400: The Truth Behind Short Term Rentals

There's 7 million people that have Airbnb.

Short term rentals are awesome.

I'm even looking to turn one of my long term rentals into an Airbnb.

You're the one sitting there with the IRS agent and the audit are answering the phone call.

So, yeah, the tax lien and the IRS notice has.

That's right. Hey, everybody. Welcome to this week's podcast, the Main Street Business Podcast. For all of you Main street business owners out there, my name is Mark Kohler. I'm here with Matt Sorenson trying to come unplugged, unfiltered, give you the truth about these short term rentals.

Yeah, I mean, I love staying in an Airbnb. I'm even looking to turn one of my long term rentals into an Airbnb. It's been a hot strategy. There's 7 million people that have Airbnbs. Is it really 7 million separate listings for Airbnb?

Okay, now here's why we're calling this. The truth is because there's a lot of promoters out there that are talking about this flow through tax loss that comes through on short term rentals and material participation. And you can do a cost seg. And they're in the way they state it from the stages. Everybody can do this. It's easy, it's great. Da, da da. And then they run off stage. But they're not the ones signing your tax return. You go talk to a CPA that's really signed your tax return. They're not. They're really nervous. So I wouldn't say they're scared to death, but there's some things you need to know here.

Warning, there are some tax code, you know, citations here, but that's what you need to know. Okay? This is where the strategy has been hyped so much that you got to dig into the details. Okay, so we're going to do that. So now, Mark, as the CPA is going to be driving this discussion, I'm going to be. I can be color commentary. Okay.

Usually I'm color commentary. This is a neat trick.

I want to be color commentary.

So also is we're going to give you a little info on our real estate tax summit that we held just last week in Austin so you can dive into some more detail. The recordings will be up soon. We'll talk about that later. Okay, so here's the first thing you need to know. Do you really have a short term rental? Believe it or not, this is the first quote, unquote box you've got to Check in the process. And most qualify. They do, but the test is on what's the average stay of one of your tenants at your short term rental. If it's not less than seven days, you really have a long term rental. And see, some people will rent their homes out to doctors at hot near hospitals or one month rentals.

Yeah. There's a lot of people that call it a short term rental, but they're renting near a hospital and they're getting people staying multiple weeks. They're getting temporary workers at certain places that are staying there for months. They're not hitting this. Maybe it's even vacation rentals where people are staying a week at a time. You're in a week. Like you got to be under a week as your average stay.

Yes. And another example would be ski resorts and places in Hawaii. Families who go stay for a couple weeks, three weeks, a month, and then. But you think it's, hey, this is my Airbnb. Well, the IRS is like, no, no, no, no. They stayed longer than an average of seven days. So what you do is you do the math. You take how many times was it rented during the year and then you take the total number of days rented and just divide it. Total days divided by the number of tenants that stayed. And if it's under seven, you're in. Now why do we care about this? Because if you're going to go down this path of taking this kind of an aggressive loss strategy on short term rentals and cost seg, which we're going to come to in a moment, if you're not a short term rental, you can't even go there. So you need to know right out of the gate, okay, I do qualify as a short term rental. You're still going to put your short term rental on schedule E. We hope we're going to come back, come to substantial services here in a moment. But the first test is not number of days.

Yeah.

So know it. Okay.

All right, we're on the first test. Now. Can I take a step back and say, like, why this is. People are talking about this in the first place. Yeah, yeah. Like what is kind of the hyped strategy if you didn't know already? Okay. Remember with your rental real estate, when you have losses, you can use that against other rental real estate you have, but they're bottled up as passive losses. If I got my regular long term rental, not short term, it's bottled up a little bit. Now we know if I'm a real estate professional and this is one of the awesome stuff we talked about at the Real estate Tax Summit from real estate professional. I can take those losses to offset ordinary income. But if I'm Matt Sorensen, I'm not a real estate professional. I'm lawyer man, I'm business guy man. I'm not in the business of real estate that qualifies as a real estate professional. My passive losses get stuck over here and I want to use those on my rental properties that are cash flowing that I get paper tax losses for against my other income. But it's stuck. Well, there's this little escape hatch on short term rentals. It gets talked about, you can take those losses and now I can throw it over here and offset my other income. Yeah, that's the cool thing about it. That's getting hyped and we're going to get through how that, that works. So I just want to say that the beginning before we dug into all

the details, why, why people?

