[00:00:00] Hi, everyone. This is the how to lower your tax bill 
[00:00:10] podcast. I'm your host, Terrence Hutchins. I'm, a financial and tax advisor in the Dallas Fort worth area. And the goal of this podcast is to help you listeners get 
[00:00:20] educated on different tax strategies. That you can implement to improve your tax situation immediately? Each episode, we'll break down useful tax tips you can use to save 
[00:00:30] money no matter what your personal or business income situation. Because our motto is keep more of what you earn. So let's get into today's [00:00:40] episode. Welcome back to this week's episode. We've been talking about real estate and how it 
[00:00:50] impacts the tax treatment for W-2 filers. And if you recall, we talked about the idea that many people get into real estate and they think immediately they're going to get tax 
[00:01:00] benefits, but they learn about these passive activity loss rules.
So just to get a quick recap, if you have a W-2 job, that's considered an active activity for tax 
[00:01:10] purposes. If you own real estate by definition, real estate is considered passive. So if you have a real estate loss, you cannot use that loss to [00:01:20] reduce your active W-2 income unless you meet one of three exceptions.
Number one, if you're a real estate, professional or your spouse is a real estate professional. 
[00:01:30] So we'll get into that more on a future episode. If your adjusted gross income or your modified adjusted gross income is below $150,000. At that point, 
[00:01:40] you can deduct up to $25,000 of losses against your W-2 income.
 But it starts getting phased out once your income reaches over $100,000, or [00:01:50] you participate in what would be considered a non rental activity. So that's where this short term strategy comes into play. Where if you own what would be considered a 
[00:02:00] short term rental, then you can actually take a tax loss and use that tax loss to offset your W-2 active income.
Now I always encourage people 
[00:02:10] that when you do any investment, taxes should be a secondary benefit. The investment itself should be the primary focus and the returns that you are anticipating 
[00:02:20] should justify making the investment. The taxes should just be a bonus. But when it comes to tax losses, I will generally look at having about a 15 
[00:02:30] percent return on the amount of tax losses that you have. So you make money in real estate three primary ways. The property can go up in value. You can pay down the debt that you have. 
[00:02:40] And then you can have cash flow. And then you get the tax benefits. Sometimes those tax benefits are realized in the current year.
Sometimes they're realized in future years. But if you 
[00:02:50] have a tax loss in real estate, I will attribute 15 percent of that tax loss towards your return. So if you have a $10,000 tax loss, I say, hey, you could have a $1,500 
[00:03:00] return attributed to that tax loss, even if you're not able to use it because you can use it in future years.
So I point out that return dynamic and how you make money in [00:03:10] real estate because whether a property is a good investment or not, taxes can certainly enhance that. But when you underwrite it for a short term rental. I encourage 
[00:03:20] investors to look for a property that can get at least 20 percent of the income compared to the purchase price. And so now with rates being as high as they are and the fact that you're going to have a lot 
[00:03:30] more operating expenses running an Airbnb or VRBO, and then you have all the capex expenses on the front end, you're going to want to make sure that you're able to generate more rental income. So if you were to 
[00:03:40] compare, the purchase price, let's say you got a $500,000 purchase price. You're saying, okay, can I get 20 percent of rental income from this property at least over time. Now, you may 
[00:03:50] not be able to do that initially, but you want to say, does this property have the potential within the first three years, to get to that $100,000 mark so that it will basically give you the return required 
[00:04:00] to make it a good investment.
Because When it comes to the total return, ideally you can get most of your return back at least on a cash basis within the first five years. So I 
[00:04:10] invest $100,000 between the growth on the property, the pay down and the cash flow and the tax benefits. Hopefully I can get that $100,000 back equivalent within the first five years of the 
[00:04:20] property.
So that's more on the investment side. But, going back more so for the tax component, when it comes to the short term rental, the IRS defines a rental [00:04:30] activity generally as the rental of real property for an average period of seven days or more. So that means a non rental activity would be the rental of a [00:04:40] personal property that is seven days or less. Which comes into play, a short term rental. Now there's also a avenue
if you provide. substantial services, and the average day 
[00:04:50] is 30 days or less which most people aren't providing substantial services. So you're not actually running a bed and breakfast or like a hotel. You're not coming in providing concierge 
[00:05:00] services for your guests. Most people are going to be looking at this to say, okay, is the average day for my guests, seven days or less.
So that's important. If you're going to go this short term rental route, You have to track 
[00:05:10] which most booking sites will do this for you, but if you self book yourself, you're going to have to track the average day per guest. Now the guest, they, they can come back. So if I stay in my short 
[00:05:20] term rental, or if I have a guest stay in my short term rental, and that same guest comes back three months from now, that's two different stays.
