxes than originally planned.
What is the 14-Day Rental Rule? (Also known as the Augusta Rule.)
If a property is owner-occupied for at least 14 days in a given year, you can rent it out for up to 14 days tax free in that same year. This short term rental tax loophole can be very advantageous for people with rental properties near widely attended events like ACL or SXSW in Austin. They can rent out their property via Airbnb or Vrbo at high nightly rates during those short periods and earn tax-free income. Another scenario where the 14-Day Rule is advantageous is when renting out a property to your own business for events, holidays, meetings, retreats, etc. Realistically, we only see the Augusta Rule used in 2-5% of the tax returns we file each year.
What other tax burdens should a rental property owner consider?
The largest burden is always the purchase, a large cash outlay that can only be deducted over over 27.5 or 39 years and cannot include any land value. If the property owner is a real estate professional or the property will be a short term rental, we always suggest having a cost segregation study performed if the property basis is high enough (over $500,000) to warrant the study.
Do you own rental properties or are you considering buying rental properties? We can help you explore the tax obligations of renting short term versus long term so you can maximize your investment every year you operate. Schedule an appointment with us today.