The Hidden Tax Impacts of Short-Term Rentals

The rise of Airbnb, Vrbo, and other platforms has made short-term rentals (STR) popular with real estate owners, but how you report that income can have major tax implications. If you are considering operating an STR, there are common pitfalls and tax planning opportunities that you should be aware of.

Many taxpayers are aware of the tax benefits of owning rental properties. What many do not realize is that strict rules apply if you want to maximize rental losses. Under the regulations, a “rental activity” is generally treated as a passive activity, regardless of the level of taxpayer participation, unless certain exceptions apply. One key exception involves STRs. While the regulations do not explicitly define STRs, they provide exceptions to what constitutes a “rental activity,” which ultimately shapes the concept of short-term rentals.

What is an STR?

Treas. Reg. §1.469-1T(e)(3)(ii) lists an exception to a “rental activity” for the rental of tangible property under certain conditions. In practice, the IRS generally considers an STR to have:

• An average rental period of 7 days or less, or
• An average rental period of 30 days or less, and significant personal services are provided to guests

Because these activities are not treated as “rental activities,” losses from STRs may be more favorable than those from long-term rentals, provided you meet the applicable requirements.

STRs can be owner-managed or managed by a third-party property management company and often can include “substantial services” provided for the renter. Examples of these services may include regular cleaning, access to recreational equipment, and bed linens and towels.

As with many tax provisions, there are nuances to operating an STR that can determine whether it’s reported as a traditional rental or a business.  Both can have benefits and consequences depending on a taxpayer’s situation.

Is your STR a Passive Rental? Use Schedule E

You rent your property on Airbnb for weekends and hire cleaning services after each rental period. The income and expenses from this rental are generally reported on Schedule E.

These properties are rented for an average period of 7 days or less, and no “substantial services” are provided. Typically, this means these rentals provide no services beyond cleaning between occupants. The rental activity is treated as a traditional rental property by default, and losses are subject to passive activity loss rules.

Property owners will want to consider the material participation test to determine the tax treatment of their rental. The IRS uses the material participation test to determine whether a taxpayer is actively involved in the activity. If you materially participate, the activity is considered nonpassive, meaning you may be able to deduct losses against other types of income, such as your investment interest and dividends.

The IRS provides seven tests to determine material participation. You only need to meet one of them. The most common are:

• You participate in more than 500 hours in the activity during the year.
• Your participation is substantially all the participation in the activity.
• You participate for more than 100 hours, and no one else participates more than you.

The material participation test must be met to qualify for nonpassive loss treatment and deductibility against nonpassive income.

Does Your STR Qualify as a Business? Use Schedule C

You own a rental property and, for example, provide bikes for your renters to use as well as daily cleaning services. Even though you are renting a property, your STR might be considered a trade or business if it provides “substantial services” to renters. Substantial services depend on the facts and circumstances of each rental property. They must generally be for the convenience of the occupant and rendered in connection with the rental of the property.

This is an important distinction that the IRS does not specifically define, so when in doubt, consult a tax professional to determine whether the services offered qualify as substantial services. Material participation rules still apply; however, once you are deemed to be providing substantial services, you must report your STR on Schedule C, and you will be subject to SE tax, even if you do not materially participate.

What If My Average Rental Period Is Over 7 Days?

Let’s say you rent your property over various weekends but also have guests who stay for two or three weeks at a time.  If your average rental period for the year exceeds seven days, you must follow the long-term rental rules and are subject to passive activity limitations. You may overcome these limitations by providing ‘substantial services’ to your guests. In that case, the rental is treated as a trade or business, reported on Schedule C, and subject to self-employment tax. Material participation rules still apply.

A Common Pitfall with Personal Use of STR

If you use your STR personally for vacations or have friends stay, you should be aware of these common tax traps. Properties used as a vacation home for a period of 14 days or 10% total rental days throughout the year are subject to the vacation home rules, which limit deductions to the amount of rental deductions recognized for the property. Any expenses not recognized in the current year due to loss limitations are carried forward indefinitely until they are allowable against rental income. The IRS requires that any property used as a vacation home for 14 days or less prorates expenses between rental and personal use.

Any property rented for less than 15 days is considered a personal residence. Rental income is not taxable, and property taxes and interest expense would be deductible and subject to itemized deduction limitations.

Choosing the Right Path for Your Short-Term Rental

Many factors can determine whether it’s more beneficial to report a property as a traditional rental or a business. Always be sure to keep records of services provided, guest stays, and all expenses associated with each property. In addition, STR owners should consider the impact on income tax, net investment income tax, and self-employment tax when planning for short-term rentals.

Need help deciding how to report your STR? Our team can help you minimize taxes and avoid costly mistakes—schedule a consultation today.