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STR 07: Renting Out a Room or Part of Your Home as an STR & Do STR Hours Count Towards REPS?

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In this episode, Brandon and Thomas discuss whether or not you could rent out a portion of your home as a short-term rental, and if the hours you spend on short-term rentals would count towards the real estate professional status.

This episode is sponsored by Landlord Studio.


Full Transcript:
This podcast has been transcribed using AI, please excuse spelling, grammatical, and other errors.

Thomas Castelli 0:00
You're now listening to the tech smart Rei podcast.

Brandon Hall 0:03
Your source for all things real estate, accounting and tax. Here we reveal our secrets that can save you 1000s in taxes, streamline your accounting process and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors and current clients on what strategies they use to grow their business, and how they steer clear of Uncle Sam.

Thomas Castelli 0:30
Hey, everyone, thanks for tuning into this episode of The Tech smart Rei podcast. In this episode, we are going to discuss everybody's favorite topic short term rentals and we're specifically going to touch on whether or not you could rent out a portion of your home as a short term rental and still use the short term rental loophole to make losses non passive and use them against your non passive income. We're also going to clarify, do short term rental hours does the time you spend on short term rentals count towards the real estate professional status. So looking forward to diving right into that but before we do a quick word from landlord studio if you're doing yourself landlord managing rental properties landlord studio is made for you. The software helps landlords simplify income and expense tracking. With their easy to use app you can digitize receipts record income and expenses in real time and generate reports and even manage leases and tenants plus landlord Studio makes late rental payments and bank visits a problem of the past with secure online rent collection get the rent paid directly to your bank account. And you can even automate rent reminder emails and late payment fees. Landlords studios also the best way to stay tax compliant, they offer a range of financial reports including Schedule II and supplier expense reports designed for tax time. You can learn more about landlord studio and start your 14 day free trial at landlord studio.com/cpa. And use the coupon code real estate CPA at checkout to get 25% off your plan. Again, that's landlord studio.com/cpa and use the code real estate CPA to get 25% off your plan today. Alright everybody, we're back and we're gonna cover the first topic today. Can you rent out a portion of your home as a short term rental and use of losses as non passive?

Brandon Hall 2:11
Yeah, we get this question a lot not only in our Facebook group, but also from our clients and that Facebook group is the text my real estate investors Facebook group facebook.com/groups/tech smart investors go check it out. We've got almost 10,000 investors and and at this point, if you're not in it, you are literally missing out you should have a little bit of FOMO right now but we get this question a lot. Yeah, you know, people have these separate dwelling units they have a basement that is totally separate even though it's in the same structure. It's it's got a separate entrance and everything, separate kitchen all that stuff. Mother in Law suites we've seen at us in the backyards but it's big in California now because California believe is La changed the adu rules and is allowing people to not develop at use in their backyard. Which is interesting for a lot of reasons. One, one question I have is infrastructure, these neighborhoods have all been built for single family home and all of a sudden you're gonna go ahead and adu with four units in the backyard. sudden, you've got a whole lot of people flowing in. But regardless, that's beside the point. So the question is, what is the tax implication if I rent these separate dwelling units out on a short term basis?

Thomas Castelli 3:22
Yep. So basically, when you rent these out right under Section Two ADEA makes it pretty clear that these are because they're not considered dwelling units. They're going to be akin to a hotel, motel and or other establishment, that the losses are not capped at the income from the property right. So if you rent out your residence, typically what's going to happen is, you're not going to be taking any losses, your expenses are going to be limited to the income from that activity. However you say

Brandon Hall 3:48
residents as in like, like I have a single family home, the basements not separate. So it's just all one unit, and I'm renting it out to you like you're in we're not actually doing this, it would be cool. If we did though, oh, we probably get a lot more done a lot faster. Anyway, the podcasts are definitely different. We can have a podcast room. But anyway. So I rent a bedroom out to Tom, on a short term basis. Right. But like I'm also in the same unit is that what you're talking about with the personal residence rules to Ada,

