Is Your Short-Term Rental Activity Really a Rental Activity?

By Melinda Kloster

In today’s era, more and more families are using owner rented vacation homes, such as Airbnb, rather than staying in hotels or property managed condominiums.  As a result, we are seeing more and more people renting out their second home or vacation home on a short-term basis.  As remote work becomes more common, and people have more opportunities to travel and work from anywhere, the popularity of these types of short-term rentals may continue to rise. The good news is that short term rentals operating at a loss can potentially offer beneficial tax savings to their owners (due to depreciation and other expenses that can be allocated against rental income).

Is it a rental property or a personal residence?

When the personal use of a rental property does not exceed the greater of 14 days or 10% of total rental days, the property is considered a rental, and you may deduct your rental losses in excess of rental income.  If the property is a personal residence, any loss is limited.

Is the income or loss rental income (passive) or ordinary income (non-passive)?

If the property is a rental, by default rental income or loss is considered passive.  Generally, passive losses can only be used to offset other passive income in any given year.  Therefore, unless you have other passive income, any losses generated by the rental property have no tax benefit until you sell the property or generate passive income.

However, there is a case where you may be able to deduct those losses and treat them as non-passive.  Under the Internal Revenue Code, the income generated by leasing your property is not considered a rental activity for a taxable year if the average period of customer use for such a property is 7 days or less. The average use is typically estimated by totaling the number of days rented divided by the number of customers who leased the property for a continuous period of consecutive days.

As a result, if you are leasing your property on average for 7 days or less, it is not a rental activity after all.  This is significant because if the activity is not a rental then it might not be subject to the passive loss rules, which could mean the loss is deductible if you meet other criteria.

Are you a material participant (active) in the activity?

In order to deduct the loss, you must have at-risk basis to take the loss and materially participate in the activity.  In general, you typically have basis in real property to deduct a loss, but the material participation requirement may be a bigger hurdle.  A taxpayer is considered to have materially participated in the activity if they satisfy one of 7 tests.  The material participant tests are a complicated set of rules, but one test that is often used to satisfy the requirement says that you must be involved in the activity for more than 100 hours during the year and have no less activity than the participation of any other individual.  For example, if you spend an average of 2 hours a week managing the property all on your own to get it leased (providing property maintenance and cleaning the property), then you could be considered an active participant.  This is just one of 7 tests.

As an active participant the loss is now fully deductible, rather than only being deductible to the extent you have passive income.  Of course, this means that if you have non-passive income, you could also end up having to subject the income to self-employment taxes.

What if it is a personal residence?

Alternatively, if you are renting your personal residence, or space in your personal residence, for a period of 14 days or less, Internal Revenue Code Section 280A says you can do so without having to report the rental income.  Therefore, if the property is a personal residence and not a rental property as discussed above, there is still hope for beneficial tax treatment if the rental is very short term.

As you can imagine, the rules in this area are complicated, and most have exceptions (which are not detailed in full within the article). As a result, as is often the case with tax planning, there is not a “one size fits all” answer to every potential scenario.  If you believe you have a rental property that is not a personal residence, please contact us to discuss the various tax implications.