Norris Lake Investor's Guide

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Why Consider Short-Term Rentals?

• Investment Diversification

• Affordable Means to 2nd Home Ownership

• Higher Returns than Long Term Rentals

• Appealing Tax Advantages

• There's Something Available for Every Budget

• Having a 2nd Home Offers Flexibility and Freedom

• You Enjoy Hosting / Creating Experiences

• Double Opportunity for Wealth Building — Income and Appreciation

• Sustainable Vacation Rental Market Demand

• Long Term Option for Affording Your Retirement Home

• You Have a Vacation Home to Enjoy!

Short-Term Rental Tax Implications

Federal Law

Short Term Rental Property and Second homes are a useful tool for wealth management and estate planning. Like other capital assets, inheritor (s) of the home receive a “step-up” adjustment to cost basis upon the original owner’s death. This effectively eliminates any appreciation gains from ownership and allows for a tax-free sale by the heirs.

1031 Like-Kind Exchange

If selling your investment property, in less than 12 months from acquistion, you'll be taxed on the gain as regular income. If held longer than 12 months, a 1031 is an excellent vehicle to consider handling the potential for capital gains taxes.

Qualifying exchanges include...

Personal Use

For a property that is held for rental, expenses may be limited if the owner uses the property more than 14 days per year or 10% of the total days it is leased out, whichever is greater. This means an investor who plans to use their rental for 30 days per year would need to lease it out for a minimum of 300 days the rest of the year to not have limitations.

This limitation applies beyond the days the investor uses the rental for enjoyment. It may also include days when the unit is leased to a charity or other auction. However, if the taxpayer meets the 14-day or 10% limitation, they can then consider the rental a business and may be able to deduct expenses and potentially some losses. (Note: different limitations will apply if owned within a Self-Directed IRA).

Deducting Losses

Deducting losses hinges on whether the rental is considered a passive activity. Income earned from an undertaking in which the investor does not actively participate is considered passive, including rental activities and other investments in which the investor is not actively involved.

The one potential exception to this rule for investors is real estate professionals who meet the requirements of the IRS under Sec. 469(c)(7)(B), which states: (1) “More than one-half of the personal services performed” are “in real property trades or businesses,” and (2) “taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses.”

This distinction is important for taxpayers because passive losses are only deducted to the extent that they offset passive income. A taxpayer who buys a rental home that generates a $30,000 loss may not be able to utilize this loss to offset their active income.

Depreciation

Investors also need to understand depreciation. Through tax depreciation, investors can recover the value of property over time. A taxpayer generating $10,000 in depreciation can utilize that amount to offset their rental income over the year.

The first step in determining the amount of depreciation is to determine the “depreciable basis” of the property. When a property owner acquires an asset, the entire amount is not depreciable. The IRS requires the value of the land to be separated from the depreciable asset. This can be done by a land valuation or looking at the assessed value of the land compared to the building.

Once the depreciable basis is determined, the next step is to determine the life of the asset. Depreciation lives are covered in IRS Code Section 168. Real property is separated into two areas: residential rental property with a life of 27.5 years and nonresidential rental property with a life of 39 years. At first glance, most short-term rental owners assume they can depreciate their asset over 27.5 years.

However, to qualify as a 27.5-year residential rental property, 80% of the gross rental income needs to come from the leasing of dwelling units (Code Sec. 168(e)(2)). The issue comes from the definition of “dwelling unit.” The IRS specifically excludes units that are rented on a “transient basis.” While the IRS does not clearly define transient, it often uses a lease term of 30 days or less. This is based on the definition under the old Section 48 and is backed by the IRS in a Private Letter Ruling (PLR-139827-07). This means that most owners of short-term rentals with an average stay of under 30 days would more accurately depreciate their nonresidential property over 39 years.

Owners able to absorb additional deductions can look at other methods to maximize deductions. This may include a cost segregation or other depreciation study. Additionally, looking at depreciable costs included in renovations, or potential deductions related to repairs, can generate significant deductions over time.

* From "Understanding Tax Issues With Short Term Rental Properties" by David McGuire, Forbes Councils Member

Specific to Tennessee

You'll need to file with the county as a local business and submit monthly records to comply with sales and lodging tax payments. If in an LLC, you'll also need to file taxes with the state — seek tax counsel!

Helpful Resources

• How Short Term Rentals are Taxed — Mark J. Kohler

• IRS Topic 414 — Renting Residential & Vacation Property

• IRS Topic 415 — Rental Income & Expenses

Taking Title

Tennessee law recognizes four basic types of ownership:

1. Sole Ownership

2. Tenancy by the Entirety

3. Joint Tenants

4. Tenants in Common

Sole Ownership in Tennessee

In this type of ownership, one individual or entity owns the property completely with no other tenants. Tennessee does not recognize community property, homestead, or dower and curtesy.

