This week’s Wealth Formula Podcast features an interview with a tax attorney. While I’m not a tax professional myself, I want to drill down on something we touched on briefly that is incredibly relevant to many of you: the so-called short-term rental loophole.

If I were a high-earning W-2 wage earner, this would be at the top of my list to implement—and I know many of you are already doing it. The short-term rental loophole is one of those quirks in the tax code that most people don’t even know exists, but once you do, it can be a total game-changer.

Here’s why. Normally, when you buy a rental property, depreciation losses can’t offset your W-2 income. They’re considered passive, and they stay stuck in that bucket.

But short-term rentals—Airbnb, VRBO, whatever—work differently. If the average stay is seven days or less and you materially participate, the IRS doesn’t classify it as passive. It becomes an active business. 

That means the paper losses you generate can offset your ordinary income, even from your day job. Normally, you’d need a real estate professional status to get that benefit. This is the one situation where you don’t.

So let’s walk through how it works. When you buy a residential property, the IRS requires you to depreciate the structure—the walls, roof, foundation—over 27½ years. On a million-dollar property, that’s about $36,000 a year. It’s a slow drip.

A cost segregation study changes that. Instead of treating the property as one block of concrete and wood, it carves out the parts that don’t last 27 years. Furniture, carpet, appliances, cabinets, and even ceiling fans—those are considered 5-year property. In other words, you can depreciate them much faster.

Now add bonus depreciation. Instead of spreading those 5-year assets out over five years, the current rules let you write off most of them all at once in year one.

Here’s the example. You buy a $1,000,000 short-term rental and finance it at 70 percent loan-to-value. That means you put in $300,000 cash and borrow $700,000. A cost seg often shows about 30 percent of the property—roughly $300,000—is 5-year personal property. Thanks to bonus depreciation, you deduct that entire $300,000 immediately.

So you put in $300,000 cash, and you got a $300,000 paper loss in the same year. In practical terms, you just deducted your entire down payment against your taxable income. This is what real estate professionals do all the time and why they often end up with no tax liability at all.

In this case, it works for you as a W2 wage earner. And for that reason, I think its one of the most powerful tools out there for high paid professionals that is grossly underutilized.

Remember, the biggest expense for most people is the amount of tax they pay—especially W2 wage earners. This strategy lets you use money you would otherwise pay the IRS to build a cash-flowing asset for yourself. 

Listen to this week’s Wealth Formula Podcast to learn other ways to legally pay less tax!

Transcript

Disclaimer: This transcript was generated by AI and may not be 100% accurate. If you notice any errors or corrections, please email us at phil@wealthformula.com.

 In general, W2 income is hard to defer and you can do things when you’re self-employed or when you have a company or when you have stock gains or investment gains, real estate, those kinds of things. But I think wages, I think you’re pretty much stuck with.

Welcome everybody. This is Buck Joffrey with the Wealth Formula Podcast coming to you from Montecito, California today. Before we begin, I wanna remind you that there is a website associated with this podcast called wealth formula.com. Go check it out. And, uh, one of the things on there that I wanna draw your attention to is the, uh, accredited investor club, otherwise just known as.

Investor club. Uh, this is where if you qualify as an accredit investor, basically that is not something you apply for, but you either are or you are not. If you make $300,000 per year or more filing, uh, jointly, or you have a million dollars of net worth outside of your personal residence, you are an accredited investor, you just didn’t know it, and, uh, who doesn’t want to join a club.

So go to wealth formula.com, join investor club. Now today’s, uh, podcast is going to be a conversation with a tax attorney. And, uh, while I’m not a tax professional myself, I do want to drill down on something that we touched on in this conversation briefly, but probably should go into a little bit more because I think it’s so relevant for this audience.

And it’s called the short term rental loophole. You may have heard me talking about this before, but you know, if I were a hiring W2 wage earner. This would be really at the top of my list to implement, and I know many of you are already using it. I’ve, I’ve talked to some of you who have used it after, during me talk about, which are good for you.

