The popularity of short-term rentals has exploded recently with the emergence of sharing economy companies such as Airbnb, VRBO and Homeaway. While these rentals provide a money-making opportunity, their tax considerations are frequently overlooked.
A short-term rental is a great way to make extra money by renting out a room or a whole house. It can also provide investors the potential to generate higher income from their rental properties. Historically used for beach houses and mountain homes, today’s short-term rentals can also be city apartments, spare bedrooms in a suburban home or even house boats.
Unfortunately, the majority of taxpayers equate such an arrangement with a standard rental property. Why would a short-term rental property be taxed differently just because the average rental period is less than typical?
Let’s examine the facts and circumstances to determine the correct tax treatment.
You first need to determine whether the activity around your short-term rental is rental income (to be reported on Schedule E) or trade or business income (to be reported on Schedule C). This decision is answered by whether substantial services were provided—in other words, services similar to that of hotels and bed and breakfasts. Examples include:
- Cleaning and maid-like services during the guest stay
- Meals and entertainment
- Concierge services
- Guest tours and outings
- Other hotel-like services
If substantial services are provided, the activity is considered trade or business income and would be subject to self-employment taxes, which is an additional 15.3% tax.
Many normal rental services are considered insubstantial services. These services can be provided and still allow you to claim the activity as rental income, which is not subject to self-employment taxes. Some examples are:
- Heating and A/C
- Water and gas
- Internet and Wi-Fi
- Cleaning of common areas
- Repairs and maintenance
- Trash collection
- Turnover between guests
Passive or Nonpassive Activity
Rental activity is generally considered passive activity, with the exception of when it is conducted by real estate professionals. Passive rental activity losses are limited and deducted only to the extent of passive income. Any excess passive loss can be carried to future years when there is passive income.
If the taxpayer makes a management decision, he or she is considered to have active participation. This allows passive losses to offset up to $25,000 of nonpassive income but begins to phase out for taxpayers with high adjusted gross income. There are exceptions to passive activity loss rules where rental active is considered trade or business activity.
- The average period of customer use is seven days or less (e.g., hotel), or
- The average period of customer use is 30 days or less and significant personal services are provided.
If the short-term rental activity is considered trade or business under passive activity loss rules, then we must use the materially participating test to determine if the activity is nonpassive or passive. These exceptions to the passive activity loss rules are not to be confused with the self-employment tax rules; these are two separate rules. How a rental activity is classified under the passive activity loss rules doesn’t determine its self-employment treatment and vice versa.
For example: A taxpayer hosts his short-term rental property on Airbnb. Substantial services were not provided, and the average days of use was less than seven days. For self-employment rules, this activity is not considered trade or business because substantial services were not provided. As such, it would typically be reported on schedule E not subject to self-employment taxes. However, because average days of use was seven days or less, the activity is considered trade or business under the passive activity loss rules.
As such, to determine if the activity is nonpassive or passive, we must use the materially participate rules for business activity. If the taxpayer self-manages the rental activity (and therefore is likely a material participant in operations), the activity will be considered nonpassive. If the taxpayer uses a property management company, the taxpayer’s activity will most likely be considered passive.
Buildings associated with short-term rental activity are depreciated over 27.5 years (residential) or 39 years (nonresidential). At first glance most short-term rentals would be considered residential property. But if the property’s average period of rent is 30 days or less, then it is considered transient for depreciation purposes. Such a property would be considered nonresidential and would depreciate over 39 years.
With more and more people taking advantage of our shared economy, it’s increasingly important to use the proper tax treatment on all your rental properties. If you can see the trend of short-term rentals popping up everywhere, you better believe the IRS does too. Will yours stand up to an audit?
Short-term rentals present a complex tax issue that can confuse many taxpayers and even tax preparers. A real estate CPA that understands both tax laws and the rental industry is your best bet to find the right tax treatment for your rental.
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