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This is our third and final episode in our mini-series about the tax strategy of using short-term rentals. In this episode, we will discuss tax court cases and the do's and don'ts of utilizing this strategy. If you haven't already listened to the first two episodes in this series, we highly recommend checking those out first!
Short-term rentals are important because many taxpayers want to offset their W2/active/ordinary/nonpassive income with real estate losses. If done properly, short-term rentals can offset directly against this ordinary income without the real estate professional status.
The first court case we are digging into is Barniskis v. Commissioner from 1999. Barniskis, the taxpayer, purchased a condo on Lake Superior. This is a travel destination. Blue Fin Condos, the condo association, had arranged for a management company to manage all of the units.
In this case, the taxpayer argued that their condo should be nonpassive because they materially participated. They got audited.
The tax court found that several of the activities in their time records constituted investor-type activities. This goes all the way back to material participation. In particular, some of the activities listed were preparing taxes, reviewing records, paying bills, and reviewing monthly financial statements.
Additionally, even if they had spent a legitimate 100 hours materially participating, they still wouldn't have participated more than the management company. The auditors investigated the management company to pull hours spent by all employees to determine the number of hours that the management company spent. Apparently, it wasn't even close.
Another court case is a 2011 case. The taxpayer owned long-term rentals and owned an inn, a short-term rental. The taxpayer claimed the real estate professional status and attempted to use the hours to make the long-term rentals nonpassive.
During the investigation of this 2011 case, the court looked at a 2001 case. In this 2001 case, the taxpayers were husband and wife licensed attorneys with a couple of four-plexes, a single-family home STR, and a STR condo. The IRS disallowed the loss from the condo because the taxpayers didn't establish that they materially participated in operating the property because they had a management company. Their status as real estate professionals was comprised of hours spent on the condo STR. Since they didn't materially participate here in the condo, they lost the real estate professional status. The STR condo hours did not count because the average tenant stay was 7 days or less, so it wasn't a rental activity, so it's not involved in the real estate professional status.
From this ruling in the 2001 case, the tax court in this 2011 case saw that the STR inn is disqualified as a rental activity because of the 7-day average stay rule. Thus, the hours spent are also removed from consideration for the real estate professional status. In the 2011 case, they applied the same logic as the 2001 case and disallowed the losses from the long-term rentals, because they were no longer grouped together for REPS to be taken as nonpassive. The inn remained an active service business.
Both of these court cases were litigated before the astronomical rise in STRs due to Airbnb and VRBO, we need to stay tuned for more recent court cases around this issue. Our next court case is from 2019.
In this next case, Eger v. the U.S., the taxpayers were real estate professionals. They aggregated their 3 properties to be treated as one activity with the -9 election. One property was a short-term rental.
The taxpayers argued that the management company was the one entity with the right to use the property and therefore the management company is the tenant, and the management company leased it out to secondary tenants. The tax court found that the management company was not the end customer, and the tax court considered the management agreement to be a 'marketing agreement'. This obviously causes the property to be treated as a short-term rental, and this STR can't be grouped with long-term rentals for the -9 election in REPS.
These taxpayers could not prove that the management company had a continuous and recurring right to use the property. Because of this, the end tenant was the Eger's tenant.
In Lucero v. Commissioner, from 2020, the taxpayer had a rental property in California several hours away from their home. They paid a management company to manage the short-term rental on a daily basis. The management agreement was a standard management agreement - day-to-day operations, marketing and advertising to tenants, cleaning, and landscaping.
Regardless, the taxpayers still claimed the losses. In addition to the issue above with the property management company, the taxpayers also stayed in the property for more than 15 days. This is a threshold of personal use that makes the property a personal residence.
"Back to the vacation rental rules - if you stay in the property for more than 14 days or more than 10% of the total rental days, then you have a personal residence - your loss is limited, you have to do expense ordering rules, and it gets messy."
However, if your time spent at the property is primarily for property upkeep, this does not count towards a personal use day. Rose vs. Commissioner in 2019. If you're there performing work and doing repairs and maintenance this doesn't count as a personal use day.
Time logs are extremely important. You must be able to substantiate your position. It must be reasonable and credible.
Ensure you have covered your bases for material participation. You must pass a material participation test with certainty beyond any doubt. Hours don't count unless they materially impact the day-to-day operations of the property. Investor-type activities do not count.
"Short-term rentals cannot be grouped together with long-term rentals. That's clear at this point. They are two separate tests, and that's a good part of this strategy, that they're separate. All you need to do is materially participate in your short-term rentals and they can be nonpassive.
This is an extremely complicated area of the tax code, it is a loophole, and it is still relatively new as Airbnbs and VRBOs are still recent - tax and legislation don't move that fast. Work with your tax and legal advisors to make sure this strategy makes sense for you holistically.
This isn't just a tax decision, this is an investment decision and it's a business decision. Because you have to materially participate, you have to play a significant role in the operations in order to make this strategy work."
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