Clearing Up Confusion on Tax Treatment of Short Term Rentals

[Greg O'Brien]

Hi All - I've seen quite a bit of confusion on the application of the Passive Activity  Loss Rules and Short Term Rentals.  Beyond BP, there is a lot of confusion in the accounting community as well but the same rules have been in existence for quite a while and often were not studied since STRs have never been so popular.  The tax code may never define "Airbnb" but there are rules surrounding these type of activities which I will give an brief overview below. 

1) My STR goes on Schedule C: It depends. Your CPA should be discussing whether or not your STR business provides substantial services.  The IRS' Chief Counsel recently published a document clarifying this.  If you are putting your STR on Sch C and NOT providing substantial services, you will cost yourself money long term and risk the IRS reclasses your activity (which may or may not have consequences).

Nonpassive does NOT equal Income from Self Employment automatically.  This is a bad application of the law if this is suggested. 

2) Some people say 27.5 years and some say 39 year depreciation - look to the average period of stay in your STR. If your STR averages 30 days or less, this is considered transient and therefore, 39 years (nonresidential). If greater than 30 days' average, it could be considered residential.

3) Passive, Nonpassive or somewhere in between? This is the largest point of confusion we see.  This all hinges on what you call a "rental property" is actually NOT a rental property in the tax code!  Huh?  So the Treasury Regulations to the Tax Code define situations in which property "rentals" are not considered real estate income.  https://www.law.cornell.edu/cf...

The Regulations state SEVERAL exceptions to "rental activities" in the tax code.  One of the exceptions to a "rental activity" is if you rent your property, on average, 7 days' or less.  This is the first piece.  The second piece is whether or not you pass the Material Participation Tests found in IRC 469 and the third piece is whether your participation rises to the level of Substantial Services (think hotel, B&B).

4) My CPA Says I can't deduct a loss that was generated!  Did they follow the Treasury Regulations above, IRC 469 and IRC 1402?  What is the support for treating as passive or nonpassive?  Are they treating it as passive automatically because you are not a REP?

What we find is the missing piece is some pros do not realize that it is indeed possible to have a "rental property" that is actually not a "rental" for tax purposes and treated as a business. Whether or not you materially participate is a different question (and deserves a full post with all of the nuances). The key in my mind is disconnecting a STR from a "rental property" for tax purposes.

5) Why does this Loophole Exist?  My opinion is this is NOT a loophole.  The Regulations clearly state how to treat a property that meets various definitions.  If tax pro is going against the regulations, isn't that a problem as well?  If you 1) Depreciate over 27.5 years a residential rental but its not 2) You list on Sch C yet don't provide substantial services 3) You list as a passive activity BUT in fact, it is non passive.  Incorrectly treating a property as passive may benefit you and the IRS will absolutely change this under audit (several cases on this).

6) No Tax Court Cases Exist?  Myth. There are several tax court cases surrounding STRs OR other cases that use the 1.469 regs above. Your tax pro needs to read these and interpret the findings. One example: Taxpayer tried to use the hours from a STR as REP hours. Finding: Disallowed, since a 7 day or less rental is in fact NOT a rental! This directly lines up with the rules above.

Hope this brief overview clears up some FAQs and confusion out there!  As always, your tax professional should help you navigate these rules and apply them to your specific circumstances as with all tax law, there are caveats and nuances to everything which need to be examined!

[Nancy Bachety]

This is a fabulous post, thank you @Greg O'Brien. I am currently in talks with the IRS regarding this very topic, unfortunately. 
I think what muddy's the water is we have four LTR and three STR's. So we have legitimate rentals and we legitimately materially participate in the STR business too. I am about to submit to the IRS my log of 500+ hours working in the STR business, most of which come from communicating with guests, cleaners, maintenance people, Airbnb, VRBO, and managing supplies, shopping, bill paying, pricing, calendars, all the daily and weekly tasks. I'm excluding travel time to the property for the STR's.

Any words of wisdom regarding material participation that you referenced?