Um, the short term rental loophole is, it’s really one of those quirks in the tax code that most people don’t even know exists. Uh, but once you do, uh, it can be a pretty significant game changer for you and here’s why. Okay. So if you’re a W2 wage earner, usually when you buy a rental property, all that good tax benefit, a lot of it depreciation, uh, depreciation losses in particular, they can’t be offset by your W2 income.

They’re considered passive and they get stuck in that bucket. But short-term rentals, we’re talking, you know, the Airbnbs VRBO, whatever. They work differently if, if the average stay is seven days or less, and you can, uh, show that you material materially participate. The IRS doesn’t classify it as passive.

It becomes an active business, and that means the paper losses you generate can offset your ordinary income even from your day job. Now, normally you would need real estate professional status to get that benefit. This is one of those situations where you don’t, so let’s walk through how it works. And by the way, you know, I keep calling a loophole.

This is, this is black and white tax law. This is, you know, they call it the loophole. I don’t even know why people call it the loophole, but the reality is that it’s not it. You follow this law. It is black and white in the code, but here’s how it works. Okay? You buy a residential property. Usually, you know, uh, you get depreciation, right?

The IRS requires you to depreciate the structure on paper, the wall, the roof, the foundation, and typically that’s over 27 and a half years. So on a million dollar property, that’s about $36,000 a year. It’s, uh, you know, it’s, it’s, it’s real money. It’s a, but it’s a little bit of a slow drip and. You know, normally on investment property, you can’t use that as a W2 wage earner anyway.

Now let’s get back to that 27 and a half years in a million, uh, dollar thing. So there’s something called a cost segregation study that we’ve talked about again on this show that changes that. And so instead of treating the property as one block of concrete and wood, a cost segregation study basically carves out the parts that don’t last.

For 27 years. And namely, those are things like furniture, carpet, appliances, cabinets, even ceiling fans. Those are considered personal property and are depreciated typically over five years. In other words, you can depreciate them much faster. Now that’s where bonus depreciation comes in. The, you know, the Trump uh, uh, laws now are allowed that five year.

Uh, the stuff that’s depreciated over the five years to be taken all at once in the first year. So here’s the example. I think maybe that’ll help to put all this together. So you buy a million dollar short-term rental, and typically, of course, you’re gonna finance that. And let’s say it’s a 70% loan to value type situation.

So you’re putting down 30%, you’re putting down $300,000 cash, you borrow $700,000. Now a cost segregation study. My experience, having done it many, many times shows approximately 30% of the property, roughly $300,000 in this case as personal property. Okay? That’s not gonna be the same every time, but I, it seems to come out to about that amount frequently.

So thanks to bonus depreciation, that $300,000 that you put down is a down payment. You deduct that entire $300,000 immediately from your taxable income. Again, let’s repeat that a little bit so it’s very clear. You put down 30% to acquire this million dollar property. The cost segregation comes out in such a way that you basically get $300,000 of depreciation.

So effectively you’re writing it all off. I mean, it’s, it’s magical. Okay? $300,000 cash, you get $300,000 pay per loss in the same year. So in practical terms, again, you just deducted your entire down payment against your taxable income, and this is what real estate professionals do all the time and why you often hear that they end up having almost zero tax liability at all.

In this case though, with this so-called loophole. It works for you as a W2 wage earner. And for that reason, I think it’s one of the most powerful tools out there for high paid professionals. And I will say, I think it’s grossly underutilized. I think a lot of people don’t even know about it. Now, remember, the biggest expense for most people in the is the amount of tax they pay, you know, and that is definitely the case for apec, you know, for W2 wage earners, it may not be for for real estate professionals, but it is for W2 wage earners.

What this strategy is allowing you to do is to use money that you’d otherwise pay the IRS to build a cash flowing asset for yourself. Anyway, I wanted to drill down on that because I think it’s really a really powerful tool. I think people should consider it. Now, for today’s show, we’re gonna talk t