Thomas Castelli 4:21
kind of with the caveat of the fact that in IRS Publication 527. It's it lists the example in the example they give it says you rent a room in your home. That is always available for short term occupancy by paying customers if you do not use this room yourself and only allow paying customers to use this room this room is used solely as a hotel motel in or other establishment and therefore is not a dwelling unit and based on other parts of the code and also have this IRS Publication meaning that it's excluded from the rules of typically renting your residence and you would be able to basically treat this as a separate business activity. Okay,

Brandon Hall 4:57
so the residence rules say that if you rent Your residence for what is it more than 14 days out of the year, then more than 14 days or 10% of the total rental days that you cannot claim losses associated with that activity, the losses are kept to income, right. So you can you can offset your income. But that's it, you can't go and claim big losses. So if I in my house rented, If I lived in it for 60 days, and I rented it the rest of the time, then I couldn't use the losses from my rental activity, because I've lived in it for 60 days, that's more than 14 days and more than 10% of the total rented days. Right. But what you're saying is that I could live in my home. And I could either have a completely separate unit, like a basement or an adu in the backyard, right. And I could rent those on a short term basis. And I could take a loss, Allah coupled to those rental activities. So we know that, but what you're saying here is that I could also have like a fourth bedroom, that I put like a key card or a smart lock on the door, and nobody ever enters it unless you're a paying customer. And I rent that room out on a short term basis. And even though it's part of my residence, my one big unit, my one dwelling unit, that specific room can be treated completely separately, it's not subject to these rules. So I could rent that room out, then I'm not subject to to at a meaning that what losses associated with that rental that room rental I could claim without any sort of limit?

Thomas Castelli 6:35
Well, that's not what I'm saying. That's what the IRS is saying in their publication 527. Just to be clear, clarify. But so yeah, I mean, but yes, what you said is accurate, right. So put this way, if you have a residence, and you rent it out the room to me for say 21 days, right, and you would have to then report the income on your Schedule A, and you would be kept, you couldn't take the expenses past the income, so there's no loss. But then you go and you use that room again, right, you continue to use that room was part of your house, then that's where the residence rule applies. But if you have that room, like you said, with a lock on it, and you never use it, and the only paying customers use it, then yes, that's when that would be considered an indoor separate establishment, it's not a dwelling unit. And in that case, it's not subject to these expense caps that do exist for renting out your residence.

Brandon Hall 7:22
Okay, that makes sense. So if I can truly treat one room in my home, or two or multiple, if I can truly treat those rooms as like a hotel unit, I never used them in the only people that ever use them are paying customers, then the loss allocatable. So I report my income report my expenses, I can allocate some of my cost basis, I'm assuming of my primary residence to that room. And if that creates a loss, I can claim the loss.


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Thomas Castelli 7:51
Correct. Assuming you materially participate as well. And it has an average, say, of seven days or less, it's all still, it's basically what this is doing is this, what we're talking about, here, it's carving out that room or that portion of your home that's exclusively used for customer use as a separate business activity, right? So then you would have to say, you would have to still had still have to have an average day of seven days or less, because remember, if that average stay of that room, even though it's used exclusively for business is over seven days, right? Or over 30 days, and you're not providing substantial services, then it's going to be a long term rental. Right? And, yeah, so that, so you still have to pay attention to the short term rental loophole rules, which is an average day of seven days or less. And you must materially participate, or can have an average day of less than 30 days if you provide substantial services, like daily cleaning, and things of that nature. So that's kind of the point. The point is, again, just to summarize this one last time, if you rent out a room in your house, or a portion of your house, exclusively to customers, and you'd never use that room, then it's excluded from the rules under Section Two ADEA. And the rules we're talking about here renting your residence, cap your expenses at your income, and you can't take a loss, but it's excluded if you did those things that we just talked about here. So that's kind of the bottom line. We get this question a lot. I wanted to bring it up here to clarify that.

