With the rise of companies like Airbnb and VRBO, you might be thinking of adding short term rentals to your holdings. This can be great for you but it could also create a tax trap. This article will help you navigate the complex rules for short term rentals and their treatment for federal income tax purposes.
Real Estate Professional Background
If you qualify as a real estate professional under the section 469 passive activity rules, you may receive special treatment when it comes to using real estate losses compared to other passive investors. For starters, real estate professionals can generally deduct losses from rentals against other types of income. This includes wages, investment income and other business income. Passive investors on the other hand can only deduct rental losses against other forms of passive income.
For example, if you have $100,000 wages and $100,000 of rental losses you would not net income. However, these losses may not be deductible on your tax return unless you qualify as a real estate professional.
Generally, you qualify as a real estate professional if:
- You spend more than half of your time in real estate activities in which you materially participate, and
- Those hours total more than 750 during the tax year.
However, just because you’re a real estate professional doesn’t mean all of your rental losses are automatically deductible. You still need to show material participation. This means that if you own several properties you must show material participation in each rental activity separately. However, you may elect to aggregate several properties into one real estate enterprise to meet the above test. Aggregation is important for real estate professionals with a large real estate enterprise.
Short Term Rental Rules
All rental activities are passive activities unless an exception applies (e.g., the real estate professional exception). These rules create higher hurdles for real estate professionals to jump over when compared to other non-rental activities. For example, a non-rental business owner can avoid the passive activity rules with as little as 100 hours.
You can circumvent the passive activity rules by classifying your short-term rental properties as non-rental activities. The regulations of section 469 provide several exceptions to the definition of a ‘rental activity’. Two of which are applicable to short term vacation rentals:
- The average period of customer use is 7 days or less, or
- The average period of customer use is 30 days or less, and significant personal services are provided by the taxpayer. This could be tours, cooking, cleaning – think traditional owner operated bed & breakfast.
If your property meets one of the above exceptions, you can use the general rules to determine material participation.
There are 7 separate tests to determine material participation but typically you can meet the material participation test either by:
- Participating more than 500 hours, or
- Participating more than 100 hours and no other person participates more than 100 hours in that same activity (e.g., employees and subcontractors).
These rules can be confusing so let’s look at an example:
Bob, an accountant, purchases a vacation rental property and list the property on Airbnb and VRBO. The property is rented on average 4 days per customer. Bob spends more than 100 hours per year listing, managing and maintaining the property. Bob uses subcontractors for maintenance and repairs, but no subcontractor provides more hours of services on the property than Bob. After conducting a cost segregation study, Bob generates a taxable loss of $100,000. Bob is able to offset $100,000 from the vacation rental against his $100,000 W-2 wages from his accounting job.
Short Term Rental Trap
Although you can show material participation in a few short-term rentals, it becomes difficult as the business scales. Remember, material participation is determined on a per activity basis so it’s almost impossible to show material participation across a few dozen short term rentals. This is especially true when they are primarily managed by employees and subcontractors.
If you have a large real estate enterprise, showing material participation becomes more difficult. Although real estate professionals may aggregate activities for the material participation test, this does not apply to short term rentals.
In Eger v. United States, Egers claimed an election on their federal income tax returns that grouped their 33 rental properties, including the three Resort Properties, as a single rental real estate activity. The court determined that because these rentals were rented on average less then 7 days per customer, it did not meet the definition of a rental activity and was not eligible to be grouped with the other rental activities. Therefore, the losses from the resort properties were classified as passive.
Without proper planning, you could risk losing out on deducting losses from your short-term rental properties
What’s the Fix?
If you have substantial short-term and long-term rental activities you will need to be careful when walking the line of material participation in two separate businesses. Short-term rentals that meet the non-rental activity definition will need to be tracked separately from the aggregated rental enterprise. Remember, to maintain the real estate professional status you must perform more than 50% of personal services to the rental enterprise. Diverting too many hours to expanding your portfolio of short-term rental properties could put your real estate professional status at risk.
Here are a few things you can do as a real estate professional to show material participation in both activities:
- Have your spouse participate in the short-term rental activities: your participation in an activity includes your spouse’s participation. This applies even if your spouse didn’t own any interest in the activity. Additionally, you and your spouse don’t need to file a joint return for the year.
- Group short-term rentals: To group short term rental activities together you’ll need to show they form an appropriate economic unit. Some factors to consider include:
- The similarities and differences in the types of trades or businesses,
- The extent of common control,
- The extend of common ownership,
- The geographical location, and
- The interdependencies between or among activities.
- Consult a tax advisor: The passive activity loss rules are complex, always consult a tax advisor.
Want to learn more about ways to expand your real estate portfolio? Make sure to check out this article here.