More and more real estate investors are adding ‘short-term rental’ properties to their portfolios and with a lot of success. However, many still have questions about how short-term rentals are taxed and where to place them in their tax and legal structure.
Investors’ concerns and confusion are certainly valid, the short-term rental rules are unique to all other types of real estate investments and need to be carefully planned for when tax planning.
What does the IRS deem to be a short-term rental property?
First, it’s important to realize there are two types of short-term rental properties:
- “Business” Short-term rentals, and
- Passive Short-term rentals
However, both classifications depend on the average rental days a tenant or patron stays at the property. Essentially, you are the owner of a ‘vacation hotel’ when the average stay at your rental property is for less than seven days and typical rental property rules go out the window.
EXAMPLE (Calculating the Average Stay): The seven-day-or-less rule is applied with the ‘average’ taken over a year’s time. For example, if you rent out your cabin 21 times during the year for a total of 108 days, your average rental is 5.14 days and falls into the less than seven-day rental category.Reg.Section 1.469-1T(e)(3)(ii)(A)
Once an investor determines they have an average stay ratio of fewer than 7 days, then the question becomes whether or not the activity is reported on a Schedule C (as a business) or on Schedule E (a rental property). This analysis comes down to the types of services you provide for the tenant while they’re staying at your property: Substantial versus Insubstantial…both have their pros and cons.
Substantial Services and a “Business” Short-Term Rental
The IRS has deemed that if you provide “Substantial Services” to your guests – in addition to a nice place to stay, then the income you make needs to be reported on a Schedule C. This essentially means that you’ve elevated your activity to that of a business and this plays a major impact in how your short-term rental is taxed.
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.
The good news is that if you’ve created a Schedule C business with your short-term rental if you produce a tax-deductible loss, you can combine it with any other self-employment income and minimize your overall self-employment tax. IF you don’t have other self-employment income, the loss is considered an ordinary loss and also deductible against any other income and essentially is an ‘above the line deduction’.
Another piece of good news is that if you generate ‘net income’ with the operation, you will likely qualify for the 199A deduction against the income (see “199A Deduction for Rental Real Estate Investors“).
However, the bad news is that any profits you generate are now subject to self-employment taxes just like any other small business operation. However, as I have taught for years, all is not lost. The S-Corporation can come to your rescue and significantly mitigate any SE Tax (see “Choice of Entity- Is an S-Corporation Right For You”).
Short-term Rentals on Schedule E
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 isn’t subject to self-employment taxes (which is obviously a big advantage).
Does this mean you can’t provide any perks or benefits for your tenants during their stay- absolutely not! 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.
IMPORTANT NOTE: At the end of the day, the more you look like a hotel or “true” bed & breakfast, the greater the likelihood you’ll have to report your income from the rental on a Schedule C, and pay self-employment taxes on that income.
However, there is a big drawback to the Schedule E reporting of a short-term rental: The Passive-Loss rules that typically apply to long-term rental properties DO NOT apply to short-term rentals.
Passive Loss Rules
When the average stay of your tenants is less than 7 days, and your rental is deemed to be a “short-term rental property” under IRS rules, then the property:
- Does not qualify to be for the Active Real Estate Investor Loss of up to $25,000
- Cannot be ‘grouped’ with your other rentals and if there’s a loss it can’t be taken under Real Estate Professional rules
- Does not produce material professional hours that you can use to become a Real Estate Professional either
This may seem like a significant drawback because the passive loss rules are beneficial to so many real estate investors (See “The Tax Strategy of being a Real Estate Professional”). But, let’s get real…the main reason you may be considering a short-term rental is for greater cash flow. In fact, if you are moderately successful you should indeed double or triple your monthly cash flow compared to a long-term residential rental (See “How to be Successful with Short-term Rentals“).
That’s what I’m seeing with my clients. The increased cash flow (income) from their short-term rentals is by far greater than the depreciation on the property, and they’re able to maximize the losses on their long-term rentals with general operating expenses for their real estate portfolio.
So my point is, do the passive loss rules really matter when you should be having positive cash flow from your short-term rental? Let’s keep our eye on the ball! Cash flow and income are more important than writing off losses. I’ll take the former any day of the week and all day on Sunday.
Now true, the hours you spend working on the property won’t qualify as material participation hours and apply to your status as a real estate professional, but again, what’s more important? Profit and income or
Personal Use of the Property
Remember, personal use of the property doesn’t forfeit the property’s status as a rental 100% of the year, so long as you don’t stay at the property for ‘personal use or benefit’ for more than 14 days or 10% of the total days it was rented to 3rd parties. But let’s talk strategy! Remember, if you are staying at the property in order to work on it (taking good notes of your activities and tasks you complete), then those days you stay at the property aren’t considered ‘personal use’.
IMPORTANT: When you incur ‘fix up days’ staying at your short-term rental working on the property, this also unlocks the write-offs for travel, dining, auto, and tools while you work on your short-term rental.
I don’t want to see any ‘personal use’ of the property. You’re always going to be there to work on the property – Right?
In sum, short-term rentals provide multiple benefits, and a little bit of tax planning can go a long way in making sure you save taxes along the way.
* To sign up for Mark’s weekly Free E-Newsletter and receive his Free E-Book “The Top 10 Best Tax Saving Secrets Everyone Should Know” visit www.markjkohler.com.
Mark J. Kohler is a CPA, Attorney, co-host of the Main Street Business Podcase and author of the new book “The Business Owner’s Guide to Financial Freedom- What Wall Street isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP.