a little confused about the short term rental loophole. Seems i can use my paper losses on my STR against active income if my avg stays are less than 7 days and I pass the materially participation test. Here's my question: I purchased a STR property but it was under and existing LT lease (though the leasee was doing STR arbitrage and renting it out). We bought it in March but once the lease ends in July, we will manage ourselves. For the materiality test and avg days test, does the fact that it was rented long term and had other property managers negate my ability to claim it as active income/loss. I'm guessing maybe I can separate out the period of LTR and STR for income but does that also pertain to the tests? hope that made sense. Would love to be able to take advantage of this loophole this year.
Accountant · Boston, MA · Member since 2019 · 386 posts · 336 votes
4y
@Bruce Woodruff All - STRs do not go on Sch C UNLESS you are providing hotel like services. See Jan 2022 IRS CCA memo which confirms this under “substantial services”.
Substantial Services and Material Participation are different things.
If you structure properly, your STR can be nonpassive on Sch E.
We specialize in STRs and u fortunately, the vast majority of accountants screw this up, costing investors serious $.
Point them to the 469 Regs and January’s CCA memo.
@Annie Balagot I believe the only way your material participation in Short-Term Rentals ("STR") can reduce your W2 tax liability is if you spend MORE HOURS working on your STR's than you do on your active W2 job. I'm hoping I'm wrong here... CPA's please jump in!
a little confused about the short term rental loophole. Seems i can use my paper losses on my STR against active income if my avg stays are less than 7 days and I pass the materially participation test. Here's my question: I purchased a STR property but it was under and existing LT lease (though the leasee was doing STR arbitrage and renting it out). We bought it in March but once the lease ends in July, we will manage ourselves. For the materiality test and avg days test, does the fact that it was rented long term and had other property managers negate my ability to claim it as active income/loss. I'm guessing maybe I can separate out the period of LTR and STR for income but does that also pertain to the tests? hope that made sense. Would love to be able to take advantage of this loophole this year.
Found this article
A taxpayer can overcome the presumption that all rental activities are passive if the taxpayer qualifies as a real estate professional by satisfying the two quantitative tests of Sec. 469(c)(7)(B):
More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and
The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
There are 11 types of real property trades or businesses: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.
Qualifying as a real estate professional allows the taxpayer to overcome the presumption that all rental activities are passive. Why repeat the first line of this article? Because qualifying as a real estate professional alone does not mean that the rental activities are non-passive. There is a second step: material participation.
Tests for Material Participation
To materially participate in a real property trade or business, the taxpayer must be involved in the operations of the activity on a regular, continuous, and substantial basis. The seven tests that measure this are:
1. The individual participates in the activity for more than 500 hours during the tax year.
2. The individual’s participation in the activity for the tax 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 the year;
3. The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax 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) for the year;
4. The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours;
5. The individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year;
6. The activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
7. Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.
Additional Notes About Material Participation
Hours spent as an employee are not counted unless the employee is a 5% owner in the company. Additionally, “investor” hours do not count toward material participation hours – such hours include: studying and reviewing financial statements, searching for new properties, education, preparing summaries of the finances or operations, or managing the finances of an activity in a nonmanagerial capacity.
If the taxpayer holds an interest in a real property trade or business through a limited partnership interest, the taxpayer may establish material participation only by satisfying the first, fifth, or sixth tests of the seven tests from above
A married taxpayer is required to count any hours performed by his or her spouse, even if the spouse does not own an interest in the business or if no joint return is filed. However, the spouse’s hours only count toward material participation and not toward the real estate professional status.
The taxpayer must materially participate in each passive activity separately. This means if you own 5 rentals, you must show you materially participated in each individual rental activity which can be extremely difficult to do. To get around this, you can make a grouping election under IRS Regs. Sec. 1.469-9(g) but it is highlyrecommended you speak to a CPA prior to this as the election can have negative long-term consequences.
Benefits of Qualifying as a Real Estate Professional
The benefits of qualifying as a real estate professional are that you can deduct passive losses in an unlimited amount and avoid the Net Investment Income Tax.
For example: Chris is a real estate agent and spends 1,200 hours representing clients in purchase and sale transactions. As a result, Chris qualifies as a real estate professional for tax purposes. Chris also has one rental property that produced a $10,000 loss that Chris cannot utilize because he earned over $150,000 during the year (see Passive Losses Article). Qualifying as a real estate professional is only step #1 for Chris as he must also demonstrate that he materially participated in his rental activity.
