Short-term rentals get special tax treatment from the IRS and have significant benefits.
The short-term rental rules are unique to all other types of real estate investments. You need to carefully incorporate them when tax planning. Learning how short-term rentals are taxed is crucial and our team can help you.
Why Are Short-term Rentals a Big Deal?
When you have a long-term rental (regular monthly rental) and you have a loss on that rental due to depreciation or repairs, you cannot deduct that loss against ordinary income like wages or self-employment income. (If your income is below the threshold, you may be able to deduct up to $25K).
When you have a short-term rental (average stay less than 7 days), AND you materially participate, AND you do not provide substantial services, you CAN deduct losses against ordinary income.
What Does the IRS Deem to be a Short-Term Rental Property?
There are four (4) types of short-term rental properties:
- “Business” short-term rentals, with Material Participation (Subject to SE Tax, losses are deductible against ordinary income)
- “Business” short-term rentals, WITHOUT Material Participation (Subject to SE Tax, losses are not deductible against ordinary income)
- Passive short-term rentals, with Material Participation (This is what you want) Not Subject to SE Tax AND losses are deductible against ordinary income)
- Passive short-term rentals, WITHOUT Material Participation (Not Subject to SE Tax but losses are not deductible against ordinary income)
All four of these classifications depend on the following three (3) factors. They will directly impact how your short-term rentals are taxed.
- Average Rental Days a Tenant or Guest Stays at the Property
The first factor to consider is the average stay at your rental property. The seven-day-or-less rule applies with the ‘average stay duration’ taken over a year’s time. Essentially, you will divide your rental days by the number of renters.
EXAMPLE: Assume you rented out your beach house 21 times to guests during the year for a total of 108 days. You would take 108 divided by the 21 guests. Thus, your average rental is 5.14 days (108/21) and falls into the less than seven-day rental category.
- IF the average stay is less than 7 days –the income is NOT subject to Self-Employment Tax (FICA)…ALSO, you open the opportunity for Ordinary Loss Treatment if you can show Material Participation (see below).
- IF the average stay is MORE than 7 days – Not all is lost, the income is NOT subject to Self-Employment Tax (FICA)…BUT Ordinary Loss Treatment is not available to you EVEN IF you can show Material Participation (see below).
The next level of analysis comes down to the type of service you provide for your guests while they’re staying at your property. Do you provide services that are considered substantial services? There are pros and cons to providing substantial services. It can affect your rental rates as well as the tax consequences.
- Substantial Services and a “Business” Short-Term Rental
The IRS has deemed that if you provide substantial services to your guests, then the net-income is subject to Self-Employment Tax.
ALSO BEWARE! This does not mean you get Ordinary Loss Treatment…you still MUST show Material Participation (see below). This essentially means you have a “Business Short-term Rental”.
- IF you DON’T provide Substantial Services –the income is NOT subject to Self-Employment Tax (FICA)…ALSO, you STILL have the opportunity for Ordinary Loss Treatment if you can show Material Participation (see below).
Examples of Substantial Services:
- Cleaning of the rental each day while the property is occupied by the same guests.
- Changing bed sheets and other linens each day while the property is occupied by the same guests.
- Concierge services.
- Conducting guest tours and outings.
- Providing meals and entertainment (Ex: providing breakfast each morning).
- Providing transportation.
- Providing other “hotel-like” services.
The IRS hasn’t provided much guidance other than the few items above. There aren’t any court cases, Revenue Rulings, or Treasury Regs on this topic. We expect to have more clarity on what constitutes ‘substantial services’ in the near future.
But a word of caution. I know some Gurus are out there promoting aggressive tactics to provide more services for your guests in order to increase demand for your property and increase rates. But be careful not to get too close to meeting the definition of substantial services – the tax result could be devastating.
- “Personally” Serving with Material Participation
Typically, in order to take flow-thru passive rental losses as ordinary losses, you must qualify as a real estate professional (More on that topic in a different blog). However, under essentially ‘outdated’ Treasury Regulations (that were put in place before the onset of the ‘Airbnb’ concept), there is a unique loophole related to how short-term rentals are taxed.
Under this provision, if an owner can show personal material participation, then the rental losses on a short-term rental “morph” into ordinary losses, which means, you can use the losses to offset ordinary income.
To qualify as Materially Participating in the operations of your rental, a taxpayer must meet (1) of the following (7) tests. NOT ALL 7, but just one.
7 Tests of Material Participation
- The individual participates in the activity for more than 500 hours during the year.
- The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year. (This includes housekeepers & contractors)
- The individual participates in the activity for more than 100 hours during the taxable year, and such an individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity like housekeepers & contractors) for such year.
- The activity is a significant participation activity for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours.
- The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year
- The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such a year.
How it Works
By qualifying under one of the tests above, any net-loss on the operations of the property is considered an ordinary loss and is deductible against any other income as an above-the-line deduction on your tax return.
This is where investors (that qualify) discover the power of utilizing a ‘Cost Segregation Analysis’ and dramatically increase the depreciation deduction in the first year they place the property in service.
However, in order to capitalize on this strategy, you are relying on an IRS Code Section and Treas. Reg. that is clearly out of date. Now, I find nothing wrong with using a loophole until it’s shut…I just don’t want to be the one (or my client) that gets their hand caught in the door when they shut it. Most CPAs agree that by taking these passive losses when their client isn’t a real estate professional, it could trigger an audit. So, go at your own risk!
What hours count towards material participation?
- Cleaning the unit(s) yourself
- Coordinating cleaning crew / contractors
- Collecting rents
- Taking photos of rental listings
- Directly communicating with guests
- Posting listing on rental platforms (i.e. Airbnb, VRBO, etc.)
- Physically walking through property for inspection purposes
- Performing repairs / maintenance on property yourself
Short-term Rentals as passive income
If you do not provide substantial services then you can report your income from your short-term rental as passive income. Passive income isn’t subject to self-employment taxes (which is a big advantage).
Does this mean that you can’t provide any perks or benefits for your guests during their stay? Absolutely not! The following is a list of insubstantial services that you can provide without jeopardizing your passive status:
- Beach Chairs/Beach toys
- Luxury Bath Towels/Mats/Wash Cloths
- Comfy Bedding/Comforters
- Welcome Basket upon arrival
- Nice furniture throughout the property
- Quality cookware & dishes
- Heating and air conditioning
- Internet and Wi-Fi
- Cleaning of common areas
- Repairs and maintenance if requested
- Trash collection
- Toilet paper/paper towels (be careful with providing personal toiletries like soaps/shampoo)
- Complimentary sunscreen/lotion
Personal Use of the Property
Personal use of the property doesn’t forfeit the property’s status as a rental 100% of the year as long as you don’t stay at the property for “personal use” for more than 14 days or 10% of the total days it was rented to 3rd parties. This also includes discounted rates to guests and each time a family member uses the property even if they pay for it.
It’s important to think about strategy! If you are staying at the property to work on it, take good notes. The notes should be of your hours worked and tasks you completed. That way those days you stay at the property won’t have to be considered “personal use”.
IMPORTANT NOTE: When you go to your rental property to check on it, make repairs, replace furniture/fixtures, stock it with amenities, etc., this unlocks the write-offs for other expenses like travel, dining, auto, and tools while you work on your short-term rental.
In all honesty, you shouldn’t have any “personal use” of the property. You’re always going to be there to work on the property – Right?
Knowing how the tax code applies to your short-term rental provides multiple benefits. A little bit of tax planning can go a long way in making sure you save on your taxes and ensure that you’re taking advantage of all deductions.
If you would like to schedule a consultation with one of our tax professionals, we encourage you to book an appointment.