Clearing Up Confusion on Tax Treatment of Short Term Rentals
Hi All - I've seen quite a bit of confusion on the application of the Passive Activity Loss Rules and Short Term Rentals. Beyond BP, there is a lot of confusion in the accounting community as well but the same rules have been in existence for quite a while and often were not studied since STRs have never been so popular. The tax code may never define "Airbnb" but there are rules surrounding these type of activities which I will give an brief overview below.
1) My STR goes on Schedule C: It depends. Your CPA should be discussing whether or not your STR business provides substantial services. The IRS' Chief Counsel recently published a document clarifying this. If you are putting your STR on Sch C and NOT providing substantial services, you will cost yourself money long term and risk the IRS reclasses your activity (which may or may not have consequences).
Nonpassive does NOT equal Income from Self Employment automatically. This is a bad application of the law if this is suggested.
2) Some people say 27.5 years and some say 39 year depreciation - look to the average period of stay in your STR. If your STR averages 30 days or less, this is considered transient and therefore, 39 years (nonresidential). If greater than 30 days' average, it could be considered residential.
3) Passive, Nonpassive or somewhere in between? This is the largest point of confusion we see. This all hinges on what you call a "rental property" is actually NOT a rental property in the tax code! Huh? So the Treasury Regulations to the Tax Code define situations in which property "rentals" are not considered real estate income. https://www.law.cornell.edu/cf...
The Regulations state SEVERAL exceptions to "rental activities" in the tax code. One of the exceptions to a "rental activity" is if you rent your property, on average, 7 days' or less. This is the first piece. The second piece is whether or not you pass the Material Participation Tests found in IRC 469 and the third piece is whether your participation rises to the level of Substantial Services (think hotel, B&B).
4) My CPA Says I can't deduct a loss that was generated! Did they follow the Treasury Regulations above, IRC 469 and IRC 1402? What is the support for treating as passive or nonpassive? Are they treating it as passive automatically because you are not a REP?
What we find is the missing piece is some pros do not realize that it is indeed possible to have a "rental property" that is actually not a "rental" for tax purposes and treated as a business. Whether or not you materially participate is a different question (and deserves a full post with all of the nuances). The key in my mind is disconnecting a STR from a "rental property" for tax purposes.
5) Why does this Loophole Exist? My opinion is this is NOT a loophole. The Regulations clearly state how to treat a property that meets various definitions. If tax pro is going against the regulations, isn't that a problem as well? If you 1) Depreciate over 27.5 years a residential rental but its not 2) You list on Sch C yet don't provide substantial services 3) You list as a passive activity BUT in fact, it is non passive. Incorrectly treating a property as passive may benefit you and the IRS will absolutely change this under audit (several cases on this).
6) No Tax Court Cases Exist? Myth. There are several tax court cases surrounding STRs OR other cases that use the 1.469 regs above. Your tax pro needs to read these and interpret the findings. One example: Taxpayer tried to use the hours from a STR as REP hours. Finding: Disallowed, since a 7 day or less rental is in fact NOT a rental! This directly lines up with the rules above.
Hope this brief overview clears up some FAQs and confusion out there! As always, your tax professional should help you navigate these rules and apply them to your specific circumstances as with all tax law, there are caveats and nuances to everything which need to be examined!
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#1 Short-Term & Vacation Rental Discussions Contributor
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This is excellent, thanks for sharing!
I see so many people say they are using schedule C and they are not providing substantial services.
This post should be referenced in the future when this question keeps coming up multiple times per year.
Glad I could help John! This is "new" to most in the tax world and often discussed in these threads.
This is a fabulous post, thank you @Greg O'Brien. I am currently in talks with the IRS regarding this very topic, unfortunately.
I think what muddy's the water is we have four LTR and three STR's. So we have legitimate rentals and we legitimately materially participate in the STR business too. I am about to submit to the IRS my log of 500+ hours working in the STR business, most of which come from communicating with guests, cleaners, maintenance people, Airbnb, VRBO, and managing supplies, shopping, bill paying, pricing, calendars, all the daily and weekly tasks. I'm excluding travel time to the property for the STR's.
Any words of wisdom regarding material participation that you referenced?
@Nancy Bachety did you file grouping elections for any of your properties (LTRs with LTRs or STRs w/ STRs)? Or are you testing per property?
Generally speaking, material participation puts the burden on us as taxpayers (ie assumed passive unless you prove otherwise). You should not have any issues if your logs were contemporaneous and meet one of the 7 tests.
Very much trust my CPA of many years but had to go look at our returns! Our STRs are not on Schedule C so I suppose we are out of trouble. Ours are passive, professionally managed by someone else and we are fully hands off…
@Greg O'Brien I believe we grouped them together, all of them. I’ll have to check, it was from 2019. All on schedule E. My logs are pretty good, actually.
