Navigating Tax Issues Related to Short-Term Rentals
Short-term rentals are all the rage in real estate investing. With droves of vacationers and business travelers using Airbnb and VRBO to seek out homey, comfortable spaces that hotels don’t offer, short-term rentals can be an outstanding real estate investment.
Although short-term rentals can get special tax treatment from the IRS and have significant benefits, you should know the tax-related pitfalls to avoid.
To better understand the tax treatment of short-term rentals compared to long-term rentals, I recommend reading Real Estate Investing: Passive vs Active Income. This article explains some of the fundamentals and verbiage in this article, including passive vs. non-passive activity.
Key Definitions to Know
Following are the definitions and key points to know before we discuss short-term rentals and their tax pitfalls.
“Passive activity” refers to any activity where an investor does not materially participate in the investment. Passive activity losses can only be used to offset passive activity income. This applies to all investments, not just real estate.
“Material participation” refers to a milestone that, if reached, means you are no longer subject to the passive loss rule. There are seven tests for material participation, only one of which needs to be met to be considered material participation. Following are the three tests relevant to this discussion.
Test 1 — The individual’s participation in the activity constitutes substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own an interest in the activity.
Test 2 — The individual participated in the activity for more than 100 hours during the tax year, and the individual’s participation was at least as much as any other individual for the year.
Test 3 — The activity is a “significant participation activity” for the year (more than 100 hours of participation per activity with an aggregate of 500 hours).
“Real estate professional” is a designation that allows the investor to avoid passive loss rules related to the real estate. This is an even higher threshold than material participation related to real estate.
A “short-term rental” is typically defined as having an average rental period of seven days or less. (There are other scenarios that can qualify as a short-term rental, but they are beyond the scope of this article.)
The Good News About Short-Term Rentals
The good news is that the IRS doesn’t consider short-term rentals a real estate investment.
Back in the day, the only short-term rentals were hotels. No one would consider a hotel a rental property. A hotel is an operating business like any other business. For your property to qualify as a short-term rental (taking the losses against non-passive income), you only need to meet one of the seven material participation tests and do not need to reach the higher “real estate professional” designation. The three tests that are most common for taxpayers to pass are listed above.
However, be careful. There are some downsides to short-term rentals.
Potential Tax Traps of Short-Term Rentals
Your tax situation could be negatively impacted if your property does not actually qualify as a short-term rental according to IRS rules.
Beware of the following tax pitfalls:
Let’s consider the first and second tests shown above. If you have a management company or cleaning service, then most likely you will not pass Test 1 or Test 2 because you are not providing substantially all of the service or spending the most time out of the individuals involved in the property’s activity.
Also, if you own the property as part of a partnership, only one partner is able to pass this test. Note that having a cleaning service that sends different people every time is considered one individual for this test.
Test 3 can be used if you have multiple short-term rentals that you can aggregate as one activity. This allows you to get over the hurdles to qualify your property as a short-term rental.
Let’s talk about depreciation. Real estate professionals know there is a different depreciation life for a residential home (27.5 years) vs. commercial property (39 years). Since a short-term rental is not considered a rental property, the depreciable life is 39 years. Although a cost segregation study for a residential property usually does not make sense, it might be beneficial for a short-term rental, especially if it has a pool.
You cannot apply the hours you put into your short-term rental as part of the 750 hours (see other blog, Real Estate Investing: Passive vs Active Income) needed to qualify for your real estate professional designation.
Be mindful of how often you use your short-term rental property for personal use. If you use it more than 14 days per year, or 10% of the total days rented out, it will fall into the vacation home category and you cannot deduct any losses. If you are at the property strictly to do repairs and maintenance, then it does not count as one of the days. You should document this activity.
Careful Documentation Is Key
As with most issues related to the IRS, documentation is critical. You should meticulously track the time spent and work performed related to your investment. It is prudent to not only track your time, but the time of other service providers (like housekeepers or landscapers) so you can prove you pass one of the tests.
A short-term rental property can be a very good investment over time. Before going down the short-term rental road, however, you should be aware of all the tax rules to understand how your investment will impact your taxes.
Contact our tax department here or call 800.899.4623 to strategize how to maximize losses related to short-term rentals.
Published on June 29, 2023