We’re frequently asked this question, and the answer we always give is, “Yes...and No.” There are a lot of variables to consider to ascertain if this kind of investment is right for you and your individual financial circumstance.
A few things to consider about this type of investment:
- Like stocks, bonds, options, futures, commodities, and derivatives, short-term vacation rentals are really a distinct and separate “asset class” and can be a valuable and prudent way to diversify a financial investment portfolio.
- Unlike those kinds of investments, short-term vacation rentals are considered a “non-correlated” asset. This means that the property’s financial performance is not directly influenced by market performance like the Dow, S&P, NASDAQ, etc. Factors that most affect a vacation property’s financial performance include: consumer confidence, overall market performance, employment/unemployment numbers, and big influencers like national and international issues and crises. We’re sure there are more, but these are the most relevant.
- Just because the “acquisition cost” of a subject property increases does NOT necessarily mean the corresponding property rental income will go up as well. The best analogy we can make is in comparing a short-term vacation rental property to a “bond” (government or commercially issued). Prices of bonds may go up and down, but the coupon/income rate remains the same - the same as a short-term vacation rental. Prices to acquire may go up and down, but generally, the income they generate may remain flat or slightly increase annually.
*** The following tools to measure property profitability rely on your home being classified as a full-time rental business. That means it’s used by you for your personal/leisure stays for less than 14 days or 10% or less of total annual rental days, whichever is greater. Keep in mind that days primarily spent repairing or maintaining the property don’t count toward personal use day. Just be sure to document what you did to the property during these stays.
If you use your rental home for personal use for more than 14 days a year, you’re only allowed to make deductions in proportion to the amount of time the property is being rented by guests. If you only rent out part of the property, you’ll only be able to deduct expenses in proportion to how much of the property you rent out.
Again, we’re not licensed accountants, so please consult with an accounting professional in your state of residence. Any tax planning tools/concepts are subject to legislative action and changes.
With that being said, there are four (4) generally accepted factors in determining the profitability of a short-term vacation rental property.
- The most obvious is the “CAP rate.” Simply put, the “CAP rate” is the percentage return when you divide the net income (after operating expenses BUT NOT debt service) by the acquisition cost. For example, you buy a $600,000 asset (cabin) and it generates $75,000 of gross rental income. When you subtract management fees, utilities, HOA fees, certain liability insurance, and other operating expenses, you may generate $50,000 “before tax” net income. You’ll have a “CAP rate” of 8.33%...not too bad! Many will refer to this as the ROI, but in the real estate world, it’s called the CAP rate.
- Tax Deductibility of your operating expenses. Since a short-term vacation rental property is considered a BUSINESS, it may provide some very attractive tax considerations and deductions for your operating expenses. Items often include (but are not limited to): management commissions/fees, utilities, HOA fees, certain insurance coverage, maintenance, cleaning, purchases, repairs, renovations, laundry, CC processing, etc. In fact, aggressive tax filers have been known to include and deduct travel expenses to and from their property. BUT BE MINDFUL…the more you deduct, the more you’re likely to increase IRS/State tax authorities’ review of your tax return.
- Utilizing “standard” property depreciation tables and rules. Rental property depreciation is actually one of the greatest benefits awarded to qualifying passive income property owners. The Internal Revenue Service (IRS) allows qualifying property owners to write off a portion of the asset’s initial cost each year in the form of “depreciation losses.” Qualified owners are allowed to recoup a portion of the initial cost of the home every year for as many as 27.5 years. Perhaps even more importantly, these deductions could reduce an investor’s tax obligations come tax time. The more they write off, the less they will have to pay in taxes. BUT using depreciation as a tax planning tool is a complex process and really requires the assistance of a licensed and qualified accountant to help you enjoy this benefit.
- reallocation or reclassification of real property assets. By using this technique, you may be able to dramatically increase the total amount of tax deductions for which you are eligible in the near future. Imagine that you purchase a building for $1,000,000. Currently, this building is depreciable over the course of 39 years. Assuming you pay a 30% rate of tax, you could effectively save about $7,700 per year in taxes by depreciating the cost of this building.
Now, imagine that it was possible to account for half the value of this building in the form of assets that are depreciable on a shorter, 5-year depreciation term. In addition to the $3,850 per year that you could save in taxes based on depreciating $500,000 over the course of 39 years, that $500,000 in 5-year depreciation schedule assets (again, at a tax rate of 30%) could amount to an extra $30,000 per year in tax savings for the first 5 years of ownership.
This is a very complex tax planning concept and requires the help of specialty accounting firms that specialize in this tool. Yes, there are upfront “study costs” to ascertain the effectiveness of this tool for you, but the overall tax savings are probably much greater than that cost.
- Bonus depreciation. Previously, business owners could only deduct 50% of the cost of personal property used for the business each year. The new tax law changes that to 100%, meaning you can deduct the full cost of property such as appliances and furniture all in one year. The changes apply to new or used property placed into service from September 27, 2017, through December 31, 2022.
- New “pass-through” business tax deduction. Under the new Tax Cuts and Jobs Act that went into effect January 1, 2017, residential landlords who own their rental property through “pass-through” entities — including sole proprietorships (meaning they own the property individually), limited liability companies, or partnerships — may be eligible to deduct an amount equal to 20% of their net rental income beginning with the 2018 tax year. This is a personal deduction that can be taken even if you don’t itemize. However, it’s not an “above the line” deduction that reduces adjusted gross income.
- New deduction for major improvements. Section 179 of the tax code allows owners to write off the costs of certain personal property used in a business. Changes to this section now allow some vacation rental operators to write off the cost of fire systems, security systems, roofs, and HVACs. The amount that can be deducted for personal property under Section 179 was raised to $1 million starting in 2018; previously it was $500,000. Section 179 is applicable only to property used for rental more than 50% of the time.
- New Limits on Property Tax and Mortgage Interest Deductions Don’t Apply. The limits on the personal itemized deductions for home mortgage interest and property taxes do not apply to rental businesses. Thus, the portion of a rental property owner’s mortgage interest and property tax allocated to the short-term rental activity doesn’t come within the limits. These are rental deductions, not personal itemized deductions.
All of these tax planning tools and concepts, if used properly and legally, CAN increase your overall profitability for your short-term vacation rental property. Again, and we can’t reiterate it enough: please seek out a licensed, experienced, and qualified accountant to help you navigate these deductions, credits, and itemizations. You’ll be glad you did!
If you have any questions regarding this or any other aspect of short-term vacation ownership and management, please fill out this form or call us at 865-505-0210.
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