The popularity of renting a house, townhome or condo on a short-term basis through websites such a Airbnb, BRBO has exploded over the past few years. Just to give you an idea of how big the industry really is, consider that Airbnb is currently active in more than 65,000 cities and 191 countries, and it is projected to log 100 million guest arrivals in 2017. Looking to book a night or two in New York City? Airbnb has more than 43,000 active listings.
Yes, the profits can be significant compared to a standard monthly rental property, but only when the conditions are ideal. Real estate investors should be cautious and prudent before assuming their property could be the perfect vacation rental property. A quality and successful vacation rental property needs to be in the right location with consistent demand and not run into any local regulatory snags.
However, assuming all goes well, the tax planning needs to be taken more seriously as well because of the typical profit due to increased cash flow. Thus, all the revenue generated by these stays begs the question: How exactly is all this income taxed? Let’s break that question down into a couple sub-questions:
How (and where) do I report my short-term rental income on my federal tax return?
First, it’s important to know that in certain (limited) circumstances, you may not have to report this income at all. If: 1) you reside or stay on the property at some point during the year; and 2) the property was not rented at a fair market rental price for more than 14 combined days during the year, then the income from the rents is likely not taxable (no matter how substantial the amount)! This can be a sweet situation for homeowners when the Super Bowl, or some other “Mega-Event”, comes to your town. In fact, I am starting a campaign to bring the 2030 Winter Olympics to Cedar City, Utah – just so I can rent out my house for two weeks without being required to report the income on my taxes! The drawback is that the only deductions allowed for the property will be otherwise deductible property taxes and mortgage interest.
If you either don’t stay on the property at all or rent it out at market rates for more than 14 days in a year, then the income from your short-term rental is undoubtedly taxable. The question then becomes whether the income is considered passive rental income (to be reported on Schedule E) or active business income (to be reported on Schedule C). The answer depends on whether you provide “Substantial Services” to your guests – in addition to a nice place to stay. When you provide Substantial Services to your guests, then the income you make needs to be reported on a Schedule C, and is subject to self-employment taxes. Examples of services that would be considered “substantial” are:
- 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 (like providing breakfast each morning).
- Providing transportation.
- Providing other “hotel-like” services.
At the end of the day, the more you look like a hotel or “true” bed & breakfast, the better the chance that you will need to report your income from the rental on a Schedule C, and pay self-employment taxes on that income.
If you don’t provide substantial services to your guests, then the income from your short-term rental can be reported as passive Schedule E income that is not subject to self-employment taxes (which is obviously an advantage). Does this mean you need to turn off the electricity and require guests to bring their own bottled water for drinking and bathing? No! The following is a list of “Insubstantial Services” that you can provide without jeopardizing your Schedule E status:
- Heating and air conditioning.
- Water and gas.
- Internet and Wi-Fi
- Cleaning of common areas.
- Customary repairs and maintenance.
- Trash collection.
- Payment of HOA dues.
How can I deduct expenses related to my short-term rental?
The answer to this will depend on how and whether the “Vacation Home Rules” apply to your situation, and whether your short-term rental is considered a “passive” or “active” activity (which is different than the determination as to whether to report the income on Schedule E or Schedule C). We won’t be getting into how these determinations are made right now, but depending on how this determination comes out, you may be restricted to deducting rental losses incurred only against other passive income (and carrying forward losses you cannot use in a given year), or you may be permitted to deduct a loss of up to $25,000 in a year against non-passive income (such as wages). Therefore, these are important issues to explore with your tax professional.
If you are (or are thinking about becoming) involved in the hot short-term rental industry, these are issues you need to be planning for and facing head-on. Please make sure you are getting the advice of a qualified and experienced professional.
Mark J. Kohler is a CPA, Attorney, Radio Show host and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions” and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. For more information visit him at www.markjkohler.com. [Written in collaboration with Jarom Bergeson, Attorney, KKOS- Cedar City, Utah]