April 11, 2022

There was once a day when all income was grouped into one bucket. This was great for high-income individuals, because they could buy rental property or other passive investments, take losses (on paper), and use these losses to offset their active income. But in 1986, Congress overhauled the tax code, creating two separate buckets of income:

Non-passive income, which comes from your W-2 job, a 1099, business income that you actively participate in, etc

AND

Passive income, which comes from stock dividends, real estate, businesses you’re not actively participating in, etc

With this new tax structure, it was no longer possible to offset active income with passive losses (in most cases).

Here are a couple workarounds:

Workaround #1 is to achieve Real Estate Professional status. This allows you to offset your W-2 or 1099 income with real estate losses. Sounds great, right? However, one of the requirements is that you spend more than half your working time in a real property trader business. Obviously that’s no problem if you work in the real estate field, but if you’re an accountant or an engineer or have any other full-time job... let’s just say it’ll be tough to work 80 hours a week year-round.

Workaround #2 is to invest in short-term rentals, like AirBNB or VRBO. If you can prove that the average guest stays 7 days or less in your property, you’re allowed to use those losses to offset your non-passive income without jumping through hoops to get Real Estate Professional status. The only other qualification for this workaround is that you have to materially participate in the property. Material participation just means that you have to spend a certain number of hours per year working on the property yourself. As long as you’re doing the staging, communicating with guests, maybe some cleaning or maintenance, you should fulfill those hours no problem - just don’t hand the property off to a property management company to do all the work for you.

There’s two options for the hour requirements:

Option A) you spend 100 hours on the property AND you work on it more than anyone else. If you hire a cleaner or a landscaper or anyone else to work on the property for you, your time investment into it has to be over 100 hours AND more than anyone else you hired to work on it. So if you spend 110 hours, and your cleaner spent 80 hours, and your landscaper spent 60 hours on it - you’re good to go because you worked on it more than anyone else.

Option B) you spend 500 hours on your property. This is much easier than the 100-hour rule because you don’t have to keep track of anyone else’s time.

 All that being said, you should start to see why short-term rentals are such a great investment opportunity. For those of us who don’t work in real estate full time, it’s a way to invest in properties, get that cash-flow, and offset our normal, non-passive income.

 **As always, be sure to talk to your CPA or financial advisor before making any moves. My advice isn’t a one-size-fits-all solution, so make sure you find a strategy that fits your specific financial situation.