That's what's at stake.

I think there's one other quick digression here too is that everybody please, no matter what type of short term rental you have, do not stick it over in your S corporation. Many of you that listen to our show know the trifecta. If you don't please YouTube go type Kohler Trifecta, Sorensen Trifecta. We've got numbers of videos on this. Some people think oh it's a short term rental, so I'm generating short term income so I should put it in my S corporation. We are firmly against that. Keep putting your short term rentals on your asset side of the equation. Put, put those in LLCs. If you do have self employment income issues, we can peel that income off to a management company to run your short term rentals. We can solve that problem. But you want the flexibility of your short term rental in an LLC. So you can do 1031 exchanges, move this around in your trust, bring on partners, all sorts of carryover basis strategies you won't get with an S corporation. So if some of you have a short term rental on an S corp, call our office and get a consultation. Go, why did I do this? Who recommended this? And, and let's get into it and maybe unravel it if we need to. You don't want a short term rental in your S corp. Yeah.

And when short term rentals and kind of Airbnb came about, a lot of people thought they're going to be taxed like hotels, you know, or maybe even a bed and breakfast. And so there were kind of Some strategies early on where S Corps were getting thrown out because that's what a hotel may use. Now we may talk about this here as a way if you're kind of in the bed and breakfast or more hotel type structure, what to do. But that's usually using an LLC and an S Corp or the S Corp management company. LLC owns the property. So I just want to note that because that is because some of you may be doing that, some of you might be providing services.

Well, brings us to issue number two. So, so point number one, determine what your average stay is at your rental, make sure your short term rental if you're going to be aggressive with your loss. Strategy number two, make sure your your short term rentals are sitting in an llc. Number three, you've got to ask your question, am I providing substantial services? This is a big one. If you say yes. And we're going to have a little grid for those that are watching this on YouTube. You'll in post production on YouTube we'll have a little slide that'll show kind of this matrix so you can better understand this visually. Some people, hey, I love the podcast. I don't need to see it. So let me try to explain it. If you're providing substantial services, you're now providing that hotel thing the Matt just said, which means you're in the business of a hotel and your income is now subject to self employment tax. Now we've got to create a management company, solve the self employment tax problem, which is okay because substantial services aren't the end of the world. It just means you've got another tax to deal with. Now there's promoters out there that are like, hey, you want to be on the cutting edge of providing more services but not crossing over that substantial line. This is a tricky one.

Yeah, there's a sweet spot, all right. Okay. And so for example, what would be substantial services that's going to cross the line would be, let's say you're providing services during the stay, like cleaning the property during the state daily. Like let's say they're there for five days and you're like I'm in there every day cleaning the property. That isn't going to work. You can do cleaning between people's stays, but the same guest, you don't want to be doing cleaning during their stay. That would fall you in. Or you would fall into substantial services which now you got to pay self employment tax. Now you're more like the hotel and we're going to get into this. Maybe you have An S Corp LLC structure possibly.

Yeah. And this is a very subjective analysis because the IRS doesn't provide a lot of guidance here. Some of the other terms in the, the publication on this that come up that are discussed in providing substantial services are providing other hotel like services, providing transportation, providing meals and entertainment. So think of like a bed and breakfast where you're there cooking breakfast for everybody. Concierge services. What the hell is happening? Right, so you now there's again promoters out that are saying do all these little things so you can charge more with your Airbnb and you'll be booked more and you'll make more money. Okay, I'm good with that. I want you to make money. But on the flip side, if you cross this line, the IRS is going to say you're on a schedule C, you've got to pay self employment tax and you as the captain of your ship, you, you've got to go in with your eyes wide open. You can't just take what these people are saying on podcasts and on stage as gospel that you're going to be

okay unless it's our podcast.