Copied from IRS pub 925 under material participation:
.
Proof of participation. You can use any reasonable method to prove your participation in an activity for the year. You don’t have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way. For example, you can show the services you performed and the approximate number of hours spent by using an appointment book, calendar, or narrative summary.Doesn’t even need to be contemporaneous logs.
@Nancy Bachety correct, you can recreate… some tax court cases shun this but if you use a reasonable method its OK. Contemporaneous always will win favor in an audit. Will send you a PM with other thoughts!
@Scott Stone here you go. https://www.biggerpockets.com/topics/1056436
@Austin Spitzenberger check out this thread
https://www.biggerpockets.com/topics/1056436
Quote from @Greg O'Brien:
@Austin Spitzenberger check out this thread
https://www.biggerpockets.com/topics/1056436
Thank you for posting this and sharing
@Nathan Robinson this may help
https://www.biggerpockets.com/topics/1056436
@Jon Abbott here is a full thread on STR Tax:
https://www.biggerpockets.com/topics/1056436
@Amby Bhagtani see here for STR info!
https://www.biggerpockets.com/topics/1056436
Thank you @Greg O'Brien, this is the post that keeps on giving. I have bookmarked, and shared this thread with many accountants who don't know much about STRs
Excellent thread. Thanks @Greg O'Brien
Great post!! I have been researching this a lot lately because I feel this could not only shelter me greatly in 2022, but make or break my chance of being a full time real estate investor (which Ive been chasing for 20 years now, police dont make a lot :). Being law enforcement in my first career I read a lot of laws, regulations, codes etc... on a daily basis. I started reading the IRC and realized it was not contrived by the same type of minds that write criminal laws immediately!
In section 3) (Passive, Non-Passive) is your understanding that all 3 exceptions must be met? Could I have an avg. rent of 4.33 days, outwork everyone (cleaner) by a substantial number of hours and not offer substantial services other than certain guest special request and meet the exception.
Does the IRS consider all the marketing, accounting, bill paying, guest communications (daily inquiries), market research, pricing, real estate purchase, taxes, supply ordering, maintenance/ cleaning set ups, and a thousand other things we do yearly to keep the STR going as hours toward material participation? or is their view extremely narrow as to cleaning and maintenance on the property?
Thank you for your time and this post!
@Jarred Bundy all 3 must be met. The items you mention MOSTLY qualify. Be careful of financial items or “investor hours” and travel.
Think this way: "If I did not do this (Insert Task) would be STR be negatively affected"?
For ex, is it necessary to visit 5 times per week to mow the lawn? Most reasonable people would say no (including the Tax Court and IRS)
Thank you so much @Greg O'Brien, I just bookmarked this thread, I stayed up until 2am last night trying to find answers to this, confused by different professional opinions and IRS publications.
I'm trying to use STRs (rented out 7 days or less with no substantial services provided in which I materially participate) to reduce my W2 liabilities and my biggest concern was if doing this will trigger Self Employment taxes.
If I understood correctly, in this situation I can use depreciation losses as active against other active income (which is what I want). I am still confused on weather I should report this on schedule E and still use the losses agains other active income or if I should report the losses on schedule C and even though it is schedule C not pay self-employment taxes (since I don't offer substantial services).
@Alex Garcia Thanks! If STRs < 7 days, no substantial services = E and NOT C
Why?
IRC 469 and IRC 1402 (SE tax) are not connected at the hip. Its very possible to have a nonpassive income or loss on Sch E that is not active income (Sch C).
In January 2022 the IRS legal department actually confirmed that what Im describing is possible (See CCA memo)!
Thank you @Greg O'Brien
I found this one, not sure if is the one you are talking about but it specifically says that not because a rental is considered active it means that it is subject to Self Employment tax: Memo 202151005
@Alex Garcia correct. The memo shows IRC 469 is decoupled from SE Tax based on the criteria laid out. Those memos do not hold authoratative weight but shows the IRS’ thoughts!
let’s say you have 300k deduction of material participation on schedule E and you have 300k in W-2 income. Are you allowed to use let’s say 230K of the deduction in the year it was realized to bring taxable income from W-2 down to 70k and carry forward the 70k to the following year. Essentially would be ideal to pay w2 income tax on the 12 and 10 percent bracket and carry forward to the following year to take the deduction on the higher marginal rate.
@John Carbone no. You can’t selectively apply the loss. Any excess is carried fwd as an NOL.
Note - excess loss business limits can apply here in some cases
How about property hunting, are we allowed to deduct those expenses? Say I want to buy a property to operate it as a STR (with material participation avg < 7days stay).
If I travel to the beach to see some properties I am interested in, am I allowed to deduct the travel, stay, meals as expenses? Or are expenses allowed only after you buy the property? At the moment I only have a LTR.
Must time be tracked per property? Or is it simply per business type?