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June 20, 2024
Last Updated : July 5, 2024

STR Loophole IRS Audits: Three Arguments the IRS is Making

STR Loophole IRS Audits: Three Arguments the IRS is Making

Over the past six months, we have been taking on new clients who are going through STR loophole IRS audits.

Most of these clients are defending real estate professional status and the STR loophole.

In this article, I’m going to share three arguments the IRS is making related to the STR loophole and citations you need to defend yourself:

IRS Argument #1: You must qualify for real estate professional status to claim STR losses

Almost every STR loophole IRS audit we see starts here.

The IRS will deny the STR losses and make the statement that, under IRC Sec. 469, you must qualify as a real estate professional in order to claim STR losses.

But this is not true if your STR has an average rental period of seven days or less.

Under Reg. Sec. 1.469-1T(e)(3)(ii)(A), a property is not a “rental activity” if it has an average period of customer use of less than or equal to seven days.

Sec. 469(c)(2) says “except as provided in paragraph (7), the term “passive activity” includes any rental activity.”

And Sec. 469(c)(7) effectively says if a taxpayer qualifies as a real estate professional, then paragraph (2) shall not apply to any rental activity.

As a result, if you qualify as a real estate professional, the definition of “passive activity” no longer includes “rental activity” and you move on to the material participation tests to determine whether or not an activity is passive or non-passive. Real estate professional status just gets you over the hurdle of “rental activities = passive activities.”

But as shown with the above Reg section, this analysis is moot because we don’t have a “rental activity” to begin with.

Thus, we don’t need to qualify as a real estate professional.

IRS Argument #2: You should have reported your STR on Schedule C

We recently handled a claim from an IRS agent that if the STR is not a “rental activity” under Sec. 469, it must be reported on Schedule C.

Because Schedule E is only for “rental activities.”

Logically, this makes sense. However, Schedule C is for reporting trades or businesses that are self-employment activities and thus subject to the 15.3% self-employment tax.

But Sec. 1402(a)(1) says rental income is excluded from self-employment taxes unless you are a real estate “dealer”

Additionally, CCA202151005 says “whether an activity is a ‘rental activity‘ under Sec. 469(c)(2) is not determinative of whether the exclusion in Sec. 1402(a)(1) applies.”

Effectively, this means that just because your STR is not a “rental activity” under Sec. 469 does not automatically make it subject to SE taxes, which would then require Schedule C reporting.

Instead, STRs are reported on Schedule E.

IRS Argument #3: spouses must hit the material participation tests on their own

Recently, an IRS agent claimed that in order to materially participate in the STR, you or your spouse must work 500 hours in the STR and the spouses cannot combine hours.

Unlike real estate professional status, where one spouse must meet the 750-hour test and more than 1/2 time test completely on their own, spouses can combine time for material participation testing.

Reg. Sec. 1.469-5T(a)(1) is the actual 500-hour test and includes the term “individual” in its wording.

Reg. Sec. 1.469-5T(f)(3) says “any participation of such person’s spouse … shall be treated … as participation of such person.”

And Sec. 469(h)(5) says “In determining whether a taxpayer materially participates, the participation of the spouse of the taxpayer shall be taken into account.”

Combining these sections produces an understanding that the term “individual” means looking at both spouses as one person for the purposes of testing material participation.

Meaning, both spouses can log time toward the 500 hour material participation test (or any material participation test for that matter).

Our team is well-versed in handling STR and real estate professional audits. We are also experts at tax planning for real estate investors. Schedule a consultation with us today.