This means that spouses can buy, sell, or own property without the involvement of the non-owner spouse. The only exception to this is when using a deed of trust. A non-owner spouse would need to sign any deed of trust other than a purchase money deed of trust.

Tenant by the Entirety in Tennessee

This is a form of ownership specifically created for spouses. In Tennessee, spouses may own property by the entirety, which functions like a joint tenancy in that the surviving spouse will immediately take ownership of the property upon the death of the other spouse, unless expressly stated otherwise in the deed. Tennessee presumes spouses intended to hold property in a tenancy by the entirety if no other tenancy is designated on the deed.

Note: Unlike other states such as Ohio, Tennessee is NOT a community property state, which means that marital property is not automatically divided 50/50 between the spouses in a divorce case.

Joint Tenants in Tennessee

Tennessee recognizes joint tenancy with right of survivorship as a common form of joint ownership for non-spouses. This form allows multiple people or entities to own a title interest to the property, and comes with various rights and responsibilities. In particular, joint tenancies with right of survivorship involve all parties having equal ownership and the right to assume another owner’s interest in the event the other owner dies.

Tenancy in Common in Tennessee

Tennessee also recognizes tenancy in common as a form of co-ownership for non-spouses. Tenancy in common allows multiple owners to own title in a property, but rather than owning equally, the owners can set varying ownership percentages. For example, one owner could own 51% of the property, with the other owning 49%. Additionally, an owner’s share would pass to the owner’s heirs upon death, rather than passing to the other tenants in common.

Estate Planning

Plan Well.

When you own a second home or investment property, you should choose how you plan to pass it on to your heirs even before purchasing it — through a lifetime gift, in your will, or by some other method.

As you work on your estate plan, decide how you want to distribute your second home. For example, you may want your children to have it for future vacations, or you may want it sold off for cash. If the real estate market is on the downswing, it might make more sense to transfer ownership of the house sooner than later. You choose whether you want to make a lifetime gift or have the house distributed along with the rest of your estate after death.

Estate Planning Methods for Transferring a Second Home

Depending on who you want to receive your second home, you can opt for different estate planning methods. For example, if you want one or two people to receive interests in the house after your death, including the house in your will may be a good option. Alternatively, you could contribute the house to your trust, allowing beneficiaries to receive rents from tenants after you are gone.

Qualified Personal Residence Trusts

Some people who want to keep their second homes in the family decide to plsce them in this special type of trust helps preserve a substantially valuable property in a tax efficient way. You can continue living in your home, and your chosen recipients (often children) will receive the property after a set term of years ends. You also receive a gift tax benefit due to the trust structure.

Family Limited Liability Company

Another option for passing on a second home / investment is creating a family LLC, You give the gift of membership interests in the LLC to your family members, and you also contribute the second home to the LLC. Each membership interest is worth only part of the second home’s total value, and there are often restrictions on transferring the interests. As a result, the gifts usually have a lower value — potentially benefiting your estate in the future when estate taxes are assessed.

* Information adapted from Estate Planning When You Own a Second Home, by Andrew Szocka. (note: consult with an attorney before making any decisions!)

LLC vs. Trust for Short-Term Rental Property

Should I hold my Short-Term Rental in a Trust or an LLC?... Or, put my LLC in a Trust?

Holding in an LLC

Holding in a Trust

Trust for Rental Property — Revocable/Irrevocable

Protecting with Insurance

What are my best protections?

• Homeowners / Hazard Insurance

Short Term Rental Rider

• Umbrella Policy

• Separate LLC for each rental?

• Require separate Damage Policy, Hold on credit card.

Other Considerations

• Make sure your property has all necessary permits, licenses, zoning approvals, septic cert, and operating permits and registrations.

• Check Past History of Claims before purchasing (Get a CLUE Report: As a buyer, you'll have to ask the homeowner for their CLUE report. Property owners are the only ones entitled to request one. They can order the report through LexisNexis.)

• If using a property management company, make sure they hold a Vacation Lodging Firm License with the state, including a Designated Agent licensee for the rental firm and carrry sufficient Errors and Omissions Insurance. Look for relevant coverages / expectations in the management agreement.

• Use a separate and thorough Rental Agreement requiring signatures on the contract and have very detailed policies, etc.

• Disclose presence of lead based paint if your property was built prior to 1978, any other potential hazards, along with your rental agreement.

• Require a minimum age limit for renters, and don't approve without proof of ID.

• Verify your property is qualified to host STR's (check HOA documents, any litigation in progress?...)

  NOTE: TN Supreme Court to hear case requesting determination of "residential housing" later in 2023. Several lake communities where STRs are being contested).

Whew... that was a lot!

Thanks for reading about Norris Lake short-term rental investments. We proudly offer a full course available upon request, which is a fantastic place to start — building upon over a decade of knowledge and success.

Want to test the waters before you jump in?

Norris Lake offers hundreds of vacation rentals, giving you a fantastic opportunity to decide if Norris Lake is the perfect place for your next real estate investment.