Brandon Hall 9:10
So let's talk about the feasibility of this though, right? I mean, I would have done this in my 20s. But I'm an old man. Now. I'm 31. And I know that was a microaggression against anybody that's older than 31 Especially our listeners that are in their 40s and 50s. I apologize. But I feel old man. I was like I was like crawling around chasing my son James the other day, we were playing like hide and seek and I was like crawling around behind the couch and stuff. Crawling on hardwood floors. And I played a lot of soccer growing up but man my knees were like just killing me after that. My wife was like I need I need knee surgery when I'm older. But anyway, so I'm 31 years old. I've got a wife and a family at this point wife and two kids and the feasibility of something like this. I'm not going to go rent a room of my home and have strangers you know trekking in and out of my house. Though it's off the table for somebody like me if I was in my 20s, and I had a three bedroom, two bath home that I had just purchased, and I was trying to help offset that mortgage payment, maybe I'm doing it there. But the other piece of this too, is that even though you can claim the loss, assuming that you rent this room out exclusively, you never use it personally. Even if you could claim the loss, the loss probably is not going to be Yeah, that large, right? I mean, we're talking about, you know, maybe you've got a 2000 square foot home, and you've got a bedroom, 200 square feet large, or I guess, maybe small. That's what 10% Of the total property. So if I bought this property for $400,000, we're talking about allocating $40,000 of cost basis to this property, net of land, maybe we're at $35,000 of cost basis. So we're depreciating 35,000 as a cost basis over 39 years, because it's a short term rental. So we're really talking about 900 bucks of annual depreciation. So we're not going to create any sort of large loss, I'm not going to go in cost segregate one room out of my home. So I guess that's the other piece of this too. It's nice if you do create a loss, maybe you've built this thing out or spent a lot of money on this one particular room. furnishing and maybe I don't know,

Thomas Castelli 11:16
yeah, maybe it's I just don't see it being that big is that big of a benefit, like to your point, like you just said, I think really where you might see this is maybe on the ad use or maybe if you have a really nice basement or something like that, that you can really rent out you have a larger space in your house. But it's not a practice is Yeah, I agree with you there that we wanted to tell everybody. It's there. It's your views, we get this question. We get this question a lot. And that's why we're having it. But the thing I'll leave here is that ask yourself is the juice worth the squeeze? Right? I've gone through all this stuff to get a benefit just to go through all the planning for a very small benefit like this. Maybe it is for you. Maybe it's not for me personally, I probably wouldn't do something like this. Maybe if I had an adu. If I lived in California, maybe the adu would make more sense. But yeah, if you're gonna use a short term rental loophole, you'll probably want to buy a separate house or a separate building to actually rent that out in a short term basis. That's where you're really going to get the most power out of that strategy. Trying to do it on a room or on a basement apartment might provide some benefit, but it's not going to be very meaningful, probably in most cases.

Brandon Hall 12:19
Yeah, I think I'm with the the adu is probably where you're going to get the good benefit of the cost segregation study, or, I mean, if you're building an adu, you already have all the cost basis information. So it's just a matter of kind of piecing all that together and reporting that on your tax returns to get that accelerated depreciation and the bonus depreciation. But that's where I would probably be spending time is if I really wanted to do this, build an adu in the backyard, assuming that you can, and then just treat that completely separately. Don't use it for personal use.

Thomas Castelli 12:47
All right, so we do have another thing we do want to cover in this episode. And that's going to be do short term rental hours, the time you spent on your short term rental properties. Do those hours count towards the real estate professional status? As yet another question we get asked a lot and things come up from time to time. So kind of break this down. Right. So part of the short term rental loophole is when you have an average day of seven days or less, it's not considered a rental activity. It's considered just a business. Right. And there's a tax court case out there called Bailey vers Commissioner. And in that tax court case, basically, the taxpayer tried to assert that their hours they spent on their short term rental property counted towards the real estate professional status. And, you know, long story short, the tax court came back and said, well, because it's not a rental activity, because it's excluded as rental activities, not a real property trader business. And therefore, the taxpayer lost a tax court case, because they said it just doesn't count towards the real estate professional status. And there's another Bailey verse Commissioner case where there's something similar that happened in that case as well, where the Tax Court ultimately concluded that the time that they spent on their short term rental activities not count towards the real estate professional status. So kind of in a nutshell, I think we have to get brands opinion on this. To me, it could maybe qualify as under operations, leasing or management of real property because the house is still real property at the end of the day, and could still be considered a real property trader business. But if you look at these two tax court cases, and you take them for what they are, it would set the precedent that short term rental hours generally won't count towards real estate professional status.