Luckily, Chris maintains great records and was able to prove he materially participated in his rental activity because he spent 500 hours managing the rental, it’s contractors and the rehab. As a result, Chris can deduct the $10,000 passive loss against his ordinary income.
It’s important to note that you must keep contemporaneous records and those records need to be absolutely bulletproof to substantiate your real estate professional status claim.
@Don Konipol I believe @Annie Balagot is referring to something other than the Real Estate Professional status you outlined above. Outside of Real Estate Professional Status, is there a separate tax incentive for Short Term Rentals?
A CPA would be helpful here. Short term rentals with avg stays less than 7 days are not considered rental activities and falls under similar status of hotels, therefore is not passive and so long as I materially participate, I can offset active income and do not need Real Estate Professional status.
A CPA would be helpful here. Short term rentals with avg stays less than 7 days are not considered rental activities and falls under similar status of hotels, therefore is not passive and so long as I materially participate, I can offset active income and do not need Real Estate Professional status.
My STR's are still a schedule E deduction same as my LTR properties.
A CPA would be helpful here. Short term rentals with avg stays less than 7 days are not considered rental activities and falls under similar status of hotels, therefore is not passive and so long as I materially participate, I can offset active income and do not need Real Estate Professional status.
My STR's are still a schedule E deduction same as my LTR properties.
This year I got my tax guy to use Schedule C so I could write off more losses. There apparently is a fine line with some overlap......
A CPA would be helpful here. Short term rentals with avg stays less than 7 days are not considered rental activities and falls under similar status of hotels, therefore is not passive and so long as I materially participate, I can offset active income and do not need Real Estate Professional status.
My STR's are still a schedule E deduction same as my LTR properties.
This year I got my tax guy to use Schedule C so I could write off more losses. There apparently is a fine line with some overlap......
My CPA said you could make an argument either way and this hasn't been tested in court so...
That's what I got from mine...He is old-school so I had to talk him into doing this. It is my first year with this one property and I have a ton of losses that I would like to take rather than paying the IRS the $$. After I showed him the IRS wording, he agreed that it was possible. After all, why shouldn't a business be able to take losses against income?
Accountant · Boston, MA · Member since 2019 · 386 posts · 336 votes
4y
@Bruce Woodruff All - STRs do not go on Sch C UNLESS you are providing hotel like services. See Jan 2022 IRS CCA memo which confirms this under “substantial services”.
Substantial Services and Material Participation are different things.
If you structure properly, your STR can be nonpassive on Sch E.
We specialize in STRs and u fortunately, the vast majority of accountants screw this up, costing investors serious $.
Point them to the 469 Regs and January’s CCA memo.
Accountant · Boston, MA · Member since 2019 · 386 posts · 336 votes
4y
@Bruce Woodruff Sch C will flip to FICA when depreciation runs out. Unless you are providing hotel services, you may want to have your CPA research this further. Sch E, nonpassive, if done correctly could help you in future years
A CPA would be helpful here. Short term rentals with avg stays less than 7 days are not considered rental activities and falls under similar status of hotels, therefore is not passive and so long as I materially participate, I can offset active income and do not need Real Estate Professional status.
@Annie Balagot is there a maximum amount that the STR "active loss" can offset your W2 "active income" by? I believe someone mentioned that there is a $25,000 cap per year.
@Greg O'Brien Thanks! and for all your answers above. Very helpful. My plan is to use bonus dep this year from 2 STR to offset W2 income. Both STR will have a paper loss even without the bonus depreciation I'm guessing so most of the bonus dep will help offset our W2 income.
That's what I got from mine...He is old-school so I had to talk him into doing this. It is my first year with this one property and I have a ton of losses that I would like to take rather than paying the IRS the $$. After I showed him the IRS wording, he agreed that it was possible. After all, why shouldn't a business be able to take losses against income?
That’s the IRS point. Is the activity a “business” or is it an “investment”? If an investment is it an “active” investment, a “passive” investment or “portfolio” income.?
The bigger question is why income from different sources is treated differently? It’s called “social” engineering by politicians, along with paying off special interests who fund politicians campaigns. Reagan almost had it eliminated with a flat tax, but then political reality forced 2, then 3 tax brackets, and over the years the income differentials being treated differently have actually greatly expanded.
I am full time in real estate, so my tax treatment of an identical item with someone who has full time employment in other field is totally different. But I learned 40 years ago better to learn how to “work” the system then to fight it.