In summary, substantial services know where to draw that line. Be careful. If you're going to push the envelope there and we want you to push the envelope to generate as much income as possible. Just be careful and we have solutions. The S Corp can be a perfect fit. Especially if you already have an S corporation in your life. We can use it to also manage your short term rentals. So it can be an easy solution. It really can.

Remember that's if you're doing substantial services, services doing the stay, cleaning while they're there. You give them a private chef or something and you know that we see those, everybody sees those short term rentals that have a lot of services during the stay. They're creating an experience type thing which is cool. But just know you're falling more into like a hotel bed and breakfast than the short term rental where you're not having to pay self employment tax.

Okay, now everybody, this is where the rubber meets the road. Two words, material participation. Now we have a lot of tax professionals that listen to our podcast and we've got to give a shout out to all of you enrolled agents, tax preparers, CPAs, attorneys, financial advisors. We're grateful that you're here. So I'm going to, I'm going to get a little technical here for a moment but I know many of you that are real estate investors. You want the, the real deal. So here's the thing. Earlier, Matt Said something interesting. He said, well, if you're a real estate professional, you can take all those bottled up losses on your long term rentals and write them off against your other income. That's true, but there's a third little box you've got to check in that process and that is that you materially participate in those long term rentals. Now, 99% of the time you do. And it's a seven part test. I literally have been, I think I was in the Salt Lake Service IRS service center with one of our clients who was a real estate agent with like 30 rentals. He was a broker and he had all these rentals and the IRS said you don't get those losses. Like, what the hell? This is a real estate professional. But when I got into the meeting, I realized that agent was saying, well, you don't materially participate. You've got property managers everywhere. And I immediately pulled out code section 469. I had the seven tests there for material participation. And I go, oh really? And I go, well, he qualifies under 3, 4 and 7. And the agent was like, yeah, and

you only needed one.

You only need one of the seven. Yeah. So you've got to be able to show that you materially participate. And that's even more important when it comes to the short term rental rules.

What did the IRS agent do? He's like, oh, you got me.

I think it was more of a Homer Simpson maybe. I don't know.

Okay, well, let's hit. There's a couple ways that are the easiest though, because there's seven. We don't need to hit all of them, but there's a couple ways that you can hit. So let's go over. We got two of them here and you'll see on the slides those. Catch this on the, on the YouTube channel. So 500 hours y participation in your short term activities. That's going to be the first one. Now how are you going to document that? Let's think about this. How much time are you really spending? 500 hours is quite a bit. Do you have one of these?

What is that, 52 weeks? So that's 10 hours a week, approximately.

Yeah.

Now this is where there's some debate at the Real Estate Tax Summit in Austin. And if you go to www.realestatetaxsummit.com, you'll be able to buy the recordings here shortly. Hopefully by the time you even see this podcast, we want to get those up right away. They're going to be raw, uncut, Just each session. We had 16 sessions and for a couple hundred bucks you can watch those, the recordings. Well, we had some excellent speakers there and we even debated amongst our speakers and some of our experts that were in the room. Is the material participation 500 hour test on all of your rentals or, or just your short term rentals. Okay, now why are we talking about this again? Everybody take a breath. Let's say you are that dentist in Duluth and you're going to buy a short term rental and you're like, hey, I'm going in for the right reasons. This thing's going to make some money. But I like a tax perk on this. Now we know short term rentals generally cash flow better than long term rentals. A long term rental might get you 2,000amonth, a short term rental might get you 5,000amonth. So you're going to have some maybe, maybe if you go, well okay, a lot of times I've seen the ratios of at least double your income per month. Now you got double your costs and you've got management involved. But yeah, anyway, so let's say I go, that dentist goes and buys this short term rental. He and let's say he's married. He nor his wife are real estate professionals. Well, there's this kind of antidated law that says with the short term rentals, if it's under seven days, you're able to take the losses as ordinary losses if you material participate. That's why we're talking about this. So this is kind of this escape hatch, backdoor side door strategy that if I buy short term rentals, I can go do a cost segregation analysis. We'll come to that in a moment. Which means I'm going to ramp up depreciation in the first year I buy this thing. So the dentist knows he's going to cash flow it, but he's going to go in and do this cost seg and maybe drum up 40,000, 50,000 or more of depreciation write offs and offset his income as a dentist, get a refund or pay less in tax. So the short term rental has a two pronged benefit. I'm going to make a good long term real estate investment and I'm going to get an immediate tax benefit on my personal tax return. But you have to show this material participation. So the debate is let's say the dentist has two or three long term rentals and one short term rental is the 500 hours on all of his rental activities or just the short term rental activities. I Debated with at least three experts at the event that said they would have argued either side of that. Yeah. So in. Matt, let me say in summary, the reason why this is so wishy washy. IRS takes a while to come out with new regs. The Congress takes a while to come out with new regs. Airbnbs, they didn't even really exist until 2015. Seven years ago. No one even could describe what this was all about. We're dealing with tax laws that were written back in the 80s and 90s and we're trying to apply this new Airbnb situation. And so it's a loophole and they're going to shut it down. Do you want to be the one that gets their hands cut in the door? Someone's going to have a loss from the IRS and they're going to be like, go, yeah.

