A W-2 employee who used real estate to reduce federal taxes on his $300,000 salary by 99% explains how to pick the right property to qualify for the tax loophole and maximize deductions (2024)

Back then, he wasn't aware of bonus depreciation, a tax break that allows a homeowner to deduct parts of their property that depreciate within 20 years. These can include fencing, cabinetry, and lighting fixtures but do not include land value or the foundation.

In 2022, he came across a YouTube video that explained bonus depreciation and how it can be used to reduce taxable income substantially. By then, he had sold his short-term rental property for a profit, but he still owned other long-term rentals.

Since his wife, Eileen Kim, was a real-estate agent, she qualified as a real-estate professional under tax law. Therefore, they used the real-estate professional status and bonus depreciation to reduce their taxable income.

According to 2022 tax records viewed by Business Insider, Michael's income was $300,106, and Eileen's was $122,403, for a total of $422,509. The bonus deductions they claimed on both properties meant they only reported a total taxable income of $6,341, reducing their taxable income by 98.5% and, in turn, letting them owe just $633 in federal income taxes. Michael received a tax refund for what was withheld. These deductions did not impact their state and self-employment taxes.

Most people won't meet real-estate professional status or don't have a spouse who can claim the status. However, other avenues will allow them to qualify, Michael noted.

The main one is through the short-term rental tax loophole (STR loophole). Simply put, when purchasing a property, it must be intended to be used as a short-term rental. This allows the owner to claim it as a business rather than a source of passive income.

In a previous interview with Business Insider, Michael and Brandon Ford, a CPA, broke down the criteria to qualify. Meeting the IRS's definitions is only one part of the process — picking the right property is essential.

The tax-break property

The first step is to ensure you can operate a property as a short-term rental. This means you must research the regulations in the areas you're interested in to determine whether short-term rentals are allowed, Michael said. Some districts may have restrictions on types of rentals and length of time. Places like New York City, San Francisco, and Santa Monica, California, have barred them.

Eileen noted that it's important to research state, county, and city regulations because they could vary. In most cases, state and county-wide rules may be too broad and not specifically ban short-term rentals. Most restrictions will be found at the city level, and they will vary.

For example, Eileen pointed to Henderson, Nevada, which won't allow a short-term rental permit for a house if there is a permit for an existing short-term rental within 1,000 feet. Some cities, such as San Jose, California, cap the number of days in a year a short-term rental can operate. Finally, properties governed by homeowners associations may have their own restrictions, she added.

The second requirement is to materially participate in managing the property. Michael noted that most of the required hours could come from administrative duties such as managing guest check-ins and check-outs, scheduling cleaners, setting up furniture, taking pictures, and making repairs. You'll need to keep a spreadsheet that tracks those hours and proof that you did those tasks. While the participation rules can be met remotely, it's easier if the property is physically near you, allowing you to take on some tasks such as repairs, he added.

But Ford emphasized that if you're remote and using a third-party property management company and you happen to get audited, that will be a red flag for the IRS. This is especially the case if you own a single property. On the other hand, if you own many short-term rentals, then that's a different story. It would be impossible to manage them all directly. On that basis, if you put in more than 500 hours managing your properties, you would meet the participation test even if you hired other people who exceeded your hours, he noted.

For higher-income earners who want to use the tax break to reduce their taxable income, how much house you buy matters, Michael said. The improvement value of a home also counts because it determines the portion of the purchase price that can be used as part of bonus depreciation.

Property with a lower land value and a higher improvement value may be ideal. For example, a property on the beach or in a high-demand area could have most of its value in the land rather than the improvement portion, Michael said. Information for each property can be found on the county website where the property is located. Michael suggests looking at the tax records of similar properties within the area for new construction.

The image below is an example from Michael's property tax record. The amounts circled in red represent the land value, which cannot be claimed under bonus depreciation. His improvement value is $672,000, the total depreciation deductions he can claim.

Finally, you don't want a house that will be a money drain for a tax deduction. And, running a short-term rental property isn't passive if you need to participate materially. The added potential of generating revenue is what makes this a great option, Ford noted. Deductions would cancel out the taxes owed from the property's revenue, and what is left will reduce your W2 taxable income.

"The tax strategy is phenomenal, but first things first, you're getting involved in real estate deals because you want to make money," Ford said.

Therefore, you want to consider what your returns will be for a property both from a cash flow perspective and appreciation, Ford said. This means you'll want to do some of your own underwriting to analyze your numbers from both a tax and revenue perspective.

While it can be difficult to forecast all the numbers, a few estimates can help you get close to an optimal outcome. Consider variables such as what you can charge a night, Ford said.

Michael added that since the average stay of guests combined needs to be less than seven days, you'll want to be sure demand for short-term stays exists in the area of interest. He noted that this can be done by viewing other Airbnb listings and checking their availability. Days that are grayed out typically mean those days are rented, which is a sign of demand. This will give you a rough idea of how booked a similar property is. He recommends a paid tool called AirDNA for deeper market research, which offers data on revenue and the best places to invest for short-term rentals.

Ford also emphasizes factoring in operating costs, property taxes, insurance, utilities, and mortgage interest. These are also tax deductibles beyond bonus depreciation.

Allowable deductions for bonus depreciation can vary by year. The current percentage is 80% of qualified improvements identified by a cost segregation study for 2023 and 60% for 2024. However, the Tax Relief for American Families and Workers Act of 2024, which is in the process of being passed, would set allowable depreciation to 100% through 2025.