As most physicians who don’t have self-employed income will attest to, there’s not a lot in the way of tax strategy for W2 earners. However, there are some powerful ways to reduce your taxable income as a doctor if you’re interested in active real estate investing. Two of those ways include electing real estate professional status (REPS) for those investing in long term rentals, and the short term rental tax loophole for those investing in short term rentals. The ability to qualify for REPS is significantly harder for physicians or physician families who are working full time, as the criteria for material participation cannot be met by most full time physicians. However, when investing in short term rentals, the criteria to take deductions against your W2 income through the short term rental tax loophole are significantly easier to meet, and combined with the popularity of AirBNB and other vacation rentals, many physicians in recent years have flocked towards investing in this asset class. When done correctly, this is a powerful way to reduce taxable income for high income professionals, but requires understanding of several nuances. Below, we’ll cover what the short term rental tax loophole is, how to meet criteria through the material participation tests, and other things you need to know about what is changing with this loophole to decide if it’s an appropriate tax strategy for you to consider.
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How did these loopholes for real estate investors come about to take deductions against their active professional income, including physician pay?
Long ago, it used to be that people were allowed to use the paper losses caused by depreciation on a property that they owned against their income, and many high income professionals, including physicians, would essentially buy rental properties that had real value but showed losses on paper to use this as a way to avoid paying taxes. In the 1980s, Congress changed this to create Passive Activity Rules that meant that all real estate activity was by default classified as passive income, and therefore these activities could not be applied to your active professional income on your tax returns. Through a series of lobbying efforts, eventually Congress passed the Real Estate Professional Status (REPS) exception, which then allowed some real estate investors to use losses from their rental properties against their active income again, assuming they met certain criteria for material participation.
The TLDR is that this reopened the ability to reclassify real estate activity from passive income to non-passive income for individuals that meet certain criteria, and again flow through on the tax return against active income such as your high income job.
There are 2 main ways you will see physicians taking advantage of this part of the tax code, real estate professional status (REPS) for long term rentals and the short term rental tax loophole for, as you would guess, short term rentals. We discuss real estate professional status (REPS) in a separate article, with the criteria summarized in the graphic below.
The short term rental tax loophole does not require that you meet all of these criteria to still count qualifying activity as active income that can be counted against your other active income. It is based on separate criteria discussed below that was originally intended to be used by those operating motels and hotels, back when VRBO and AirBNB weren’t really a popular thing. However, many short term rentals do technically meet these criteria, allowing them to be counted as well. This is why people refer to it as a ‘loophole.’
What is the short term rental tax loophole?
The short-term rental tax loophole is a powerful way to actually reduce the amount of income taxes you pay on your income as a physician (or other active income). This is done by applying the losses on your real estate investing, notably including paper losses of depreciation, on your short term rental investment properties against the income you’ve earned in your day job(s) on your tax return, reducing your overall taxable income for the year.
This will not only reduce the amount of dollars you owe taxes on, but if significant, can even bump some of that money into a lower marginal tax bracket, meaning that you pay less in income taxes on the dollars that remain as it lowers your effective tax rate.
In order to do this, the income from your short term rental has to be excluded from the definition of rental activity outlined by the IRS (see the area on Exceptions under the section titled Rental Activities on IRS Publication 925). If it meets one of the following exception criteria directly quoted from the publication, it would not fall into that category of being automatically considered passive income discussed above:
The average period of customer use of the property is 7 days or less. You figure the average period of customer use by dividing the total number of days in all rental periods by the number of rentals during the tax year.
The average period of customer use of the property, as figured in (1) above, is 30 days or less and you provide significant personal services with the rentals. Significant personal services include only services performed by individuals.
You provide extraordinary personal services in making the rental property available for customer use.
The rental is incidental to a nonrental activity.
You customarily make the rental property available during defined business hours for nonexclusive use by various customers.
You provide the property for use in a nonrental activity in your capacity as an owner of an interest in the partnership, S corporation, or joint venture conducting that activity.
