This is the second episode in our series about short-term rentals. If you haven't listened to STR 01, you should do so first, as these episodes will build upon each other!
In this episode, Brandon and Thomas discuss the technical aspects of what you need to understand including the code sections, material participation, where this activity falls on your tax return, and several other things.
One of the hurdles to REPS is spending more time in real estate than anything else. With short-term rentals, an average stay of 7 days or less, this is not considered a rental activity under Section 469, so investors need not qualify as a real estate professional to reclassify those losses out of the passive bucket - they only must materially participate.
Treasury Regulation Sec. 1.469-1T(e)(3)(ii)(A) gives exceptions to the rules that define rental activities. There are six exceptions. One of the exceptions is: "The average period of customer use for such property is seven days or less".
Originally drawn up for hotels and hospitality, the relatively recent rise in Airbnb and VRBO platforms for vacation rentals absolutely does qualify under the same tests as other short-term living arrangements!
How are these properties depreciated?
Residential homes are depreciated over 27.5 years.
"Short-term rentals are considered nonresidential property. Former Reg. Sec. 1.1679(k)-3C1 was removed in 1993 but referenced in a 2011 CCA.
If more than 50% of dwelling units in a building are used on a transient basis, it's a nonresidential property. Transient basis means occupied by a series of tenants whom each stay less than 30 days.
A vacation rental is 1 dwelling unit, so 100% of units are rented on a transient basis.
With a nonresidential property, you can use 100% bonus depreciation on Qualified Improvement Property (QIP).
"If your rental activity has an average stay of 7 days or less, it's not considered a rental activity for Sec. 469, instead, it's considered a business. As with any other business, you must take a look at the material participation tests in order to determine if the activity is passive or nonpassive. If you materially participate, it's a nonpassive activity... you can take the losses, and make them nonpassive."
With short-term rentals, do you materially participate?
500 hours OR 100 hours and more than anyone else OR substantially all of the participation in the activity
We have seen taxpayers lose on the 100-hour test when they don't know how much time the others in their business spend. Aka cleaning crews and property managers.
If you're married, spousal hours do count towards these tests. However, you can't double-count time. If you both go to Home Depot for your short-term rental, you don't count that time twice.
Substantial Services - Schedule C
If you provide substantial services that are primarily for your tenant's convenience, you report your rental income and expenses on Sch C.
Substantial services are additional services that you'd do for a guest while they're at the property, such as cleaning (during their stay), tours, providing food, accessible amenities, and subscription services available at the rental.
There will be a point where you're providing enough substantial services where your short-term rental business should actually be considered a service business. At this point, your business will be reported on Schedule C, not on Schedule E. On Schedule C, you're subject to the 15.3% self-employment tax.
These rules come into play from IRS Publication 527.
Personal Use of Short-Term Rentals
Personal use of the property of 15 days or more OR more than 10% of the total rental days will cause the property to become a residence. Exceeding these thresholds will cause this property to be treated as a primary residence. You won't be able to deduct any losses generated by the property, though the losses can still carry forward. You also must allocate all expenses based on the proportion of time spent, allocating the expenses between your personal deductions and the rental property profit and loss.
Stay tuned for STR 03 where we speak about tax court cases related to short-term rentals.
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