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When it comes to tax considerations for short-term rental property owners, one crucial factor is the average period of customer use. This can impact whether a property is considered a short-term or long-term rental for tax purposes, with varying implications for deductions and other tax benefits.
This article explores how you can navigate through these complexities.
Understanding the Short-Term Rental (STR) Loophole
Here's a practical two-step guide to help you understand this better.
Step One: Ensure the average stay per guest is seven days or less. This needs to be 7.0000000 or less, not 7.01 or above. Furthermore, it is generally advisable to have at least two stays before the end of the year. This is particularly important if you are placing your property into service towards the end of the year.
Step Two: You must materially participate. There are seven tests you can look at for this, but the three most common are:
- You spend more than 500 hours for the year.
- You do substantially all of the work on the property for the year.
- You spend more than 100 hours and more time than anyone else.
This strategy can shift your short-term rental from being passive (which it is by default) to the non-passive side. This is quite a powerful strategy because it allows the losses from your short-term rental to offset your W-2 income or income from an active trade or business.
In order to utilize this strategy, we must know how to calculate the average period of customer use in single-unit and multi-unit properties.
How to calculate the average period of customer use for a single-unit property
The process for a single-family property is pretty straightforward. The calculation involves two main components:
- The total number of stays you had throughout the year. This could be any number – 10, 50, 100 stays, and so forth.
- The total number of days the property was rented.
The formula for calculating the average stay is simple: you divide the total number of days the property was rented by the number of stays you had. For instance, if you had 10 stays and the property was rented for 60 days in total, the average stay would be 6 days (60 divided by 10).
Maintaining an average stay of seven days or less is critical for leveraging the short-term rental loophole.
If you never have a stay longer than seven days, your average will naturally fall under this threshold. However, as soon as you start accommodating stays longer than seven days, even if just one or two, it becomes necessary to keep track of the average for the year meticulously.
An important point to clarify here is that the calculation involves the total number of days rented, not the total number of days available for rent. In other words, days when the property is vacant do not count towards this calculation.
This detail is particularly important because, as mentioned previously, you need to have at least two stays by the end of the year. There are court cases where taxpayers have argued that they had their property available for stays of seven days or less but did not actually get any bookings. The courts have rejected such arguments, further emphasizing the need for a minimum of two stays within the year.
How to calculate the average period of customer use on multi-unit properties
We will now shift our focus to multi-unit buildings. This topic often raises numerous questions, particularly when some units are designated for long-term rental and others for short-term use.
If you own a multi-unit property like a duplex or triplex, the calculation process becomes more intricate. For instance, you might want to lease one unit for a 12-month period (long-term), while renting the other unit(s) on a short-term basis.
A common misconception among tax professionals and investors is that each unit is considered a separate activity – and that if Unit A has an average stay of 300 days (long-term) and Unit B has an average stay of six days (short-term), they can be treated independently. This, however, is not accurate.
To calculate the average period of customer use accurately, you need to follow a specific process outlined in Reg Section 1.469-1(e)(3). But don't worry; we're going to simplify it for you:
Step 1: Break Down the Property into Classes
First, you need to categorize the property into distinct classes based on the difference in daily rent.
Let's assume that Unit A is a long-term rental and Unit B is a short-term rental, each attracting different daily rents. Therefore, we consider them as two separate classes.
Step 2: Determine the Average Period of Customer Use for Each Class
Next, calculate the average period of customer use for each class, similarly to what we explained for single-unit properties: divide the total number of days rented by the total periods of customer use for each class.
Step 3: Calculate the Average Use Factor for Each Class
The average use factor is computed by dividing the total gross rental income for the entire building by the total gross rent per class (or unit). For instance, if Unit A (long-term rental) brings in $10,000 and Unit B (short-term rental) makes $20,000, the total gross rent for both units is $30,000.
To calculate the average use factor for Unit A, you would divide its gross rental income ($10,000) by the total gross rent ($30,000), resulting in an average use factor of 33.3% (repeating). Do the same for Unit B to get 66.7%.
Step 4: Determine the Average Period of Customer Use for the Entire Property
Next, multiply the average use factor for each class by the average stay for each class.
If, for example, Unit A (long-term rental unit) has an average stay of 300 days, you would multiply this by its average use factor (33.3%) to get 99.9 days. Repeat this process for Unit B (66.7% by 6 days) to get 4.002
Finally, sum up the average use factors for all classes to find the average period of customer use for the entire property.
For instance, adding 99.9 days (Class A) and 4.002 days (Class B) gives you an average period of customer use of 103.902 days.
While this calculation may seem complex, it is crucial for multi-unit property owners aiming to utilize the short-term rental loophole.
Tax Regulations on Multi-Year Bookings
A frequently encountered conundrum revolves around the length of stays in short-term rentals spanning across years.
The question commonly asked is, "If I have a guest booking a stay with 11-days in 2023 and 10 days in 2024, do I consider this as two distinct stays or a 21-day stay as a whole?" Unsurprisingly, the answer is nestled deep within the complexities of Treasury regulations.
To answer this question, we must refer to a specific section of the Treasury regulations, 1.469-1(e)(3)(iii)(C)(1). It states, "The aggregate number of days in all periods of customer use for property in the class (taking into account only periods that end during the taxable year or that include the last day of the taxable year)".
The word "or" in this context is a crucial delineation. In tax code, 'or' implies that you can satisfy either part of the sentence to fall into that jurisdiction. It's not an 'and' situation where every criterion has to be met.
When applied to the example of a December 20th to January 10th booking, what we find is surprising. The 21-day stay counts as a 21-day stay in both 2023 and 2024. The reason is, in 2023, the booking period includes the last day of the taxable year, and in 2024, the period ends during the taxable year. Consequently, extended stays wrapping around the end of the tax year could potentially disrupt your average stay calculation for both tax years.
Further complicating matters, the same rule applies when converting a long-term rental into a short-term rental within the same tax year. If you have a lease ending in early 2024, for example, and intend to convert it into a short-term rental, you'll run into a mathematical conundrum. The 365-day lease appears to get counted as a full-year stay in 2024, making it nearly impossible to reduce your average stay to seven days or less in that tax year.
In terms of tax strategies, it's crucial to be aware of the risk versus reward associated with tax positions that carry ambiguity. When dealing with uncertainties in the tax code, one must not only scrutinize code sections and regulations but also refer to tax court cases and other authoritative sources. In some instances, clear-cut conclusions may not always be possible. In such scenarios, it's essential to weigh the risks and rewards and make an informed decision.
Year-End Lease Considerations
When a property begins service late in the year, things could become a bit more complex. Let’s imagine you get a few short-term rentals around Thanksgiving and early December. Then, a tenant wants to start a long-term lease (like a 365-day lease) on December 25th. Even though the majority of their stay falls into the next year, this would push your average length of stay above seven days for the current year, thanks to the 'or' clause in the regulation's definition.
The tax implications for short-term and long-term rentals can be quite different. Being aware of these details can help you plan accordingly and potentially save on taxes. However, tax law is complex and changes frequently.
For the most accurate and personalized advice, always consult with a tax professional who is familiar with your specific circumstances. If you are looking for Short-Term Rental Loophole experts, contact us today.