So even though it's the same person, it would be considered as a different guest. [00:05:30] It just can't be consecutive as far as when they decide to stay. So you're gonna have to count the average stay that they have and it, it can't be 7.1, [00:05:40] 7.2, it has to be seven or less on average for you to be able to take advantage of this tax rule.
Secondly, you have to materially participate in the management 
[00:05:50] of your short term rental. There are seven different criteria that would allow you to qualify for material participation on a rental.
For the most part, 
[00:06:00] most people would be looking at the first three. So either you spend more than 500 hours a year on your short term rental business. You do substantially everything for that 
[00:06:10] short term rental, meaning no one else does anything. You do the cleaning, you do the tenant maintenance, all the responding. You're doing everything or you spend at least 100 hours a 
[00:06:20] year and more than anyone else. So if you look at. That criteria, if I'm looking at hours, that means I would actually have to track my time. So when I 
[00:06:30] have to track my time, I now have to determine which hours count towards those material participation rules.
Now, hours that are pretty easy would be, for 
[00:06:40] example, showing the property, reviewing tenant applications, cleaning, doing repairs or improvements, inspecting the property, evicting tenants, collecting rent. All those things are 
[00:06:50] just going to be obvious. Now, other areas that generally will not qualify are education hours. Now, if you're not a realtor, for example, and you need like continuing education or 
[00:07:00] you're not, doing some type of educational activity that would be directly related to operating your property, then those hours are going to count. Research. You can 
[00:07:10] obviously look all day for properties, but if you're going to be doing research, this would be, you actually being on the ground, inspecting a property or going to different properties that 
[00:07:20] you're looking to purchase and being able to document which they were, how long you spent and being more detailed in the notes that you take on the activities yourself. So if you ran to the store, you would 
[00:07:30] document the time that you were at the store and what you specifically purchased. Also, if you have a property manager, you're probably going to be hard pressed to determine that you materially participate 
[00:07:40] in the rental activity at least more than anyone else. Now, if you do your bookkeeping, you're going to need to not have a property manager.
If you have a property manager, then the hours that 
[00:07:50] you take maybe reviewing the financial statements from property manager aren't going to count towards the material participation. So it's important that if you want to take advantage of this, 
[00:08:00] that you're going to have to go through the inconvenience of tracking your time to make sure that if you did get audited, you would be able to pass that audit and you would be able to 
[00:08:10] demonstrate that the time you spend is organized and count towards the hours that you have total. One thing to consider is if you have multiple 
[00:08:20] short term rentals and it would be, let's say you kind of have them on autopilot in a sense, you can do what's called a grouping election so you can effectively tell the IRS that, hey, 
[00:08:30] I spend an aggregate. I spend total of 500 hours total between all my activities. So you could essentially count all the activities in short term as one [00:08:40] activity, so if I have 10 properties, I don't have to spend 100 hours on each of them. I could spend, let's say, 50 hours on average on each of them, and that would round up to 100, and that would 
[00:08:50] count to allow me to materially participate. So you have to make that election on your tax return and make sure that it is filed and written properly.
So a few things when it comes to the short 
[00:09:00] term rentals that you need to be aware of. When I think about it, I'm factoring in that one, if the property can cashflow at 20 percent of the property value, then 
[00:09:10] more than likely you're not going to have a tax loss on this property, the worst thing, because if you have depreciation, which we've talked about, that's going to wipe out some of the taxable income that you have.
So I 
[00:09:20] always say, hey. If you make a dollar in real estate and you don't have to pay tax on it, that's, that's better than making a dollar in your business because you have to pay tax on that. So even if you're not reducing your tax [00:09:30] bill in aggregate, you are reducing the percentage of tax that you pay on your income. So that would be a win. But if you just look at the numbers, it would probably make sense for the first year or two, 
[00:09:40] because you're going to have all the capex to get the, property furnished a lot of your time is probably going to be devoted towards that. So it would be a lot easier to maturely participate in the beginning.
[00:09:50] And then you could do what's called the cost segregation study. So you can potentially take, you know, generally between 20 to 30 percent of the purchase value of the property. And for 2025, 
[00:10:00] you can actually do that at 40 percent, which means that if I could take $100,000 first year depreciation, I'll be able to take 40 percent of that
on the property. And 
[00:10:10] so we talked before about what the cost segregation, you essentially will get an engineering firm that will break up the property into four components. You have the land, personal property, land improvements, and the [00:10:20] structure. The personal property are going to be generally things that can be removed from the property. You're going to get a firm that's going to assess the value of each of those components. And as
[00:10:30] long as the components are 20 years or less property, which is going to be your personal property and then your land improvements like the landscaping or a pool or your deck. 