As always, defer to the exact wording on the publication and discuss nuances with your accountant.
Criteria number 1 is the one that we see most physicians following to qualify as an exception to their rental income being considered passive.
What is rental property depreciation?
Rental property depreciation can be confusing to those not used to investing in real estate, but it is one of the biggest tax advantages offered by real estate investing and a big part of why physicians invest in real estate.
Essentially, the IRS recognizes that at least on paper, the value of the hard assets that you bought when you buy a rental property decreases over time. Things wear down, need to be replaced, etc. So regardless of whether the MARKET value of your property is actually increasing, the IRS allows you to deduct the cost that you paid for a rental property over a set period of time. For residential properties such as long term rentals, this is usually 27.5 years, resulting in about 3.6% depreciation every year, and for non-residential properties such as short term rentals this is 39 years.
In the current tax code, the amount of depreciation you can take in one year can also be accelerated, which we will discuss further in the section on bonus depreciation below.
That means that for as long as you hold the property, you use this on paper amount of depreciation as a “loss” on your property’s accounting. In a lot of cases, this depreciation can offset the cashflow from your rental property significantly, or even completely neutralize your cashflow such that you aren’t paying taxes on your rental property cashflow on your tax returns while you hold the property.
If you have a savvy accountant who is well versed in real estate, they may also be able to help you with something called a cost segregation study, which can actually reclassify certain parts of your property from following that 39 year depreciation schedule for an STR to a 5 and 15-year life, allowing you to take more depreciation upfront as well.
It’s important to note that the IRS does eventually get the taxes owed on the income back in the form of “depreciation recapture” when you sell the property. However, if you are a smart investor, you’ll take that money that you would’ve paid in taxes and invest it while you’re holding the property, compounding the returns on your investment.
Why is the short term rental tax loophole popular amongst physicians?
While physicians love to talk about real estate professional status (REPS), the truth is that most physicians have a hard time qualifying for it unless they or a spouse are working part time or not working. This is because the material participation rules for this include working on real estate 750 hours or more in a year (almost 19 full 40 hour work weeks!), and this work has to be more than the amount of time you spend working professionally on anything else in that year.
With the short term rental tax loophole, you don’t have to qualify for REPS status in order to use your ‘losses’ from your real estate activity against your income as a physician on your tax return to reduce your overall taxable income.
What are the material participation tests and requirements you need to meet to qualify to claim the short-term rental tax loophole?
Okay, so if you’re sold on the value proposition of the short-term rental tax loophole, the next question is what you have to do to qualify.
The first is that the activity has to qualify as non-passive, according to the criteria outlined above.
The second is that you yourself have to meet the criteria for material participation. There are seven ways to meet this, of which you must meet one.
You spent more than 500 hours on the short-term rental business
Your participation was substantially all the participation in the activity of all individuals in that tax year (this includes the participation of individuals who didn’t own any interest).
You participated in the activity for more than 100 hours during the tax year, AND you participated at least as much as any other individual (including individuals who didn’t own any interest) for the year.
The activity is a significant participation activity (any trade or business activity in which you participated for >100 hours during the year and in which you didn’t materially participate under any of the material participation tests), and you participated in all significant participation activities combined for more than 500 hours.
You materially participated in the activity (other than by meeting this fifth test) for any 5 (do not have to be consecutive) of the 10 immediately preceding tax years.
The activity is a personal service activity (non-income-producing) for three (doesn’t have to be consecutive) of the previous taxable years
You can say that you participated in the activity on a regular, continuous, and substantial basis for more than 100 hours during the year (see IRS guidelines for relevant exclusions)
The ones that most physicians use to qualify are the three at the top.
The IRS further outlines these criteria for material participation here. You should of course clarify all of this with an accountant well versed in real estate before making decisions based on this information, as there are lots of nuances.
What kind of activity counts as ‘participation’ for the purpose of determining material participation?
This is a little nuanced. You can’t just count anything you want as participation - it has to be work that is done in connection with running the property, not just things that go along with owning or investing in the entity.