Brandon Hall 14:22
Oh, yeah, absolutely. I mean, the two Bailey cases, you know, I think that they got hosed. Personally, I think we actually talked about this one time on one of our podcasts episodes, but the to Bailey cases, the tax court basically said, because it's not a rental activity, because of that Treasury regulation that we've beat to death at this point. And if you don't know what we're talking about with the short term rental loophole, you need to go back and listen to the earlier sessions of our short term rental series on the tech smart investors podcast. So you can just like look for STR at the beginning of the podcast episode, and that's how you know you're on the short term rental series. And so I'm not gonna go and explain the entire loophole and everything but just know that with short term rentals, you can claim large tax losses, whereas you cannot with long term rentals, it's easier to do with short term rentals. And that's kind of something I believe is fueling the growth of short term rentals is everybody kind of figuring this tax loophole out, but the Bailey cases, the reason that a short term rental qualifies for this loophole is because the the Internal Revenue Code or the Treasury regulations that support the Internal Revenue Code, say that a short term rental is not a, quote, rental activity. And the Internal Revenue Code section 469 applies all these limitations to quote, rental activities. So if a short term rental is not a rental activity, then it doesn't have as a separate set of kind of tests. Think of it that way. And again, we explained this in depth in our earlier sessions on short term rentals. So go back and listen to those podcast episodes. So the Tax Court says, well, basically, you can have it both ways is I think kind of what the tax court saying it's a, hey, if a short term rental is not a rental activity, then sure, yeah, you don't have to qualify as a real estate professional. But because the short term rental is not a rental activity, you can also use the hour to qualify as a real estate professional, right. So you don't have to qualify as a real estate professional, but you can also use the short term rental hours to help you qualify as real estate professional. And they said that there was early 2000, the first Bailey versus Commissioner case, and then I believe, is like 2010 or 2011. The second Bailey unrelated Bailey vers Commissioner case, where they just reinforced that now, as Tom mentioned, that sets the precedent that your short term rental hours cannot qualify as real estate professional status hours. So that is technically correct. I would be very interested to see if somebody ever took the issue to tax court and called their short term rental operation, a real property operation business, because there are 11 Real Property trades or businesses under Section 469. That were if you spend time in those real property trades or businesses, they count as real estate professional status hours. So leasing is a real property trader business brokerage is a real property trader business, construction reconstruction or real property trades of businesses, rental property management, those are all real property trades or businesses, there's 11 of them defined in Section 469. So the theory is like, okay, even if we don't have a rental, real property trader business, what's stopping this short term rental from potentially being another one of those 10 remaining 10 Real Property trades or businesses. And when you look at the definition, it's in Treasury regulation 469 dash nine, when you look at the definition of a real property operation, I think that there's potentially room I'm gonna say potentially, because I honestly don't know. And we have two tax court cases that say that short term rentals are not rental activities. But just because they're not rental activities doesn't mean that they couldn't potentially be one of those other 10 Real Property trades of businesses. And real property operation, the definition is handling by a direct or indirect owner of the real property, the day to day operations of a trade or business under paragraph B, one of this section relating to the maintenance and occupancy of the real property, that affect the availability and functionality of that real property used or held out for use by customers, where payments received from customers are principally for the customer's use of the real property. To me, that means that if you are self managing, or even if you have somebody else that's managing for you, because this says by direct or indirect owner, well, I don't know about the managing somebody else managing for you, I guess that doesn't really communicate that. But to me, this kind of does say if you're self managing real property, in the day to day operations of this real property trader business, where it's held out to use by customers, where payments received from customers are principally for the customer's use of the real property, that to me kind of communicates that short term rental activity could be a real property operation. And I'm kind of surprised that the two Bailey cases did not previously address that.

