2022 is flying by and the 4th quarter is rapidly approaching. The news is filled with articles about the impending recession, potential housing market crashes and more. Investing right now can be scary, especially when combined with real life increased mortgage rates and decreased retirement accounts returns. It is easy to see why some have turned away from real estate right now. But there are still opportunities out there…
If you are still in the game then the 4th quarter is your time to buy.
Why is the 4th Quarter of 2022 so important for Short-term rental investors?
The 4th quarter of 2022, is the last time to capture 100% bonus/accelerated depreciation before it begins to gradually fade out in 2023.
Purchasing and setting up a short-term rental property in the 4th quarter is also the easiest way to meet the material participation rules discussed below.
What is the 4th quarter STR Investment strategy?
The goal is to purchase a short-term rental property before the end of 2022 and place it into service (rent it). In addition, you need to materially participate in the management of that property. (This means no property managers. You need to manage the property.)
If you can do that (which you can) and meet ONE of the 7 material participation test then you can deduct your “losses” against your non-passive income (w-2,1099) and Maximize your 2022 tax savings.
What are material participation tests and why are they important to short-term rental investors?
To claim your losses as non-passive you will need to demonstrate that you materially participate in the management of your Short-Term Rental.
To demonstrate material participation you will need to self-manage your Short-Term Rental via Airbnb, VRBO, or your direct booking site. (IRS link, Material Participation)
Now, you may be saying… Why do I want to purchase a short-term rental that will have a “loss” to report? I’m looking for cashflow or at least to cover costs… read the Cost Seg section below to learn more…
There are 7 material participation tests but THREE that matter most for Short-term rental investors.
1. You participated in the activity for more than 500 hours.
(This would be the goal for an investor purchasing multiple properties in 2022. The nice thing about meeting this test is that your participation does not need to be more than anyone else)
2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
(To meet this criteria, you need to do it all… no cleaners, handymen, rehabs etc… this would be hard to meet purchasing in January but might be possible at the end of the year… but still if that is your plan you are better off pursuing test #3)
3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
(This test may be the most common test to qualify for material participation for investors purchasing one property. One strategy here would be to purchase in the Fourth quarter.)
Brandon Hall describes this concept perfectly in “The Ultimate Guide to Eliminating Your Tax Bill While Sleeping Well at Night” by Brandon Hall CPA (The Real Estate CPA)
He writes most “AirBnB and VRBO properties are not considered “Rental Activities” under Section 469.” Treas. Reg. Sec. 1.469-1T(e)(3)(ii)(A) provides an exception that states an activity is not a Section 469 rental activity if the average period of customer use for such property is seven days or less“.
Therefore, if Short Term Rentals do not count as Rental Activity then you do not need to qualify for REPS (Real Estate Professional Status) to claim losses as non-passive.
This means you can still practice medicine while enjoying your property and the tax benefits associated with short term rentals (As long as you pass the Material Participation test).
Meeting Material Participation tests # 2 or # 3 is the goal for a STR investor purchasing in the 4th quarter.
Meeting test #3 by recording over 100 hours of MP and more than anyone else can be achieved with a good STR set up. (This approach allows you to have cleaners, handyman etc as long as your hours exceed those services.)
Test #2 can also be used but may be harder because you would be responsible for cleaning, handyman work etc to meet the “substantially all” criteria.
How do you maximize your tax savings by purchasing a Short-term rental and materially participating in the management of that property?
One the most powerful strategies to implement is to perform a Cost Segregation combined with Bonus Depreciation…
What is a Cost Segregation study?
Cost segregation study: is a detailed property analysis performed by an engineer. This study breaks down a property into components and identifies the components of the property that can be depreciated over 5, 7 and 15 years. The components that are in the 5, 7, 15-year category (qualified assets) can account for approximately 25% of the property purchase price (cost of land is excluded). Using 100% Bonus Depreciation you can deduct the 25% identified via the Cost Segregation study, in the first year of purchase.
A general “napkin math” calculation is you can deduct approximately 25% of the property purchase price in the 1st year of purchase when you combine a cost segregation study with Bonus depreciation. In years past depreciation would be spread over 27.5 years (residential) to 39 years (commercial).
Therefore, you can decrease your taxable income by 25% of your property purchase price… That is a big deal… (see the example below)
100% Bonus Depreciation
100% Bonus Depreciation: allows businesses to expense 100% of the components identified in a cost segregation study (5, 7, 15-year components) in the first year they acquire them, rather than depreciating them over a period of years.
This change was put into effect with The Tax Cut and Jobs Act (TCJA) from 2017 which added provisions to the IRS code Section 179 deduction, allowing business owners to take a bonus depreciation of 100% for qualified assets (Identified by a Cost Segregation Study) in the first year. In years prior, bonus depreciation was limited to 50%. The 100% Bonus deprecation will begin fading out in 2023.
100 percent After September 27, 2017, and before January 1, 2023
80 percent After December 31, 2022, and before January 1, 2024
60 percent After December 31, 2023, and before January 1, 2025
40 percent After December 31, 2024, and before January 1, 2026
20 percent After December 31, 2025, and before January 1, 2027
None After December 31, 2026
An Example of Cost Segregation combined with Bonus Depreciation:
You purchase a property for $1,000,000 and perform a cost segregation study.
The cost segregation study identifies that $250,000 worth of the property’s components fall into the 5, 7, 15-year category and qualify for bonus depreciation (25% of the purchase price).
After discussing with your CPA you elect to take 100% bonus depreciation of the cost segregated components for the tax year that you acquired the property.
If you pass one of the 7 material participation tests in managing your Short-Term Rental(s) you can take a depreciation expense of $250,000 resulting in a tax saving of $92,500 depending on your Federal tax bracket (example uses the 37% tax bracket).
If you placed a 10% down payment, $100,000, to purchase your $1,000,000 property, then the tax savings you achieved ($92,000) via your cost segregation study and bonus depreciation are nearly equal to your down payment. As you can see this can result in a great return on your investment.
This is an unbelievable opportunity and incentives real estate investment. Read about these principles and discuss with your CPA, financial advisors and investment team about these topics.
If you are interested in learning more about Short-term rental investing and self-management then check out:
The Carpe Diem MD Short-Term Rental Course + Physician Burnout & Wellness CME (click the link below)
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Carpe Diem MD
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