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Major Tax Savings on Short-Term Rentals


 


 

Ownership in real estate is an excellent tool for tax-savings strategies. This article will provide a detailed review of short-term rental properties and how to ensure you can maximize your tax savings.


Generally, long-term rental properties generate passive income, so you do not have to pay self-employment taxes. The loss on the rental property does not provide a significant tax benefit, especially when there are phase-out limits and additional requirements to offset your other income with a passive loss. However, there is one way around this, but this is a discussion for another time.


Then there are short-term rental properties. Regardless, these properties are not passive income and are subject to self-employment tax. However, the loss on this “business” activity can only be used to offset your other income if you meet the short-term rental definition and materially participate in the activity. In addition, this strategy is used together with cost segregation and bonus depreciation to maximize your tax savings.


First, your rental property must meet the short-term requirements defined by the Internal Revenue Code (IRC). The definition of a short-term rental property is:

  • The customer's average time in the property is seven days or less.

  • The customer’s average time in the property is 30 days or less, AND you provide significant personal services.


Secondly, you must also pass the material participation rules. The two most common ways to qualify for material participation are:

  • You have spent more than 500 hours of participation in a year.

  • Your participation is more than 100 hours during the year, AND you participate at least as much as any other individual. (Explained further in the article)


Sounds easy, right? Well, let's break down this “Material Participation” some more:


  • Work performed in an investor's capacity does NOT count toward your hours.

    • Reviewing financial statements is considered an investor activity.

    • Internal Revenue Service (IRS) Agents are allowed to throw out hours you claimed which they believe you should have hired someone else to do. Yes, you read that correctly!

    • IRS Agents are allowed to throw out hours you perform as a property manager IF you are currently hiring a property manager!

    • Travel time, from one state to the next, generally is not included in your hours. However, traveling to a hardware store is included in your hours.

  • Time spent in the day-to-day management of the property does qualify.

  • The IRS does not give a detailed description of what is allowed as qualifying hours, but the Internal Revenue Code has one section that gives us an idea of what may qualify. IRC Section 469(c)(7):

    • Real Property Development: working with architecture, working on city plans and permits, etc.

    • Construction or Reconstruction

    • Acquisition: Time and effort spent searching for a property. Hours spent on finding a property you do not purchase does not count!

    • Rental Operations Management: dealing with maintenance issues, paying bills, responding to messages, dealing with emergencies, etc.

    • Leasing: Listing property, managing your booking website, and determining rates


So you have correctly classified your property as a short-term rental and believe you meet the qualification for material participation. Let's look at this from the eyes of an IRS Agent. Here are some of the essential items they will be reviewing, requesting, and analyzing:

  • If the taxpayer or family spent more than 14 days at the property and/or more than 10% of the property's rental time, then losses generally are not allowed under the rules in IRC Section 280A.

  • What is the location of the rental? If it is out of state, it will indicate to the agent that you are less likely to qualify, and they will investigate your documents further.

  • Did you hire a management company? If so, it will be harder for you to qualify for the material participation rules, so your timekeeping records are very important.

  • Did the taxpayer work at least 100 hours on the property, AND did the taxpayer work more than anyone else?

    • For example, you hired Barb to clean your short-term rental and paid her for 105 hours. If you report only 102 hours of your own time spent on the property, you have disqualified yourself! The same concept applies to property management companies.

    • Make sure to hire different people throughout the year. Your time spent on the activity must be more than anyone else’s.

  • The IRS Agent will review your time log, which will be one of the first things they ask you for. They will also ask for the management agreement.

  • They will ask you verbally about your time spent on the rentals. How did you answer this question? Can the time log back up your response?


Lastly, you must ensure your time log meets IRS standards! The four requirements include:

  • Date of activity performed

  • Total hours spent on the specific activity

  • Description of activity or service performed. If you are married, indicate if the Husband (H) or Spouse (S) performed the activity.

  • If required by the IRS – how could you prove this record? (Not as important, but it’s still on the IRS’s list)


Final Key Points

  • Make sure your property qualifies as a short-term rental, and you meet the material participation rules!

  • Document everything!

  • Accumulate more hours than you need to! Assume the IRS agent will remove some of your claimed hours, so always have more hours than needed.

  • Do not allow one person to work on your rental more than you do!

  • The spouse’s time spent in the property is included in the taxpayer's time spent for meeting the material participation rules. This is true regardless of which spouse owns the property and if returns are filed jointly or separately.


Contact us if you have any questions. Remember, it is the taxpayer's responsibility to analyze their situation and ensure they qualify to utilize the loss to offset their other income. That said, you always consult your tax professional to ensure you understand the rules and are following IRS regulations.




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