Short-Term Rentals and Taxes: When Losses Can Potentially Offset W-2 Income
Rental real estate losses are generally considered passive losses, which means they usually cannot be used to offset wages, business income, or other nonpassive income.
Short-term rentals can be different.
Under the passive activity rules, certain short-term rental activities are not treated as rental activities at all. If you also materially participate in the activity, losses from the property may be treated as nonpassive and potentially used to offset other income.
And importantly, you do not have to qualify as a real estate professional to use these rules.
The Seven-Day Rule
One of the most important rules involves the length of your guests' stays.
If the average period of customer use is seven days or less, the activity is not considered a rental activity for purposes of the passive activity loss rules.
The key word is average.
For example, assume your property had:
50 separate stays during the year
250 total rental days
Your average customer stay would be:
250 days ÷ 50 stays = 5 days
Because the average stay is seven days or less, the activity can fall outside the normal passive rental rules.
There is also a separate exception when the average customer stay is 30 days or less and significant personal services are provided, although the seven-day rule is generally the more relevant test for a traditional short-term rental.
You Still Need to Materially Participate
Meeting the seven-day rule does not automatically make your losses nonpassive.
You must also materially participate in the activity.
The IRS provides several ways to satisfy this requirement. Some of the most common include:
Participating for more than 500 hours during the year
Performing substantially all of the work in the activity
Participating for more than 100 hours and at least as much as any other individual
There are additional material participation tests as well.
For an owner who actively manages their own short-term rental, the 100-hour test can be particularly important. However, hours worked by property managers, cleaners, and other individuals may affect whether you satisfy that test.
Keeping records of your participation can therefore be an important part of the tax strategy.
Example
Assume you own a short-term rental and earn $45,000 of rental income during the year.
After operating expenses and depreciation, the property produces a $30,000 tax loss.
Your guests stay an average of five days. You also spend 150 hours managing the property, and no property manager, cleaner, or other individual spends more time participating in the activity than you do.
Because the average customer stay is seven days or less, the activity is not treated as a rental activity under the passive activity rules.
You also satisfy a material participation test.
As a result, the $30,000 loss may be treated as nonpassive and potentially offset wages, business income, or other nonpassive income.
Other tax limitations, including the at-risk rules and excess business loss limitation, can still apply.
Cost Segregation Can Increase the Savings
A cost segregation study can accelerate depreciation by identifying portions of a property that qualify for shorter recovery periods and, in some cases, bonus depreciation.
When a short-term rental qualifies as nonpassive and you materially participate, that accelerated depreciation may help create a larger loss that can potentially offset other nonpassive income.
State treatment can differ from the federal rules, especially when bonus depreciation is involved. For example, Minnesota generally requires an 80% addition for most federal bonus depreciation, with the addition recovered over the following five tax years.
For a deeper explanation, see Cost Segregation Studies: How Real Estate Owners Can Accelerate Depreciation.
What About Schedule E vs. Schedule C?
Another common misconception is that a short-term rental becomes a Schedule C business simply because the losses are nonpassive.
These are separate tax rules.
Rental real estate is generally reported on Schedule E. However, if you provide substantial services primarily for your guests' convenience, such as regular cleaning or linen changes during their stay, the activity may instead need to be reported on Schedule C.
So a short-term rental can potentially be:
Nonpassive for the passive activity rules while still being reported on Schedule E.
That distinction can also be important when determining whether the rental income is subject to self-employment tax.
Personal Use Can Change the Result
Personal use of the property also needs to be considered.
Vacation home rules can limit rental deductions when your personal use exceeds the greater of:
14 days, or
10% of the days the property is rented at a fair rental price
If those rules apply, they can limit your ability to generate a deductible rental loss.
This can be especially important for owners who purchase a vacation property that they plan to use personally while also listing it as a short-term rental.
Own or Plan to Purchase a Short-Term Rental?
Short-term rentals can create valuable tax planning opportunities, particularly when the rules are considered.
Sharp Tax & Accounting can help you evaluate your short-term rental, determine how the passive activity rules apply, and estimate the potential federal and state tax benefits.
This article provides general tax information and is not intended as individualized tax, legal, or financial advice. Tax treatment depends on the specific facts and circumstances of each situation.