In Part 1 we discussed how your objectives should align with your decision to RBO or contract with a PM. In Part 2 we’ll discuss some of the challenges with the industry and how taxes may have an influence on your decision.
Are you prepared for unexpected?
In life, things happen – and usually at the worst times. A/C units don’t go out in 70 degree weather. It’s usually when it’s 95 degrees outside and 30 mins after close of business. You’ll want to have mitigation and contingency plans for any critical aspect of your business. If your coffee maker doesn’t work, you may get a bad review if it’s not replaced immediately, but you won’t likely need to compensate the guest and disrupt the next few guests while you replace the machine. You’re A/C unit, refrigerator, hot water tank, etc. – those can be show stoppers.
If you don’t live within a short distance of your property, you’ll need to consider your options for storing items and getting staff on-site for replacement. If you’re wanting to own multiple properties and avoid the risk of all investments being in the same location, you’ll need to consider how to diversify your investment portfolio along with your emergency planning.
If you’re a remote owner, you’ll also need to have a plan for dealing with disruptive or destructive guests. Neighbors are quick to call the policy when a party gets out of hand. It’s also a pretty disheartening experience to get a phone-call from your cleaner that your property has been trashed or items have been stolen. If the next guest is arriving in 4 hours and you’re missing all of your TV’s, it’s enough to make you sell your properties and give up.
I’m not telling you this to discourage you from getting into the short-term rental business. I firmly believe this is a better cash-flow business than long-term rentals, but you need to be aware of the risks and ensure you have a solid mitigation and contingency plan (not to mention have the time and availability to be responsive). If you feel you aren’t prepared or your portfolio isn’t large enough to justify the cost of these plans you may want to consider utilizing a PM. I’d look for a PM that not only can explain their emergency plans but also illustrate how they can generate more booking revenue to cover their management fees.
Tax Advantages and Implications
I’m not a CPA but any business person should be well versed on the laws, including tax laws, that relate to their market. I would highly recommend engaging with a CPA and possibly a bookkeeper before you make the decision to manage a property yourself or contract with a PM.
How often will you use the property? This will be a big factor in determining your ability to take deductions on taxes. Let’s start out with the simplest of rules: if you rent out your property 14 days or fewer – that is TAX FREE INCOME!!! During special events you could generate $20,000 or more – completely tax free. If you’re not going to frequently rent your property you should take a very strategic approach on this. If you can generate $20,000 in 14 days but only generate a total of $30,000 by renting it more often, you’re much better off not renting it beyond 14 days. That additional $10,000 of revenue will require a more complex tax filing and likely not produce any additional net income after taxes.
Scenario 2: if you personally utilize the property less than 14 days a year – or less than 10% of the time it’s been rented (whichever is greater) – this qualifies as an investment and allows for deductions of expenses. If your expenses exceed your rental income you could wipe out any taxable rental income liability. Note: without getting too far into the weeds…the IRS typically considers this type of income to be passive and won’t allow you to apply losses to your earned income. Instead, the losses can be applied to other sources of passive income (stocks for example) or carried forward to future years to reduce your potential tax burden. Some experts may argue there are ways to get around the passive income rules by qualifying as a “Real Estate Professional” but it’s much too complex to discuss here and best handled by the professionals.
Scenario 3: if you thought the other two scenarios were complex, you better take a seat. If you decide to rent out your property more than 14 days but also use it yourself more than 14 days, you’re putting yourself in this strange mixed tax situation that could require some detailed record keeping. All revenue received for the year is taxable (to clarify: if you receive $20k for 14 days of rent and $10k for an additional 60 days of rent, the entire $30k is taxable). But that’s not the complicated part. The challenge is identifying your deductible expenses. You can deduct “operating costs” for the ‘percentage of time the property was used for rental’. (to clarify: you would add up the amount of time the property was used for both personal and rental purposes in order to calculate the percent of time it was used as a rental). You can then deduct that percentage of your “operating costs” from your taxable passive income. The biggest downside here is any interest or property taxes are not deductible within the business. With the tax changes introduced within the Trump administration, you could be missing out on one of the biggest advantages of real estate investing – the ability to still deduct interest and property taxes.
Once again – don’t make an investment decision based on the input I’ve provided within this blog post. I recommend you consult a professional so they can provide you guidance that’s applicable to your situation and the ever changing tax laws. My intent in providing this data was simply to make you aware of the complexities and the value of doing proper tax planning before investing.