Thomas Castelli 19:19
Yeah, you know, as you were reading that, I was like, wow, it's kind of fits the bill with short term rental, right. It's still real property. You know, what I think is when tax court cases happen, you know, these are isolated incidents, right? People aren't going through all of the tax code necessarily in the case. And maybe whoever was defending them, either the taxpayer themselves or perhaps their attorney, or their CPA or whoever they had, in the case with them just didn't present this point, in fact, to the tax court, right. And it was never brought up for discussion. And the task force has looked at the rental activity in isolation. So to Brandon's point earlier, it would be interesting to see if this was brought to tax credit case again, and someone did make the argument that Well does qualify as a real property trader business under an operating business, like Brennan just had mentioned when he just read the tax code to see what the conclusion would be if those facts were indeed presented to the tax court. But having said all that, you got to if you're going to try to claim your short term rental hours towards reps and use that as a justification, you would have to be prepared for the hassle and the headaches that would come with, you know, a should you get audited and having to go through the audit and be having to make it through tax court and actually winning the case. And there's, there's going to be substantial amount of time and effort, I would imagine that we're going to go into that probably money as well. And if definitely money,


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Brandon Hall 20:36
time and effort means money. So yeah, you will be forking out a lot of cash to defend your position. Yeah. And

Thomas Castelli 20:44
you have tissue that is that worth the potential tax savings that you may receive as a result of winning that case and claiming your short term route rental hours towards reps. And, you know, kind of as I'm just going on about that kind of brings me just to another quick point on this topic. And it's the bottom line is if you're going to try us reps and the short term rental loophole, as it stands to taking the conservative position, you would need to qualify as a real estate professional, meet the material participation tests on your long term rentals and meet a separate material participation test on your short term rentals, which is absolutely feasible. But for the majority of investors out there, it's not even going to be a problem, because you should probably just for the majority, not everybody, of course. But for a lot of people who are interested in general properties, pick one strategy and go for it and use that one strategy as an effective tax reducing strategy rather than trying to, you know, go for it. All right, that'd be my two cents on it there.

Brandon Hall 21:34
Yeah. And I do want to say that what we have are two tax court cases, the Bailey's verse commissioners that say, No, and those are authoritative, right. So that is what the IRS will rely on. That's what the tax court will review if you were to ever bring this up and try to challenge this. So just be prepared to lose like what we're saying here today is not an endorsement of the fact that you can use real property operation as a real property trader business for your short term rentals and have your short term rental hours count as real estate professional status hours. That's not what we're saying at all. We are saying that could potentially happen. And there will probably be a tax court case on it. At some point over the next five years, I would imagine because I think that a lot of people are going to be going to tax court with short term rentals as they've exploded in popularity recently. So I think that we're going to see tax court cases pop up over the next five, potentially seven years. And we'll get some clarity on this real property operation question. But I just want to make sure that if you're listening to this podcast, do not take this as an endorsement to go and count your short term rental hours as real estate professional status hours, because they're real property operation. That's one of those 11 Real Property trades and businesses. Don't do that. Okay, make sure that you get qualified help make sure that you run it through a CPA, even if you came and ran it through us we would have you probably signed some sort of disclosure that said, we're not liable if this all goes down in the toilet, because we just don't know we don't know if you can actually qualify short term rental as a real property operation, trade or business. There's still no

Thomas Castelli 23:06
yeah, all we know at this point is at least two people have tried and lost in tax court. And that just speaks for itself. And we'll leave that there. Having said all that, I want to thank everybody for listening to this episode checking it out. If you have not already joined the tech smart investors Facebook group again, you can go there to facebook.com/groups/tech smart investors and join the free Facebook group or if you want to get even more information on these topics. You want to join some live q&a As we host to a month where we'll answer your questions live. And we'll also post detailed blog posts include all of our citations on our tech smart insiders platform. If you want to get a tech smart insiders free trial, you go ahead and go to web dot tech smart investors.com. And sign up for a 14 day free trial there and we'll catch you maybe on the next live q&a. And until next time, Happy investing.

Brandon Hall 23:54
Thanks for listening to today's show. If you enjoyed the show, please find us on iTunes and leave us a review. You can also email us at contact at the real estate cpa.com with any feedback or topic suggestions, we are always taking on new clients and with the new tax laws in play. You really don't want to navigate this alone. Let us help you save money on taxes with your accounting and CFO needs. To become a client navigate to our client page at the real estate cpa.com and fill out a webform with as much detail about your situation as possible. Thanks so much for listening. Have a great rest of your week.


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