Investing in real estate generally 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.
• Investing in Real Estate Yields Tax Savings and Returns but Requires More Hours: Real estate investments can yield large depreciation deductions as well as ongoing income. But in order to offset non-real estate income with real estate depreciation, the investor must be a “real estate professional,” which requires the investor to devote several hundred hours each year to real estate.
• Investing in Short-Term Rental Real Estate Yields Tax Savings and Returns: Short-term rentals can yield large deductions as well as ongoing income from the rentals. The material participation requirements are less strict than the material participation requirements for other types of real estate investing.

What are Real Estate Investments?

This article uses “real estate investment” broadly to mean any investment involving the purchase, sale, management, or leasing of property for profit. Real estate investors can benefit from several tax-saving strategies, but depreciation (specifically accelerated depreciation) is the most important for people looking to reduce their ordinary income taxes. Critically, to offset ordinary income with real estate depreciation, you need to be a real estate professional, which means spending more than 500 or 750 hours in a year on your real estate business. For practical purposes, that means you can’t have another job. But if your spouse doesn’t have a full-time job (and wants to spend 750 hours per year on real estate), or you don’t have a full-time job (and want to spend 750 hours per year on real estate), it can work.

Benefits of Real Estate Investments:

1. Tax Deductions: Investors can deduct a range of expenses, including depreciation, which reduces taxable income.
2. Appreciation Potential: Real estate can appreciate over time, providing both rental income and capital gains.
3. Leverage: Real estate allows investors to use debt to finance purchases, amplifying potential returns and tax savings from depreciation.

Drawbacks of Real Estate Investments:

1. Illiquidity: Real estate investments can be difficult and time-consuming to sell.
2. Management Burden: Owning and managing real estate requires significant time, effort, and expertise.
3. Market Risk: Real estate markets can be volatile, and values may decrease due to economic downturns or other factors.
4. Material Participation Requirements: To use the depreciation to offset ordinary income, real estate has to be your (or your spouse’s) full-time job.

What is an Ideal Use Case?

Kevin, a married New Jersey resident who is a real estate developer, is earning $1,000,000 with a $420,000 annual tax bill. In the past, he has only invested in stock indexes. Tired of paying so much tax on his salary, Kevin buys a $500,000 duplex and rents it out. 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 50%, that will save him $150,000, effectively reducing his taxes in that year from $420,000 to about $270,000 (not including the income tax generated by the rental). Due to leverage, he may have only had to invest $100,000 in the property upfront, with the rest covered by loans. The loan interest will also be deductible, reducing his taxable income by another $20,000 or so. In future years, he’ll be able to deduct additional depreciation as well as interest on the loan. That said, taking on leverage is risky and means that Kevin will have to cover the interest and principal payments as they come due. Kevin or his spouse will also have to qualify as a real estate professional in order to use the depreciation to offset his ordinary income.

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?

Investing in real estate generally and investing in short-term rentals are variations on the same real estate-based tax and investment strategy. Both provide upfront tax deductions. But investing in short-term rentals is more feasible for people with full-time jobs who aren’t otherwise “real estate professionals.” These two strategies also have different investment return profiles — an important factor that should be weighed alongside the possible tax benefits.

Conclusion

Investing in real estate generally 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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