That means things like reviewing financial statements or reports on operations, preparing financial statements, and monitoring the finances in a non-managerial capacity don’t count.
What does count are things like developing or improving the property, construction activity, operating the asset, and actively managing the property or the business of the short term rental with things like handling guests.
Importantly, if you have a spouse, your participation includes their participation, even if they are not an owner in the entity and if you’re not filing a joint return for the year.
It is very important to keep careful records that prove your participation. The most straightforward if you were ever to be audited is just to have a log documenting every hour you worked on the property, although it is technically not required. However, to avoid any subjectivity about how long something should take, many physicians on our communities encourage each other to just log the hours.
What is bonus depreciation?
Above, we discussed depreciation being calculated as even spread over the course of 39 years for a short term rental. However, there is another way to do the depreciation schedule that allows you to take more depreciation on a portion of the assets upfront, which is called bonus depreciation. This is essentially an accelerated business tax deduction that allows you to deduct a fixed percentage of the cost of an eligible asset right in the first year, providing a much bigger immediate tax deduction.
It’s important to note that bonus depreciation is only applicable to certain assets of a business that meet eligibility requirements, so even if you buy a property for ‘x’ amount, the entire value of that may not be able to be used for bonus depreciation. Whatever remaining cost is not used for bonus depreciation can still be deducted using regular depreciation methods.
You can learn more about FAQs related to bonus depreciation on the IRS site or by talking to an accountant with real estate expertise.
How is the short-term rental tax loophole changing in 2024 and beyond?
You’ll hear a lot of people incorrectly stating that the short-term rental tax loophole is going away. It is not.
However, the amount that you can bonus depreciate upfront is changing.
The Tax Cut and Jobs Act made it possible to double the eligible bonus depreciation deduction for qualifying properties from 50% to 100%, dramatically increasing the power of bonus depreciation.
This was the case from September 2017 - December 2022, after which it started going down and is on schedule to go down to zero if not changed or extended.
In 2023, you were allowed to do a 80% bonus depreciation.
This year, in 2024, you’re allowed to do a 60% bonus depreciation.
You see a trend here - in 2025, you’ll be allowed 40%, in 2026 20%, and in 2027, it disappears - assuming that something isn’t changed or extended in the interim.
Even if bonus depreciation does go away, the ability to do a cost segregation study will remain to change some of the assets to a 5 or 15 year depreciation schedule.
Conclusion
Short-term rentals offer physicians a unique opportunity to maximize the tax benefits of real estate by utilizing the short term rental tax loophole, assuming that they meet qualifications to make their activity count as non-passive and that they meet criteria for material participation. These benefits can be further amplified by combining them with cost segregation studies and/or bonus depreciation. The value of being able to take this tax deduction against your income as a physician can be pretty powerful. Along with Real Estate Professional Status (REPS), is one of the more powerful tax benefits of real estate investing touted by physicians who are very involved in active real estate investing. If you hear from them that they pay zero dollars in taxes, chances are they’re using one of these two tax strategies.
However, these are not strategies you want to employ without careful guidance from a licensed individual well versed in these topics, such as an accountant specializing in real estate that routinely works with real estate investors, as they can be quite nuanced. When done appropriately, this can be a game changer!
Related Short Term Rental Investing Resources for Physicians
If you want to learn more about investing in short term rental real estate, check out the following resources:
Short-Term Rental Courses:
Accelerating Wealth: Short-Term Rental Blueprint - run by a married hospitalist couple that walks you through how to find the right short term rental investment, the business of owning a short term rental, and tax savings.
There are also more courses that also cover short term rentals in addition to other forms of real estate investing on our real estate investing for physicians page under Active Real Estate Investing courses.
Free Real Estate Educational Events on Short Term Rentals (you must be a member of our communities to access these)
AirDNA: AirDNA provides market and property data and insights for the short-term rental market, assisting property owners and investors in making informed decisions about vacation rentals.
Explore related PSG resources: