Income and losses from rental real estate activities have generally been classified as passive, regardless of the amount of participation by the taxpayer. The result is that the losses from these activities can only be deducted against income from other passive activities. They could not be used to offset nonpassive income, such as wages, interest, dividends or certain capital gains.
However, certain developments in the law combined with the advent of Airbnb- and Vrbo-related sectors can result in losses from rental real estate being characterized as nonpassive and, thus, being available to offset nonpassive income. For this to happen, the taxpayer must “materially participate” in the activity, and the activity must not be treated as a rental activity.
Know the rules
Regulations issued under the passive activity rules provide that a taxpayer materially participates if he/she:
- Engages in the activity for over 500 hours during the year.
- Participates in the activity for the taxable year and their activity constitutes substantially all of the participation in such activity of all individuals for such year.
- Participates in the activity for over 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual for such year.
- Engages in a significant participation activity for the taxable year, and their aggregate participation in all significant participation activities during such year is over 500 hours.
- Materially participated in the activity for any five taxable years (whether or not consecutive) during the 10 taxable years that immediately precede the taxable year.
- Engages in a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis during such year (i.e., over 100 hours).
However, an activity is not treated as a rental activity if:
- The average stay of a guest is no more than seven days.
- The average stay of a guest is 30 days or less, and significant personal services are provided by or on behalf of the owner on par with the services a hotel would provide.
- Extraordinary personal services are provided by the owner (i.e., services that are not incidental to the property).
- The rental of the property is treated as incidental to the nonrental activity of the owner.
- The property is available during business hours and is not exclusive to any one guest.
- Any part of the property for use in activities conducted by a partnership, S corporation or joint venture in which the property owner has an interest is not a rental activity.
To deduct otherwise passive losses against nonpassive income, the landlord must satisfy at least one of the material participation tests and one of the exceptions to rental property treatment. Most Airbnb landlords can meet the second or third items of the material participation tests and the first exception above.
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Don’t forget depreciation
Most people do not realize that their short-term rentals can reduce their tax liability while simultaneously earning them extra cash. This is because of the depreciation deduction, which does not require a corresponding outlay of cash. A taxpayer is not allowed to deduct in one year the entire cost of the short-term rental property but must instead recover the cost of the property over several years. Depreciation deductions can turn rental profits into tax losses. Because a short-term rental period is usually 30 days or less, the IRS classifies it as a commercial property with a depreciation period of 39 years.
Depreciating property over 39 years doesn’t yield a big annual expense (about 2.5% of the cost each year). However, there are ways to accelerate the depreciation deduction and, thus, increase the annual expense. The landlord can arrange for a cost segregation study. Such a study reclasses a portion of the real property into assets that have shorter depreciable lives, which results in an increased depreciation expense and bigger tax savings for the property owner.
Track your expenses
The landlord must learn which expenses are deductible and keep track of them. Allowable tax deductions include mortgage interest, property taxes, travel and transportation expenses to and from the property, maintenance and repairs, utilities, legal and professional fees, insurance premiums and more.
Keeping track of expenses is necessary to maximize the tax savings. Using bookkeeping software or keeping a spreadsheet of income and expenses is a good practice. Or simply get a separate credit card and use it only for the expenses having to do with the rental property. At the end of the year, your accountant can take the credit card’s annual summary to complete the tax return.
Short-term rental properties can be profitable from both a business and tax perspective. However, it is important to follow all the necessary rules and methodically keep track of income and expenses. One should always consult with a tax adviser to determine if this process is a good fit.