Well, I mean, here's the thing for me is like we play the what is the course is laid right, right now the IRS has left this door open and we'll see what happens on it. And so we just want to be cautious on it, you know, to say, what is the IRS's job? To collect tax revenue. This is, you know, subverting their efforts here. But it's what the law says. So on this material participation, just remember, if you have all these losses, and I want to talk about cost seg too, but let's just say the first year you buy the short term rental, you actually have a lot of upfront costs.

True.

These are typically furnished. Okay. You're going to furnish it. That's a lot of money up front that you want to expense and have and, and take that loss. If, if that's your first year, you're not going to have enough rental income to recoup that, even if it's a really awesome cash flowing property. So I want to get those losses over here now. We can even supercharge it with the cost seg and get more losses built up faster because the cost seg basically takes certain items in the property and says you get to write that off faster because the life of all the things in the property is a shorter life lifetime. So we're going to give you a faster expense that you got to take now. That's essentially the gist of it. And so I've got all these front loaded expenses I had to furnish. I do a cost seg so in this first year of operating, I could have a huge write off and incentive to help dentist who's drilling and billing all day making Money.

Yep.

You know, I love it. You like that drilling and Bill, that was nice.

I like that. I was like, are we talking about oil rigs? You know, I love it. Now, again, for you techies out there, we've got to add another. This is like baking a cake. We've been talking about sugar, baking powder, baking soda, salt, you know, all the pieces here. Here's another piece. You have to realize, up until the Tax Cuts and Jobs act with Donald Trump trying to revitalize the economy and come in with this huge tax legislation, the biggest one we've had since Ronald Reagan, the only way we could take cost seg or take some of these write offs was what's called a 179 deduction, where you can ramp up the depreciation but it can't drive you into a deductible loss. That. That was my computer, by the way. Guys, I'm going to get. My producers already gave me a little. So if you're driving down the road, it's not your phone. Don't grab your phone.

Okay.

That was my computer here. So bonus depreciation was unleashed. And bonus depreciation says I can go do this cost seg and buy all that furniture and all that stuff for that Airbnb and I can write it off. And if it gives me a loss, that bonus depreciation can drive me into a loss that I can use against my other income. With 179, you're stopped at whatever your income is. Now, bonus depreciation is 100% of acquired assets or cost this year. It goes down to 80% next year. So there's a little clock ticking here with that. That benefit of bonus depreciation is going away slowly but surely. So there's a. There's a setting sun on this strategy as well that creates a little urgency. A lot of people are excited about getting into an Airbnb before year end, in the next three months, because they could. Yeah, okay. We never got into the second material participation strategy. Number one was 500 hours. 500 hours.

Number two is it's just a hundred hours, but you're doing more than anyone else. For example.

Any more than one person.

Any more than one person.

Yes. Not everybody combined. So let's say you have three short term rentals and you add up how much time they take during the year and each one is at 75 hours. And then. But you put in 100 hours managing the whole three. Well, you put in 100 hours and it's more than any other individual or company helping you.

