Even with rising interest rates, the short-term rental market is booming. Our client base has become much more involved in these types of investments over the past few years. We suspect that it will continue to grow. Do you own short-term rental properties? This article will briefly address five tax issues that every owner of a short-term rental property should consider.
1 – How much can I use the property?
While allowed under current regulations, your personal use can impact the treatment of your short-term rental for tax purposes. Personal use includes family use and when leased under fair market value.
Expenses from the property may be limited if the owner uses the property more than 14 days or 10 percent of total days it’s rented out – whichever is greater. This means that if an owner plans to use their property for 30 days, they’d have to lease it out for 300 days during the rest of the year to avoid any limitations.
Interestingly, if you rent your personal or vacation home for 14 days or less, rental income earned generally isn’t taxable. The catch is the expenses are not deductible other than what is allowed as itemized deductions (mortgage interest, property taxes). This 14 day or less period (for the entire year) is also known by some as the Augusta Rule or the Masters Exemption which takes advantage of Section 280A(g) of the Internal Revenue Code, referred to by the IRS as Minimal Rental Use.
2 – How to treat the costs that go into the property?
In general, the cost of a residential rental property, whether a new purchase or a conversion from a personal use property, is depreciated over 27.5 years. The cost of the property should be split between the structure (the home itself) and the land. Any major renovations to the property are capitalized and generally depreciated over the same 27.5-year life. In contrast, the land value is never depreciated.
Furniture, removable fixtures and appliances all carry their own useful lives under the Internal Revenue Code (3, 5, 7, 10 and 15 years) and are normally capitalized and depreciated according to those useful lives and the applicable depreciation methods approved by the IRS (straight line, MACRS, etc.).
Under certain circumstances and depending on the item, it may fall under the IRS Tangible Property Regulations’ De Minimis Safe Harbor election where an item of $2,500 or less can be expensed rather than capitalized and depreciated.
As long as maintenance and repairs costs don’t substantially extend the life of an asset, they’re normally expensed as incurred.
3 – Your participation level matters!!!
Probably the most misunderstood part of deductibility of short-term rental losses or how net income will be taxed is participation level (by the owner) in that rental activity. Tax treatment of your rental income and expenses depends on your participation in the rental activity regardless of the average length of stay of your guests. Rental properties are generally considered a passive activity. Unless you qualify for one of the exceptions, net passive rental losses can only offset income from other passive activities.
Considerations such as:
- Your level of involvement in making significant management decisions (decide on rental terms, lease preparation/review, approving rental agreements and expenditures, credit/background checks on potential new tenants),
- Providing substantial services (daily cleaning, concierge services, providing meals and entertainment, providing transportation, etc.) and/or
- The amount of hours you participate in rental activities
will make a difference between treating the rental activity as passive or non-passive on your tax return. Another point to consider… Passive income is subject to an additional 3.8% net investment income tax for higher income individuals.
Practically speaking, current rules make it a challenge for higher income owners to meet the passive activity rule exceptions if you have a day job outside of real estate activities. Short-term rentals caught in the passive activity rules don’t lose the unused passive losses. Losses get carried forward to future tax years to reduce future sources of passive income. Or they can be released when the property is sold.
If you operate your short-term rental more like a bed and breakfast, your rental activity is treated as non-passive. It is not subject to the passive activity loss rules. And since you’ve materially participated in the activity, those non-passive losses can be used to offset other sources of your income such as wage income.
4 – What is your average rental period?
Outside of your level of participation, the average rental period is the next biggest step in determining how a rental activity will be classified and taxed.
Your short-term rental property could have a different tax treatment if the average lease term is seven days or less. If you materially participate in the activity, net income is generally not subject to the passive activity limitations mentioned earlier. And if you provide substantial services, similar to a hotel, the rental income may become subject to an additional 15.3% of self-employment tax.
5 – Documentation is key!!!
If your goal is to be able to deduct short-term rental losses to offset other earned income, document everything.
Tips for Documentation
- Utilize a logbook or an excel file by year
- Show what service was performed on what date, by whom and how long it took to complete
- Add in what the weather was for that day
- Document mileage when visiting the property to make sure there’s no damage
- Document mileage when visiting the property to check-in new renters or to check the renters out
- Perform walkthroughs and document the condition of the property
These are only some of the items that will only help your case if the IRS ever questions your participation in the rental property.
In conclusion, you can see the tax rules for short-term rental tax treatment are complex. It doesn’t matter whether you own multiple houses, apartments with short-term leases, a condo or even a cabin in the woods. Furthermore, this article only serves to skim the top of a few major considerations regarding short-term rental properties. Make sure to keep your tax advisor up-to-date on your investments and plans. Your tax advisor can help to make sure you’re doing everything you can to maximize this investment and future ones.