Using real estate as a source of income is only becoming more popular with the advent of sites like Airbnb and VRBO that enable homeowners to earn extra cash from property they already own. Taxpayers who are new to leveraging real estate for income may be unfamiliar with the tax loopholes available to them. As a tax professional, you may have to overcome your clients’ uncertainty in taking advantage of these loopholes. Take the time to explain how legitimate loopholes were intentionally created by the U.S. government to promote property ownership. By enticing taxpayers with tax benefits, more people are able and willing to make this sizable and possibly intimidating financial investment.
Real estate owners have four main ways to make money off their property:
- Rental income
- Appreciation on the property itself
- Appreciation of inventory
- Short-term rentals
Given its surging popularity and lesser-known tax rules, we will focus this article on short-term rentals. Again, sites like Airbnb and the evolution of the gig economy are presenting opportunities for income and tax planning that were not available before. If someone has an additional unit on their property—say a converted garage apartment or a “mother-in-law suite” as they are sometimes called—that space will receive different tax treatment than a typical rental of a full house or apartment.
A major benefit for short-term rentals comes from what is known as the “Augusta Rule” (Section 280A in the tax code). This rule says that if a taxpayer rents out their primary or secondary residence for fewer than 15 days, then they do not have to report that income. In other words, they can rent out a property for 14 days within one tax year and pay no tax on the income they received. If the total rental days fall within that boundary, the owner also does not have to prorate any of the ordinarily deductible expenses from the home, like mortgage interest and property taxes.
This perk does come with certain limitations, however. For instance, any expenses that are directly associated with the rental—like advertising, commission, or cleaning—are not deductible. This restriction does make sense when you consider that the owner does not have to claim the income on their tax return. Additionally, those 14 days are cumulative if a taxpayer has both a primary and a secondary residence they sometimes rent out. One property owner cannot claim 14 days for one property and then an extra 14 days for the second one.
The rules also differ for a non-rental property that is just personally owned (versus an investment property). For personal property, the owner can only deduct rental expenses to the extent of their rental income. They will also be subject to passive activity rules, which say that these expenses are only deductible to the extent that there is passive income. When the losses exceed the taxpayer’s income, those losses cannot be deducted in the current tax year and are suspended until a date in the future when they are eligible to be deducted.
So what happens if the total short-term rental days exceed that 14-day maximum? The property owner will have to report the rental income earned. However, the benefit is that they may now be eligible to deduct rental expenses, such as repairs, utilities, depreciation, or insurance. What can be deducted depends on factors like the amount of personal use versus rental use of the property. For instance, the owner cannot deduct any interest that is attributable to the personal use of the home. However, say a portion of your property tax can be attributed to the rental use of the home—that amount would not be subject to the $10,000 limit on state and local tax deductions. Allocating property tax to the rental could therefore result in a high overall tax deduction.
Fortunately, even if they do have to claim real estate income, this income type is not generally subject to self-employment tax. Of course, this will depend on how the taxpayer is earning income on that property. Collecting rent alone will not typically be considered self-employment income. However, a real estate agent who is paid commission every time they represent someone in selling or buying a home will have to pay self-employment taxes. Similarly, if the sale of property as inventory is part of someone’s business as a dealer or developer, that income will be subject to self-employment tax.
Lastly, depreciation can be a major tax planning tool. Depreciation can be simply understood as a paper loss—a portion of what was paid for that property. This loss lowers taxable income, so at minimum, the taxpayer will pay less tax on their rental income. Since property is a capital asset, the owner will need to track the property’s tax basis, which is an area where the assistance of a tax professional can especially come in handy. If the property is qualified for depreciation, knowing the basis will enable you to accurately calculate the depreciation and get a bigger write off.
To boost your knowledge on tax benefits for real estate rentals and better prepare yourself to support your entrepreneurial clients, apply to become a Certified Tax Planner today.