[00:10:40] Those are 15 year property. You're going to aggregate all that together and say, Hey, how much of the house is devoted to that area? I can take a 40 percent tax deduction on those items in the first 
[00:10:50] year. If I do that, that's probably going to generate my big tax loss. I have my hours. And then after that. I now have this cashflow in property, which may not generate a loss, but I was able to use 
[00:11:00] that in the first year.
And then I can basically take my tax savings and maybe apply it to another property and repeat the process. So that's how I would be thinking about using this, because I think 
[00:11:10] that if you're using it properly, you shouldn't see a tax loss on these properties, in relation to how much capital you're able to generate. Now when you are following your 
[00:11:20] taxes, these do go on schedule E. That's another thing that I see a lot where people will follow this on schedule C. Schedule C is for an active business that is 
[00:11:30] subject to self employment taxes. So if you're not providing substantial services for your short term rentals, then this isn't considered a business activity for self employment purposes.
[00:11:40] However, if you are actively participating in the business and you have income, it will be considered a business for section 199A. So if you have [00:11:50] positive income from the property, you still would be able to take that 20 percent tax deduction on the profit that you have. So, I would say year one I would plan to do a lot of my CapEx 
[00:12:00] potentially my cost segregation study so that I can get the big tax loss in year one. I can get all the tax savings, take that money and use it to reinvest into other properties. Then year two, 
[00:12:10] years three and four and beyond, I still want to measure the return on the property. So I'm still looking at my return on equity and my total return on the property overall. But by that 
[00:12:20] point, hopefully I should be positive cash flow at that point, I want to make sure that I'm taking the QBI deduction so that I get a 20 percent deduction on my income, which is still going to say, Hey, if I go to my job 
[00:12:30] and I make an extra $10,000 bonus, I'm paying tax on that first on the full $10,000 versus if I go do it in this real estate venture, I'm only going to pay tax on 80 percent of it.
[00:12:40] So even if I'm showing positive income the full amount still not gonna show because of the depreciation plus I get an extra 20 percent discount on any positive profits that I have. Hopefully you 
[00:12:50] take some things away from this with your short term rentals that yes If your situation deems you to be a high income taxpayer You could still get into real estate and still take your tax losses if you qualify 
[00:13:00] to have a short term rental Which means seven days or less And you've been materially participate and you don't provide substantial services.
If you have all that in place, I would encourage you to look at doing a [00:13:10] cost segregation study on your first year, taking the tax savings, reinvest in that, and then making sure that you're taking the QBI deduction for future years if you do have positive income from 
[00:13:20] that activity. All right. So my tax court case I'll hit you with this week actually happened back in 1985. This was Moss versus Commissioner and it 
[00:13:30] involved a group of three attorneys who went out to lunch pretty much every day and they were trying to deduct the cost of every lunch that they had because they said that they 
[00:13:40] discussed case strategy and managing their law practice. Now, I'm not saying that you can't have a deduction for your meals, but the IRS says that the meal can only be 
[00:13:50] deductible if they're directly related to your business.
 If you're just talking to your law practice, specifically on a daily basis, that's just not going to fly. Now, if you're doing this in like a corporate meeting type structure, or if 
[00:14:00] this was like a weekly meeting for your staff and you provided food, that would be something that would be justifiable.
But just shooting the breeze with your business partners or your spouse, which I see that from time to 
[00:14:10] time. Hey, we're talking about business, so we get to write this off. That's probably not going to fly, especially if you're doing it at such a high rate. Now sometimes I will say, uh, if you have an S corporation 
[00:14:20] owner and you want to try to artificially inflate your salary, you could count the value of your meal in your pay.
And that value is not subject to 
[00:14:30] FICA taxes. So you basically say this is a fringe benefit, I guess you can call it. Where if I did have 10, 000 of meals because, you know, I've worked through 
[00:14:40] lunch, my escort was providing me the value of that meal, but they will include it in my W2 income, that could inflate my salary to try to appease the IRS for me having a quote, unquote, 
[00:14:50] reasonable salary, but I can still not pay as much in FICA taxes.
So if you do have the hankering to have your meals all the time, that might be the strategy to go with if you own an S 
[00:15:00] corporation, but until next week, remember. Keep more of what you earn and we'll talk further about more real estate strategies in regards to W-2 filers. Have a good week.