You know that saying "You can't have your cake and eat it too." Whoever said that never reaped the tax benefits of a vacation home. So, the question then, how does this work from a tax perspective?
Best to start with an example on how Jon & Jane got an $18,000 refund, and move into the principal's on why this works:
Quick Facts:
John & Jane Doe (ages 40) earn roughly $200,000 per year from W-2s.
John & Jane purchase a vacation home for $400,000, putting $80,000 down.
They'll rent the home when it's not being enjoyed by them. They expect to generate $40,000 in rental income per year, which will be offset by $38,000 in expenses, so they'll have $2,000 of profit each year.
They used the home personally for 30 days, but rented it the other 335 days out of the year.
They spent approximately 200 hours during the year managing the rental property. They had a cleaning person come in to change sheets during the year, that person worked 150 hours.
Tax Results:
John & Jane's property qualifies as short-term rental for tax purposes to which they materially participated in. To offset their $2,000 or profits, they got to claim Bonus Depreciation (wear-and-tear expenses) on the building they purchased at $80,000, so they claimed a taxable loss of $72,000. That loss offsetting their other income generated an $18,000 tax refund for them.
Now, John and Jane are happy customers, as that 18K of savings can be used in a variety of ways to help them fund their goals. Let's explore some of the specifics on how this work.
How this works:
Short-term/vacation rentals can give people the ability to claim losses against their other income, if certain conditions are met:
Short-Term Rentals - Avg. stay is 7 days or less (e.g., Airbnb style) OR avg. period of customer use is 30 days or less and you provide significant personal services (e.g., turndown service).
Material Participation - To be able to claim losses on a short-term rental against your other income, you need to have "materially participated" in that activity. Basically, the IRS is saying you need to have actually treated this like a business in some manner (e.g., managing the business nature of renting the property. To "material participate", you need to either work at least 100 hours and more hours than anyone else or you need to work about 500 hours in the activity (about 10 hours per week, or 2 hours per day).
Depreciation (wear-and-tear) - Probably the coolest part about real estate investing is "depreciation", or wear-and-tear expense that you can claim on the building. The great part, you claim depreciation on the purchase price, not just what you put down. So in John and Jane's case, while they only put $80,000 down, they still get to claim depreciation on the full purchase price of the property.
Vacation Home Loss Limitations: To claim losses against your other income, your personal use of the property cannot exceed the greater of 1.) 14 days or 2.) 10% of the time the home is rented out.
Analysis & Final Words:
John and Jane Materially Participated in the activity working more than 100 hours and more than anyone else that participated in the property. Their personal use of the property was less than 10%, and they provided significant services for the property. As such, while they generated a profit on the property, they got to offset their other income with a massive loss through depreciation.
Real estate is an incredibly nuanced part of our tax code, and the facts and circumstances matter in terms of how the tax treatment works. If you own real estate, are considering purchasing real estate, or just want to learn more about it, book a complimentary consultation with me here: https://calendly.com/curatedaccounting/30min?back=1&month=2020-10