Getting into real estate investing has become more complicated over the last few decades. Traditionally, real estate investors would rent properties to tenants as long as they could pay the rent. With the rise of companies like Airbnb and VRBO, there is a whole new class of investing within real estate, namely the short-term rental investments (STR). For those trying to invest in rental properties for the first time, choosing between short-term and long-term rentals could have serious implications for your overall financial plan.
Key Takeaways
- Rental property investing can offset wages or business income when you file your taxes; however, you will need to meet Real Estate Professional Status and/or Material Participation tests for specific properties.
- Short-term and long-term rentals have different REPS or Material Participation rules.
- If your objective with a rental property is to maximize profit and get a tax break from your other income, then the short-term rentals (STRs) may be best for you.
- If you are looking for more stability and less hands-on management of your rental property, then a long-term rental (LTR) may be ideal for you
Tax Implications of Rental Investing
Rental income is generally considered a passive activity for tax purposes on new rental properties. One of the best advantages of rental property investing is that, under the right circumstances, rental losses may offset wages or business income. However, that is only true if one meets either the Real Estate Professional Status and/or Material Participation tests for specific properties. Without doing so, rental losses can only offset rental income, and any additional losses can only be carried forward to offset future years of rental income.
Achieving Real Estate Professional Status (REPS) is ideal, but as the name implies, you need to be a real estate professional. The IRS sets these levels at either 50% of your working hours annually or at least 750 hours each year dedicated to real estate. For those whose primary job is not in real estate, this could be a higher limit than is worth attempting to reach. While tax savings are preferable, you need to factor in the time and energy required to get to this level, and whether the extra tax savings are worth the work for your real estate investments.
The benefit to the REPS is that it is not specific to one individual property. The Material Participation tests, on the other hand, are generally subject to specific properties. The IRS provides 7 material participation tests, and meeting any one of them may allow the activity to be treated as non-passive. Unfortunately, none of these tests are relatively easy to meet. The most popular and arguably easiest way is to participate for more than 100 hours in the activity, and more than anyone else for that property. This means more than any vendor, cleaning service, property manager, etc. Once reached, the property could then likely qualify for active status and allow losses/deductions to offset your income, which was generally the goal in the first place.
Short-Term Rentals
One of the biggest advantages of choosing Short-Term Rentals (STR) over Long-Term Rentals (LTR) is that, in the right situation, the REPS threshold is not required. Traditionally, LTR activity is generally considered passive by the IRS. So, to receive favorable tax treatment, LTRs must meet both REPS and material participation. However, if a property can meet the IRS definition of short-term, then the property may automatically be considered an active business income and therefore does not require REPS for favorable tax treatment.
To distinguish the short-term properties from the stereotypical long-term rentals, the average stay for guests of the property needs to be 7 days or less. The most common example of this is for Airbnb properties in vacation destinations. Most rentals may be for a weekend or a week before the renter leaves, and a new renter comes in. Due to the high turnover, increased maintenance with cleaners, repairmen, etc., these activities require business-like management to operate.
So, from a financial planning standpoint, you may not need to be a real estate professional if you operate STRs, but you still need to meet one of the material participation tests. If you decide to go down the path of STRs, make sure you can reach the level to offset other income. Otherwise, you may put in a lot of additional work for the same benefit as LTRs.
Long-Term Rentals
If the goal instead is to get exposure to real estate, earn a profit, have some rental income, and keep the entire process relatively hands-off, then LTRs may be the better approach. They will generally require less tax complexity, less management, and less time required on your part. You don’t have to worry about logging hours, reaching REPS, or materially participating at each property.
The main trade-off is that you may not receive the same tax advantages that STRs could provide. To get to those advantages, LTR owners generally need to pass both REPS and material participation rules. If not met, any losses in these investments will simply offset the rental income/gains. Sometimes, giving up the best tax situation is worth not taking on the required time and commitment to maximize every tax strategy. For those looking at rentals as a long-term investment and less like another company to run, LTRs may be a more appropriate path than STRs.
Short-Term Vs. Long-Term
Choosing between short-term and long-term rentals will mean different paths towards either the REPS or Material Participation rules. Understanding what your goals are within your real estate investments is critical here. If the goal is to maximize profit, as well as a tax break from your other income, then the STR may be the preferred approach. If you are looking for more stability and less management for your rental income, the LTR may work best.
