Entering into conservation easements and investing in short-term rental real estate are two popular strategies for offsetting ordinary income tax. How do you know which one is right for you? This article explains what these strategies are and when they make sense.

Key Highlights and Takeaways

• Two Ordinary Income Tax Strategies: Both strategies can offset ordinary income tax at least to some extent.
• Conservation Easements are Risky but Can Yield Large Tax Savings: A conservation easement is a legal arrangement in which a landowner agrees to restrict the use of a piece of land. Conservation easements are a type of charitable gift and yield similar deductions. Donors often claim very aggressive valuations for the land over which the easement is being granted. The resulting tax savings can be quite large, but it is a very aggressive tax strategy that involves significant legal risk to the donor.
• Investing in Short-Term Rental Real Estate Yields Smaller Tax Savings but Higher Returns: Short-term rentals can yield large depreciation deductions, though the upfront deductions may be smaller than the deductions generated by conservation easements. That said, the income generated by short-term rentals can be high, and the rules for using depreciation from short-term rentals to offset other types of income are less strict than the rules for other real estate investments.

What are Conservation Easements?

A conservation easement is a legal agreement between a landowner and a qualified organization, such as a land trust or a government agency, that restricts the development of the land in perpetuity, protecting wildlife habitats or preserving historic sites even if the property is later sold or passed down to future generations. Conservation easements, in short, are a way for landowners to protect property from future development, no matter who ends up in control of the land in the future.

Conservation easements are also a tax tool. When you agree to restrict the use of your land for conservation reasons, the government considers that a type of charitable donation, and you get a charitable deduction based on the lost value of the land. In practice, taxpayers often claim a value that is a multiple of the value at which the land was purchased. This deduction can be used to offset ordinary income up to 30% of the donor’s adjusted gross income (AGI), with any excess carried forward for up to five years.

Because a number of players in the space are unscrupulous, the IRS has become concerned in recent years that the tax code’s conservation easement rules are being exploited. Certain types of conservation easements are now considered “listed transactions” that must be flagged for the IRS. Sen. Ron Wyden, chair of the Senate Finance Committee, has been consistently critical of conservation easements, which he describes as “a tax shelter gold mine.”

Benefits of Conservation Easements:

1. Tax Benefits: A donor can receive a charitable deduction for the value of the easement, which can significantly reduce the donor’s taxes. The resulting deduction may exceed the initial cost of the land.
2. Preservation of Land: The easement permanently protects the land from development, preserving its historical or environmental value.

Drawbacks of Conservation Easements:

1. Permanent Restrictions: Once granted, the easement permanently restricts development of the land.
2. Complex Valuation Process: Determining the value of a conservation easement can be complex and may require an expensive appraisal.
3. Legal Risk: The IRS has been scrutinizing conservation easements very closely, so there is substantial risk that an aggressive deduction will be disallowed.
   

What is an Ideal Use Case?

Gabriel, a single New Jersey resident, earns $1,200,000 per year. His annual tax bill is $550,000. Gabriel happens to be an avid conservationist with an appetite for risk. Tired of paying so much tax on his salary, Gabriel purchased a $100,000 property fours years ago and this year he put a conservation easement on the land to protect it from future development. The easement is valued at $350,000 and he is allowed to deduct this entire amount from his income, reducing his taxable income by $350,000 this year. If his marginal tax rate is 50%, that will save him close to $175,000, effectively reducing his taxes this year from $550,000 to under $375,000.

What are Short-Term Rentals?

Short-term rentals are residential properties that are rented out for a short duration, often through platforms like Airbnb or VRBO. These rentals can generate income while offering substantial tax benefits, including deductions for depreciation, mortgage interest, and other expenses.

How are Short-Term Rentals Treated for Tax Purposes?

Income generated from short-term rentals is considered active income, which allows property owners to deduct ordinary expenses such as property management fees, maintenance costs, utilities, and mortgage interest. Additionally, property owners can depreciate a property over time, further reducing their taxable income. If the property owner actively participates in the rental activities, they may be able to offset other forms of active income with losses from the rental property.

Benefits of Short-Term Rentals:

1. Income Generation: Renting out a property for short durations can generate substantial income, often more than traditional long-term leases (but with higher volatility).
2. Lower Material Participation Standard: If the average length that your tenants stay in your property is less than seven days, you can meet the material participation standard by spending either 100 hours on the rental activity each year (and more than anyone else spends on the rental) or a total of 500 hours working on the rental business throughout the year. The typical real estate professional standard for material participation requires either 500 hours spent on the rental activity or a total of 750 hours spent on the business.
3. Tax Deductions: Property owners can deduct a wide range of expenses, including mortgage interest, property taxes, repairs, and depreciation.

Drawbacks of Short-Term Rentals:

1. Management Burden: Managing a short-term rental can be time-consuming, involving frequent tenant turnover, cleaning, and property maintenance.
2. Regulatory Risks: Many cities and municipalities have strict regulations regarding short-term rentals that are rapidly changing, which can impact the viability of these investments.
3. Income Volatility: Beyond regulatory risks, rapidly changing supply, demand, and platform take rates can dramatically change the income and value of these properties.

What is an Ideal Use Case?

Peter, a married New Yorker earning $1,200,000 per year, has historically invested only in stock indexes. Tired of paying $550,000 of tax on his salary each year, Peter purchases a $500,000 house and lists it on Airbnb. He deducts 60% of this amount as depreciation in the first year, reducing his taxable income by $300,000 that year. If his marginal tax rate is 51%, that will save him close to $153,000, effectively reducing his taxes this year from $550,000 to under $400,000 (not including the income he generates from the rental).

Why Choose One Strategy or the Other?

Entering into conservation easements and investing in short-term rentals accomplish different things. Both provide upfront tax deductions. But conservation easements preserve existing land uses, while short-term rentals generate investment returns. When choosing between these two strategies, the key question is: What are you trying to accomplish? If your goal is simply to maximize tax savings, then it may be a close call. If your goal is to maximize total returns, short-term rentals may be a better choice.

Conclusion

Entering into conservation easements and investing in short-term rentals are both viable tax strategies, but they serve different objectives. Hopefully this article has given you a better idea of what each strategy entails, and whether one or the other might be a better fit.

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