By Carmen Barrett, CPA, MST, Senior Manager, Tax & Advisory
ASL Real Estate Group
You may have seen the social media trend about the benefits of short-term rentals (Airbnb, VRBO, etc.), the catch is simple, if you have a vacation home or other dwelling unit that is non-income producing, you can make it profitable by using it as a short-term rental, vacation or otherwise. This all sounds great but there are unintended tax consequences to consider if the operation of this venture is not set up correctly, which many catchy articles, blogs and posts do not address. Additionally, most every taxpayer is unique so don’t go it alone and heed the well-intentioned advice on social media but simply contact your trusted and knowledgeable tax advisor to determine the best path forward. After all, no one wants to become the next social media post about what not to do.
While it may seem like this idea is new and trendy, short-term rentals have been around for quite some time which means federal and state taxing authorities have well-established rules one must follow. The IRS defines a dwelling unit as a home, apartment, condominium, mobile home, boat or any other structure containing a sleeping space, toilet and cooking facilities. These dwelling units come in many forms (i.e. second home, vacation home, houseboat, accessory dwelling unit, casita, etc.) and if you own one and use it personally, and are considering a short-term rental activity or just started one, keep reading.
When there is personal use, the rules for deducting expenses with short-term rentals become more complicated. All is not lost if you use the property personally as depending on the number of personal use days, deductions may be limited. The number of personal vs. rental days will determine if the property is considered a personal residence, or not, which ultimately determines the amount of deductions allowed.
How does one determine impact of personal days? When a rental property is used by the owner, or “related parties” for personal use and the time exceeds the greater of 14 days or 10% of the number of days rented at fair market value, the rental will be considered a personal residence. Personal days and related parties are defined on a straightforward set of rules.
Related parties are:
- Direct family members, these count as personal days even if they pay fair market value rent;
- Co-owner(s) and their direct family members;
- Unrelated individual(s) if they are paying less than fair market value rent, this could also be considered a gift. If the discounted rent exceeds the annual gift exemption a gift tax return may be required and, finally;
- Engagements in a switching arrangement with another property owner, this is trading your property for another in a different location (e.g. a week at a beach house for a ski cabin).
Additionally, a personal day is any fraction of a day the owner has occupied the property, if an unrelated renter arrives in the afternoon and the owner left in the morning, this is a personal day. Days not counted as personal are those when repair and maintenance occurs and time held out for rent. For repairs and maintenance, the main purpose for the trip should be to work on the property with recreation time being incidental. Once the personal days vs. fair market rental days are known, this will determine if the activity rises to be considered a rental activity or is a personal residence with different limitations that apply.
If the property is a personal residence, all the expenses are pro-rated amongst personal and rental based on days of use. The personal portion of qualified mortgage interest and property taxes, are reported as itemized deductions on the taxpayer’s Schedule A, and subject to further limitations. The rental portion is reported on Schedule E along with the other rental expenses. Some of the trendy articles do not mention this fact. In this scenario and if some rent is received, other allowable rental expenses (depreciation, insurance, utilities, HOA dues, etc.) are deductible up to the amount of rent received and any unused (excess) expenses are carried forward to future years. Essentially, if there are too many personal days than rental days the allowable rental expenses only offset the rent received.
If the activity is determined to be a valid rental and has a loss, the net rental loss may be allowed to offset other current year income and this is where things get very complicated. The loss deduction is then subject to the material and active participation and passive activity rules (see Qualifying as a Real Estate Professional) to determine if the taxpayer can deduct the loss in the current year or if it will be carried forward to future years. If the taxpayer is engaged in full-time employment (with an employer or for self), it can be very difficult to meet the material participation rules in order to actually deduct these rental losses in the current year. These rules are complex, are not addressed in this article and is a primary reason why it is imperative to contact your tax professional prior to embarking on this, or any type of, business venture.
Another item trendy articles tend to gloss over with short-term rentals, is that the taxing rules are slightly different from traditional long-term residential or commercial rental/leasing activities. If there is a profit from this venture, self-employment taxes (see Social Security and Medicare Taxes) may need to be paid. The self-employment tax and the lack of immediate loss deduction are points many social media articles avoid mentioning as they only tout the immediate loss deduction as the major benefit of this type of operation. But, as mentioned earlier in order to get the immediate loss deduction it is not so easy.
In every rental situation, some level of services are provided but the influential factor for short-term rentals are the average days of customer use and the level of services exceeding what is usual and customary when simply renting rooms or other spaces solely for occupancy if the customer use is beyond 7 days.
If the average customer stay is 7 days or less the rental is considered short-term. If the average customer stay is 8 to 30 days, significant personal services must be provided like staff and housekeeping service, meals, and transportation.
To better market the property, the offering of amenities and services such as internet/Wi-Fi, linens, kitchen utensils and cookware, individual-use toiletries, blow dryers or other sundries, recreational equipment, etc. is helpful as well. Essentially, items to make the property fully habitable and convenient for the customer. It is also highly encouraged to list the property on vacation rental websites/apps as well.
Professional property management, this cannot be overlooked. When trying to achieve the best tax benefits in the short-term rental context it is imperative to self-manage. Unless you are considered a real estate professional (see Qualifying as a Real Estate Professional), it will be difficult to meet the material participation tests (mentioned above) since the services they provide are the activities a taxpayer needs to perform to meet the material participation rules. If the taxpayer engages in other full-time employment, it will be difficult to qualify for the immediate loss deduction and losses will be carried forward to future years. Again, the trendy articles do not mention this key fact.
While taxes play a large role in operating any type of business they are not the only aspect as there are many other non-tax issues to consider when converting or starting a short-term rental such as:
- Time considerations, for instance full-time employment, family responsibilities or volunteer commitments. How much time and effort can be devoted to this activity;
- Lender approval, if the property is mortgaged does the lender need notification;
- Homeowners insurance, this needs to be changed from residential to rental;
- Are special operating permits or licenses required from appropriate governmental agencies;
- Homeowner’s association, condo or coop rules, do they allow for these types of rental activities;
- Legal advice for leases and local/state landlord responsibilities;
- Property taxes, if there are any special rates received because the home is considered a primary residence this status may need to be changed as the home may no longer qualify for special rates and;
- Hotel/lodging/occupancy taxes, what are the amounts and filing requirements; who is responsible for preparing, filing and paying, you or the online platform, if using one.
Having such a rental can create specific state or international tax matters, or estate and gift tax matters, which should also be discussed with your tax advisor if these issues pertain to you. Every taxpayer is unique and we encourage you to contact us to discuss your situation, in depth, to provide a tailored solution.