Short-term rentals often shelter lots of income from taxes. And regularly they save lots of tax.
But those big savings push the IRS to look closely at tax returns that include this gambit.
Then a couple of other things to know: Not only is it easy to fumble the short-term rental tax shelter. But the IRS finds these returns easy to audit. They can sometimes blow up your tax return with relatively little effort.
So, let me explain the loophole first.
Then I’ll point out the three common blunders that can cause the short-term rental strategy to fail. And suggest ways to protect your tax return.
Short-term Rental Loophole in a Nutshell
First, the good news: Unlike most other real estate tax shelters, the short-term rental loophole works easily. And simply.
All taxpayers really need to qualify? First, taxpayers need to show average rental intervals of seven days or less. And, second, they must materially participate (which usually means more than a hundred hours in a year).
Example: You own and operate a short-term rental. The rental shows large losses due to depreciation. The average rental period equals one week. As long as you and your spouse materially participate by spending more than 100 hours a year managing and maintaining the property? Bingo. You can probably use the large losses due to depreciation as deductions on your tax return. Even if the property appreciates.
Just to make this point clear, what gets attractive about the short-term rental option? You can use the losses–assuming you qualify–to shelter other income. So your W-2. Or investment income.
Example: You and your spouse together earn $100,000 in W-2 wages. If your return shows a deductible short-term rental loss of $75,000, your adjusted gross income equals $25,000. And probably, once you take the standard deduction, your taxable income equals zero and you owe no income taxes.
But as noted, it’s not all good news. The bad news is, the IRS often uses three simple tricks to blow up the tax savings that stem from short-term rentals.
The rest of this blog post quickly explains those tricks. And it identifies how you can sidestep problems with the IRS.
IRS Short-term Rental Audits Trick #1: Disqualification Using Section 280A
A first trick the IRS uses to disqualify a taxpayer from using the short-term rental tax shelter?
Looking for and then finding that the personal use of a vacation property exceeds the “greater of 14 days or 10 percent of the number of days during the year the unit rents at its fair market value.”
That personal use pushes taxpayers into treating their property as a Section 280A mixed-use dwelling unit. And Section 280A severely limits the deductions a short-term rental owner can deduct.
In fact? For purposes of our discussion here, assume Section 280A basically limits tax deductions on a vacation propery to the rental income. Which means you don’t save any taxes with your short-term rental.
Note: When you do the short-term rental gambit correctly, you use a chunk of tax law contained in Section 469 of the Internal Revenue Code. However, when you personally use a property, you easily lose access to Section 469 and find yourself following the rules of 280A.
As noted, the problem is personal use of a property. And the Section 280A tax law labels three types of use as personal use:
For purposes of this section, the taxpayer shall be deemed to have used a dwelling unit for personal purposes for a day if, for any part of such day, the unit is used—
(A)for personal purposes by the taxpayer or any other person who has an interest in such unit, or by any member of the family (as defined in section 267(c)(4)) of the taxpayer or such other person;
(B)by any individual who uses the unit under an arrangement which enables the taxpayer to use some other dwelling unit (whether or not a rental is charged for the use of such other unit); or
(C)by any individual (other than an employee with respect to whose use section 119 applies), unless for such day the dwelling unit is rented for a rental which, under the facts and circumstances, is fair rental.
The actionable insight here? In a year when you want to easily move large rental property deductions onto your tax return? Don’t personally use or allow a family member to use the property. (See “A” above.) Don’t trade the use of your property for the use of some friend’s property. (See “B” above.) Finally, don’t let anybody use the property for free or for some discounted rate. (See “C” above.)
IRS Short-term Rental Audits Trick #2: Failing Material Participation
The next thing to pay attention to: As noted earlier, taxpayers also need to materially participate.
Taxpayers achieve material participation in a handful of ways. The gold standard? Work more than 500 hours on the short-term rental activity. But that’s hard in most vacation rental cases.
Fortunately, easier participation thresholds exist. If taxpayers work more than 100 hours and no person works more hours? That level of work counts as material participation.
Note: Married taxpayers combine their participation. For example, if two spouses each work 55 hours, their material participation equals 110 hours. If no other person works more than 110 hours, they qualify.
Another even easier threshold? If taxpayers do substantially all of the work on a short-term rental—meaning basically no one does any work—that counts as material participation.
The predictable trick the IRS audit guide tells agents to use? Take the position that the taxpayers can’t prove someone else didn’t work more. Or at least, the taxpayers can’t convincingly prove someone else—a property manager, a leasing agent, or the cleaning service—didn’t work more.
The actionable insight here, then? Taxpayers who want to use the “more than 100 hours” route to material participation should not only keep a great record of the time they spend. They should also keep a record of the time that their vendors spend.
And double ditto for anyone who wants to use the “substantially all” route to material participation.
IRS Short-term Rental Audits Trick #3: Throwing Out Hours
A final trick to mention? And one you see recommended again and again in the IRS audit technique guide that talks about how IRS agents audit short-term rental tax returns?
The IRS will attempt to throw out hours of material participation. Because the law says they do get to do that.
Specifically, for example, the IRS can throw out investor-activity-type hours (studying financial statements, analyzing the property) if a taxpayer isn’t involved directly in day-to-day management. And agents can throw out any property management work you do if you hire a property manager or leasing agent. Or if you have a friend or family member help out for free and that person spends more time that you do on management stuff.
Note: The audit technique guide even suggests agents can discard the time you spend organizing your financial records (so I guess doing your books?), doing your tax return and paying your bills. As if, apparently, taxpayers aren’t required by tax laws to do these things. And as if these things wouldn’t by themselves indicate that you’re involved in day to day management. (I know. Weird, right?)
Another type of work you need to watch out for. Agents can throw out work they think you should have assigned to an employee or contractor. So blatantly disregarding the reality that most small investors—even high-income ones—will spend tons of time doing stuff themselves.
Finally, agents take the position—even when courts don’t—that you can’t count travel time. (The usual rule is you can’t count commuting time. So, this one sort of makes sense. But not all travel time would be equivalent to commuting.)
The actionable insight here then? In a year when short-term rental property investors want to really load up a tax return with deductions? Yeah, that’d be a good year to run up the hours in some legitimate way: painting, catching up on deferred maintenance, or updating the website used for your marketing. Also absolutely do participate in day-to-day management and operations in a year where you want to make big deductions bullet-proof.
One other thing: You may also want to dial down the work that individual vendors do. Perhaps by spreading the work around to more than one person. Having two different cleaners who each spend 75 hours a year works better than one cleaner who spends 150 hours a year.
You absolutely can get the short-term rental tax planning gambit to work well. But you want to think, from the very beginning, about how you survive and then win an IRS audit.
Some Other Resources You Might Find Useful
The IRS Passive Activity Loss Audit Technique Guide, available here, gives you the low-down on how the IRS will audit a tax return if it includes a short-term return. A good document to read if you’re trying to learn more.
Finally, if you’re really serious about using the short-term rental trick for saving taxes? Our CPA firm can provide consulting services in this area: Becoming a client.