Disclaimer: I am not a CPA or a tax professional or a lawyer. Please consult an appropriate professional for legal or tax advice. The views expressed here are purely for informational purposes.
What is your biggest Expense? Tax or Mortgage? For high income W2 earners with $500,000 plus taxable income, tax is the biggest expense. Unfortunately, the IRS code provides very few options for W2 earners to reduce their taxable income. The code is designed to spur economic activity by providing tax advantages for running businesses.
That begets a question, how do W2 earners take advantage of the business tax deductions considering their busy schedule. One business that provides high deductions to offset the high W2 income is short term rentals. Read further for the nuances to maximize tax deduction with minimum involvement.
To take advantage of this tax reducing strategy, buy a property before the end of the year, preferably in November and set it up for short term rental. IRS requires material participation to claim business expenses against active W2 income. IRS has six criteria defining material participation, of which only one is to be satisfied. For short term rentals, setting up and managing the rental satisfies the material participation criteria. With busy professional lives, the end of the year timeframe makes this strategy most efficient. The other nuance to watch out for is that the property is rented for not more than seven days at a time. Ticking these boxes qualifies the short-term rental as an active business to offset the expenses against active W2 income. One can take advantage by implementing this at the end of the year and hand it to a management company early next year if this is not cup of your tea.
Easier to understand with an example, say one buys a property of $ 1 million, one can claim set up expenses but the substantial deduction that makes this strategy lucrative is non cash expense depreciation expense. Take advantage of cost segregation. (accelerated depreciation) and claim almost 30% of the value in the tax year. A $1 million property can provide depreciation of $250,000 or more. Now your taxable income is reduced from $500,000 to $250,000 (more as set up, purchase expenses will qualify for deduction), the tax savings will fund your short-term rental. From 37% tax bracket, you are at 22% or less tax bracket, saving more than $130,000 in taxes. Why will you not do two of these and eliminate your taxes?