Table Of Contents
In the ever-evolving landscape of real estate tax laws, one question has been making waves among investors and professionals alike: "Do hours spent managing short-term rentals count towards achieving the Real Estate Professional status?”
Understanding the Short-Term Rental Loophole
The general rule as dictated by Section 469 is that all rental activities are passive by default. However, this section also provides certain exceptions that can change the way rental activities are treated for tax purposes.
Here are the two most important exceptions that concern us:
- If your property has an average rental period of seven days or less.
- If the average rental period is 30 days or less, and you provide substantial services to your guests, akin to what hotels offer.
In these scenarios, the activity is not considered a "rental activity" for tax purposes, which means you are not required to qualify as a real estate professional to deduct losses against your active income. Essentially, you can avail of these benefits while still working a full-time job in another field, thus making this a lucrative loophole.
The Real Estate Professional Status: What is it?
For those newly initiated into the world of real estate investment, it’s crucial to understand what the real estate professional status entails. This status allows you to deduct losses from your rental properties against non-passive income, which essentially turns losses from your rental activities non-passive.
To qualify, one has to:
- Spend more than 750 hours and more than half of their total working time in a real property trade or business.
- Materially participate in the rental activities.
Historical Context
Two landmark tax court rulings, namely Bruce Bailey vs. Commissioner in 2001 and a separate case involving Todd and Pamela Bailey in 2011, have set significant precedents in defining the boundaries of what can be considered as "rental activities" for the purposes of real estate professional status. Both cases upheld that short-term rentals with an average customer usage of seven days or less do not fall under the umbrella of “rental activities,” and hence, cannot be used to meet the hourly requirements for the real estate professional status.
The 2021 Amendments
By amending section 1.469-9, the definition of "real property" was expanded to include structures like hotels, motels, and the likes. These structures are similar in nature to the backbone of the short-term rental industry. As such, This indicates that short-term rentals might qualify as real property trades or businesses, which could mean they count towards the required hours for Real Estate Professional status.
The critical aspect of this exploration is understanding the definition of “real property” as outlined in section 1.469-9(b)(i). This segment defines real property as inclusive of land, buildings, and other inherently permanent structures affixed to the land. Subsequently, section 1.469-9(b)(i)(d)(2) provides a detailed list of assets deemed as buildings, which notably includes houses, townhouses, apartments, condominiums, hotels, and motels, amongst others.
Typically short-term rentals such as houses, townhouses, and apartments squarely fit within the delineated definitions of “real property”, indicating that short-term rentals should rightfully be considered real property trades or businesses.
Strengthening the Argument
Adding strength to this perspective is an example presented in the same regulation section illustrating a hotel’s operation. Despite offering substantial personal services to customers, the hotel’s primary offering remains the provision of rooms and suites, i.e., the real property. Consequently, the situation with short-term rentals is akin to that of hotels, where the primary payment is for the utilization of real property, thus fitting within the framework of a real property trade or business.
Implications
If the amendments are interpreted in favor of counting short-term rental hours, the implications for real estate professionals are significant. By combining the hours spent managing both short-term and long-term rentals, one could surpass the 750-hour threshold. This would not only allow individuals to attain the Real Estate Professional status but also unlock the potential to write off losses from long-term rentals, given they meet all other criteria.
Caveats
Despite the promising indications of the 2021 amendments, there exist tax court cases that contradict this position. This discrepancy leaves room for considerable risk in adopting such a stance. Until a definitive tax court ruling emerges, the ambiguity remains, potentially deterring individuals from leveraging this interpretation to their advantage.
There’s a substantial risk for individuals who decide to leverage these new regulations to claim real estate professional status, given the existing contradicting tax court cases.
It's of paramount importance to consult with a tax strategist or accountant to understand the inherent risks in this unsettled area of tax law. Contact us today.
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