So, let’s talk briefly about Section 183 and your short-term rental property. It’s summer obviously. You’ve probably been renting the place. Maybe even visited the property. Thus, now’s a good time to point out the risky connection between your short-term rental and Section 183.
What is Section 183?
First, some background. Section 183 is a part of the tax law that says you can’t deduct expenses of activities you’re not engaging in for profit. You possibly know this law by another name: the hobby loss limitation rule.
But it applies to short-term rentals too if you’re losing money most years. Or if you run up a string of losses in the early years.
To be clear, then, Section 183 creates another way you can lose your deductions on a short-term rental. This law adds to the headaches and requirements of the Section 469 “passive loss limitation” rules and Section 280A “rental of vacation homes” rules.
However, the good news here? The Section 183 risk falls entirely within your ability to manage and control. All you need to do is engage in your short-term rental activity for profit. Seriously, that’s it.
But let’s delve into the details because you’ll want to know the specifics.
Dodging the Section 183 Deduction
The Section 183 Treasury regulations outline nine factors used to determine if you’re engaging in an activity for profit. I list these factors next. Consider each carefully.
- Manner in which a taxpayer carries on the activity: Is the activity carried on in a “businesslike manner” similar to other profit-oriented activities?
- Expertise of the taxpayer or his/her advisors: Does the taxpayer rely on expertise or experts?
- Time and effort expended: Does the taxpayer devote substantial time and effort to the activity, especially if it lacks substantial personal or recreational aspects?
- Expectation of appreciation in the value of assets used in the activity: Even if the activity doesn’t produce an operating profit, will it produce a profit when liquidated?
- Success of the taxpayer in carrying on other activities: Is the taxpayer a serial entrepreneur?
- History of income and losses with respect to the activity: A history of losses during the early years may not be problematic, but sustained losses year after year might be.
- Amount of occasional profits earned: Occasional small profits may suggest a lack of profit motive, while occasional large profits or the possibility of a large windfall profit may suggest a profit motive.
- Financial status of the taxpayer: Someone who lacks substantial income or financial resources likely cannot afford to lose money in an activity unless they expect profits eventually.
- Elements of personal pleasure or recreation: Deducting expenses from an activity others consider a hobby could be problematic.
In an audit, predictably, you want to be able to point to several of these and say, “See that? And that? And that? Yeah. Profit motive.”
Because the challenge with Section 183 and short-term rentals is convincing an IRS auditor, appeals officer or judge that your short-term rental activity was pursued for profits.
Examples Where Section 183 Short-term Rental Problems Crop Up
The Section 183 regulations (specifically Reg. Sec. 1.183-2(c)) provide examples of activities that probably qualify and probably don’t qualify. Practitioners should read these if they’re working with clients who may risk disqualification of deductions.
But let me highlight some situations that either strengthen or weaken the pursuit of profits argument.
In the category of situations that weaken? As compared to other alternatives in the area, you only infrequently or “lightly” rent the property. Maybe you never or almost never show a profit. Perhaps you operate only a single property. Maybe the property is a legacy your family appears to own because dad or grandma owned the property? The property is filled with family photos and personal items. Or, perhaps most problematic: After operating the short-term rental for a year or two, you convert it to personal use. All these situations? Probably bad. Maybe even really bad.
In the category of situations that strengthen your profit motive argument? You either have enjoyed or expect large gains on the sale of property. The deductions and any losses stem from cost-segregation studies (so in a sense Congressionally approved tax accounting tricks that create large losses). You book similar numbers of guests as competitive rental properties. Or you own multiple short-term properties, far more than you could ever personally use or enjoy. All of these situations? Probably okay. And possibly very helpful.
Final Comment about Section 183 and Short-term Rentals
If you’re investing in short-term rentals as a way to invest pre-tax money and build wealth—similar to investing in 401(k) or IRA accounts—you’re clearly doing this for profit. And you should be safe. However, develop and save good documentation to support this.
On the other hand, if you’re investing in a short-term rental to afford a second home for your family? Sorry. Section 183 likely limits your deductions.
Some Other Articles about Short-term Rentals
Surviving Short-term Rental Audits
The Vacation Rental Tax Strategy