Short-term rental properties get special tax treatment from the IRS and have a lot of significant benefits. As such, 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 really three (3) types of short-term rental properties:
- “Business” Short-term rentals
- Regular Short-term rentals
- Passive Short-term rentals
Next, all three of these classifications depend on multiple factors that have to be carefully considered:
- Average rental days a tenant or patron stays at the property.
- Are you providing ‘Substantial Services’ with the rental experience, and
- Are you personally serving with ‘Material Participation in the management of the property
Based on all of these factors above, it will directly impact how a short-term rental is taxed and treated on your tax return.
Average rental days a tenant or patron stays at the property
The first factor to consider is the average stay at your rental property and whether or not it’s for less than seven days. The seven-day-or-less rule is applied with the ‘average’ taken over a year’s time. Essentially, you will divide your rental days by the number of renters.
EXAMPLE: Assume you rented out your cabin 21 times (the renters) during the year for a total of 108 days. One would take 108 divided by the 21 renters. Thus, your average rental is 5.14 days (108/21) and falls into the less than seven-day rental category.
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).
The next level of analysis comes down to the type of service you provide for the tenant while they’re staying at your property; i.e. whether or not it’s considered “Substantial Service”. Obviously, there are pros and cons to providing ‘substantial services’ and 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 income you make needs to be reported on a Schedule C. The end. No further argument and the 7-day average stay rule is irrelevant.
This essentially means that you’ve elevated your activity to that of a business (think of it like a hotel) and now it must be reported on a Schedule C, or better yet, probably thru an S-Corporation.
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 income and minimize your overall income AND self-employment tax.
Essentially, the loss is considered an ordinary loss and is also deductible against any other income as 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”).
The Short-Term Rental Taxation Matrix
As a short-term rental property owner/investor, once you determine:
- your average rental stay, AND
- whether or not you are (or want to be providing) substantial services,
then you can consider the following matrix to determine how your operations will be taxed.
Notice that there is a new term I introduce with this matrix…it’s the concept of “Material Participation”. This is a unique rule in the Internal Revenue Code related to the strategy for Real Estate Professionals.
Typically, in order to take flow-thru passive rental losses as “ordinary losses’ one has to qualify as a real estate professional. See “The Tax Strategy of being a Real Estate Professional.”
However, under Treasury Regulation Sec. 1.4689-1T(e)(3)(ii)(A), there is a unique loophole related to short-term rentals. Under this seemingly aggressive provision, if an owner can show personal “Material Participation” then the rental losses ‘morph’ into ordinary losses.
As I stated above, this is an aggressive strategy and most CPAs agree that by taking passive losses on your tax return, when you normally don’t qualify as a real estate professional could very well trigger an audit.
IRS Regs. Sec. 1.469-5T(a)(1) provides seven (7) tests to demonstrate material participation in a short-term rental. A taxpayer must meet only one (1) of the following tests in order to qualify. The first three are the tests our clients most often meet:
- 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.
- 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) 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.
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 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 PodCasts “The Main Street Business Podcast” and “The Directed IRA Podcast”, and the author of “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”, as well as several other well-known books. He is also the CFO of Directed IRA Trust Company, and a senior partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP, and the accounting firm K&E CPAs, LLP.