Right.

But if you have one property manager putting in 150 hours, managing all three, or 225 in that example, then you're out because you're 100. You put in 100 hours, but one person put in more than you did. It's any more than. It's. Again, read it again. A hundred hours of participation and it's more than any other one individual.

Okay.

Not as a group.

Okay. Right. All right.

Yeah. That's tricky, huh?

The person that puts in the most hours.

Yes.

Okay. Yeah. And it was at least 100.

It was at least 100. All right. But you don't have to add up. Everybody just add up each ones and know that you're at the top of the spreadsheet.

Yeah, yeah. So if you have one short term rental, you know, and you have a property manager and you're pretty much not doing anything because the property managers handling everything, this isn't going to work.

No. All right, then we have to go back to number one.

Yeah. And that's probably not going to work either because you're not going to have 500 hours.

Yeah, yeah.

So. So what you would need to be doing in number three there is. You got to be putting in that time. You got to find out how do I get enough time into this where I'm beating that property manager if I have one and I'm doing at least 100 and I know a lot of clients and I, you know, we've had done direct Ira webinar and Short term Rentals, had some experts on. A lot of people do not like using a management company. They feel like they can. That's a big piece of the profit margin if you do it right. But again, if you're hiring all these people, you're just taking over the property manager role and hiring all these people. You still got to hit the 100 hours yourself.

Now, since this is a podcast, should we read off the other five just so people can hear them? And if you're watching this on YouTube, you'll be able to see a slide of the other five. I titled it the five other crappy ones. Okay, so let's just go through this. So now 1 in 3 are your most likely chance of qualifying. So I'm going to read number two and then go to four. Number two is the individual performs substantially all of the participation relative to all other individuals. So now you're adding up everybody and adding up your time. You may have not hit 100, but you. But you do more than the whole group as a whole. And so it's kind of a different way of looking at it, but that's a hard one. So I, but it's maybe a close third. Number four, significant participation activity for the taxable year and aggregate participation in all significant participation activities exceed 500 hours. That's a mouthful. So basically we're back to the 500 hours and you're again putting in significant time and 500 hours. And you may say, well what's different than that? Than number one. And it's basically you're trying to get around the fact that other people are putting in more time. And so the IRS is going to say, well, you put in 500 hours, but, but other people put in more time. So number four is kind of a weird one. But I said this is the list of crappy ones. Number five, the individual materially participated in the activity for any five out of 10 prior tax years. So of the last five out of 10 you did meet the test, but this year maybe you didn't. Maybe you had bad health.

That could be a saver. That could, you would have had to have qualified separately in a, in a prior year. That could be a saver. If you do have a year, you're off on hours.

Yeah. You've got to have at least five under your belt. So let's say you've been doing this for a While, you've qualified five years or and you look at the last 10, as long as you hit five now you can take it easy, you can say, well, I'm going to not manage as much this year or whatever and then you're done. Number six, personal service activity and participation for any three prior years. I'm not going to BS you. That is a hard one. I've never seen a really good example of that. This personal service activity. I believe you're, I'm going to just say here, I think you're showing that it's your primary occupation and that you're doing this and nothing else. But we, that's another consideration. Number seven, based on all the facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis during such a year. Now I love that one because it's a catch all. So when you're trying to fight the IRS on it, you're like, yeah, well maybe I didn't hit 100 or I maybe didn't hit 500, but based on all the facts and circumstances, I did it. You know, and so that's kind of your, it can be very subjective and this is where on appeal you would get to an ir, usually a US District attorney in tax court, which we've had a lot of success with. Usually they're a lot more pragmatic and they're like, we don't want to fight this, we'll go under seven and you're done. But anyway, those are the other five. I, I try to steer clients away from them.

Yeah. And if you think of this, this material participation is important because what they're letting you do, they're basically what the IRS is saying is if you've worked enough into this, we're going to let this count. More like a business that you can take the loss to offset other income. If you don't materially participate enough. We're just going to say passive income loss over here. It's stuck over here. You didn't really do much. You weren't involved a lot. And so in these tests, the point is I'm showing, I'm doing enough to show that the services I was providing, that was material participation.

You know, let me give you my summary takeaway with all that said. Matt alluded to this cost segregation and it's a separate. We've had different podcasts on that topic alone. Go dive deep on it. Understand what it's all about. But it's again, ramping up your write offs in the first year. And if you miss that first year, you can go back up to three and amend and get a refund for that year. So not all is lost. But you have to do the cost sag in the year you put the property into service. You can't say, oh, I'll do it this year. I've had it for five years. Too late. But here's my big takeaway with the cost seg. It allows you to get these pass through losses on steroids in the first year. Like Matt said, your first year you're going to be acquiring, you know, maybe furnishing this place. You're going to have a lot of write offs anyway. And I agree. But cost seg, if you're going to do it, you might as well freaking go all the way. If you're going to take this strategy and go, I'm materially participated, I'm going to take those losses. Yeah, shoot your shot, you know, shoot your shot. Throw some gas on that fire. Let's throw in cost seg. Why not? I'm going. If I'm going to hell, I'm going there. Freaking on the in the fast lane little ACD going to make it count. Man. Yeah.

So

that's when this really matters. Because really, people, if you're doing a short term rental, you better be cash flowing. You're going to have a cash flow scenario and you see that time and time again. The long term rentals, you're building equity, you're covering your piti, your, your cash flowing, but not to the, you're usually going to have losses on paper. A short term rental usually has gains on paper. So this is his first year. Go for the jugular strategy. And if you can hit this material participation, these other tests, review them, make sure that you're driving your ship.

Yeah, yeah. I just go back to, this is an amazing strategy for an investment. Think about a short term rental as an investment. Why would you do a short term rental to get better cash flow income than you could with the long term rental. The properties are both going to appreciate similarly. I mean, the short term rental might get a little more wear and tear, but they're both going to appreciate. But buy it because of the numbers. The tax thing is just like dessert, you know, and you can skip dessert a lot of times, if it works for you, great. But we also don't want you to be like having dessert and you know, getting sick afterwards because you didn't qualify. All this stuff. The IRS starts raining down on this

strategy or you shouldn't have bought the rental in the first place. You went straight to the dessert. Ooh, I love this example. This is a really good dessert first. Yeah.

And then you couldn't even get to dinner because you bought a crappy property.

Oh, I know. Okay, so in this last slide that you're seeing, if you're watching this on YouTube, you can see the matrix. Go across the top and say, am I providing substantial services? Yes, no or no. And then down on the left side column or rows, you can see, did I have a less than 7 day average stay? Yes or no? The reason why Substantial Services has two columns is because one is non material participation, the other one is material participation. So that's going to, if you can follow the little matrix and go, here's where I'm at. Well, here's my benefit. And here. But again, this is all secondary to making a good smart purchase in real estate. So unplugged, uncovered, dissected.

Yeah.

Deconstructed. The truth.

Yeah. You say, I mean, we just tried to deliver for you, you know, and there was so many great tax strategies. I'll say though, at the Real Estate Tax Summit, this is one of the newer ones.

It's a little hot.

We're going to, of course, be following this, see if the IRS does freaking give us any guidance on it or there's any cases that come out of tax court. It's still pretty new, but if you miss the real estate tax summit, the recordings will be out in a week or two. So just be following our newsletter. Make sure you're signed up. You can sign up right@mainstreetbusiness.com and or get over to realestatetaxsummit.com you can always. You'll be able to buy it there, too, in a week or two.

Yep. Thank you. I love how you give James all that extra time. See, James is smiling right now in the studio because he's like, thank you, Matt. I'm like, james, I want these out tomorrow. Yeah. He's like, what the hell are you thinking, Mark? Don't you just push a button? Just flip the switch?

Yeah.

You know Brian Regan. Just switch flipper. Just flip the switch, James. Oh, I love him.

Hi.

Thanks, everybody, for being here today. Hopefully you had a little fun while you digested this complex topic. We'll be here next week with another killer tax legal business building strategy for all of you Main street business owners. So continue to share, give us five stars and we'll see you next week.