Why You Should Know about the Seven-Day Rule
Aug 23, 2024Rental Income and the Seven-Day Rule
Investing in rental real estate is quite rewarding, but not all rental activities are created equal, especially when it comes to taxes. If you are savvy, leveraging cost segregation strategies can unlock significant tax breaks, particularly through the short-term rental “loophole.” Here is how you can make the most of rental real estate.
Active vs. Passive Income and the Game-Changing “Seven-Day Rule”
Imagine running your rental property like a mini-hotel. If you pass one of the IRS’s “material participation” tests and your average rental period is less than seven days, you’re in luck! Your activity is classified as an active business, allowing you to deduct depreciation against active income. This deduction can lead to massive tax savings, especially when paired with cost segregation.
Normally, active income includes salary or wages, while passive income comes from rental properties where you don’t materially participate. IRS Code §469 usually prevents offsetting active income with passive losses, but there’s a gold nugget in Treasury Regulations §1.469-1T(e)(3)(ii)(A). If your average rental period is seven days or less, your activity is not considered passive.
This Seven-Day Rule is a game-changer for short-term rental owners, including vacation homes and Airbnb properties.
Reap the Rewards with the Seven-Day Rule
When your rentals qualify under the Seven-Day Rule, they’re treated as an active business, unlocking several significant tax benefits:
- Property Deductions: Deduct expenses like mortgage interest, property taxes, and maintenance from active income.
- Loss Deductions: Offset rental activity losses against other active income.
- Avoid Self-Employment Tax: Normally, income from self-employment is subject to self-employment tax, but the Seven-Day Rule exempts your rental earnings from this tax.
Supercharge Your Seven-Day Rule Savings with Cost Segregation
Cost segregation is your best friend when it comes to accelerating depreciation deductions, deferring taxes, and boosting cash flow. Typically, 15% to 30% of a building’s depreciable basis can be written off faster than the standard 27.5 or 39-year periods for residential and non-residential properties. Items like carpeting, kitchen cabinets, and landscaping often qualify for shorter depreciation periods and bonus depreciation.
A professional cost segregation study ensures you maximize these tax incentives, potentially slashing your federal and state tax bills and freeing up funds for further investments.
Nail Down Material Participation and Stay Compliant
The Seven-Day Rule offers substantial tax benefits, but you must meet the IRS’s material participation requirements. According to IRS Publication 925, you need to satisfy any of the following annually:
- Participate in the activity for over 500 hours.
- Your participation is the most substantial in the activity.
- Participate for over 100 hours and as much as any other individual.
- Combine more than 100 hours in significant participation activities exceeding 500 hours.
- Materially participate for any five out of the past ten years.
- Participate in a personal service activity for any three preceding years.
- Your participation is regular, continuous, and substantial.
Short-term rental owners should keep detailed records to meet IRS requirements and understand local regulations affecting tax obligations. Note, short-term rentals are depreciated over 39 years if rented transiently, which is less than 30 days.
Conclusion
The Seven-Day Rule is a powerful tool for slashing tax liabilities by classifying short-term rentals as active businesses. This opens doors to property expense deductions, loss offsets, and escaping self-employment tax. A cost segregation study can further amplify these tax savings.
With our and your CPA's help, we will make sure that you meet IRS criteria, maintain accurate records, understand depreciation rules, and consult certified professionals to maximize these benefits. Harnessing the Seven-Day Rule can lead to substantial financial rewards for savvy real estate investors like you.
Contact us to see if COST SEGREGATION is a good fit for your business.
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