Some travelers want to experience the natural wonders of an area to feel like a local when they stay in a new city. They do not want to be confined inside a highway motel.
They dream of staying in a quaint cottage, venturing out of an apartment into the jazz district, of feeling the vibe of the local community. These adventurers create the market for short term rentals like those seen on Airbnb, HomeAway, and VRBO. If you want to jump into the real estate market, short term rentals can offer higher rewards due to the higher price than can be charged when renting for the night vs. the month. From an investor’s standpoint, they can lead to great returns. From a tax perspective, short-term rentals can leave you with an unexpected tax bill come tax time.
Real Estate Income Defined and Taxed
The tax trap is laid in how the income from real estate is defined and taxed. Section 469 defines rental real estate as a passive activity and limits the amount of losses from the rental activity to the amount of income from passive activities. Major remodels that on paper, make your business look like a huge loss can be trapped as a passive loss waiting for a year when you have passive income to offset the loss against. (There is an exception for real estate professionals, but let’s assume that you are reading this article as someone with a full-time job that is thinking of buying a lake house and would like to know what the taxes would be if your rent out the lake house when you are not using the property. So back to real estate passive activities…)
- If you rent out your personal residence or a second home for less than 14 days, you are in luck; you do not have to report income as taxable. Unfortunately, you will not be able to deduct any of the expenses from maintaining the property either: no depreciation, no interest, not property tax expenses, no repairs expenses.
- You will only be allowed to claim interest and taxes as a deduction on your Schedule A if you can itemize.
- If you rent out your property for more than fourteen days in a year, you have what the IRS deems a property held for use in a trade or business. This property is now allowed to take deductions like depreciation, interest, and repairs, but you must also report the rental income as taxable.
You should keep good records of all income received and all expenses paid. You will also need to keep track of the days that the property is rented out and all the days you use it personally.
What is a Short-Term Rental Property?
If you can only rent out the property for less than seven days at a time on average, you will be considered to have a short-term rental property. Short term rental properties are not considered rental real estate activities. The losses are not limited to passive activity income and can offset other income like W2 wages or other business income. However, positive net income is subject to self-employment taxes of 15.3% on top of your ordinary income tax rates. You will be able to deduct a portion of the self-employment taxes on your return, but the self-employment tax can add significantly to your overall tax bill.
If you can rent out the property for, on average more than seven days at a time but less than thirty, you will be considered as having a real estate rental activity as long as you do not provide extraordinary personal services along with the property.
Generally, this includes services such as maid service or the use of an onsite chef. If the services’ total value is more than 10% of the gross rental price, you most likely will be reclassified back to the non-real estate rental activity and again subject to the self-employment tax. Providing trash service, changing the sheets, and cleaning the property after guests leave are considered excluded services and do not factor in providing extraordinary services.
Third-Party Vendors May Help
The best way to make sure that you do not fall short of the seven or thirty-day average rental period is to rent the property to a third party who has the right to lease the property all year to available customers. You would effectively be leasing the property to the management company on an annual basis.
They would take a commission off the rent, but they would then take care of the day-to-day activities for you.
The income from the activity would be categorized as passive income and free from self-employment tax. If you wanted to use the property, you would have to pay a fair market rental rate for the night and go about the booking process like anyone else. The reason to do this is that if you do not rent the property out for an average of seven days, then you will pay the higher tax rates on all the income from the property. You might be out the commission on the ten days you use the property, but you would be saving the 15.3% tax on all the other income.
There are several other important factors to consider when you begin your adventure into real estate investing, such as when to make repairs or improvements, when to capitalize vs. expense, how to set rental prices, and how to structure property ownership. Ensure that you research the risks and benefits of real estate investing and assemble the right advisory team. Real estate investing can be a great diversification tool in your portfolio, but it can create unforeseen problems without the right group of advisors. So, if you are interested in making the leap, maybe next time instead of staying at a hotel, try staying in an Airbnb and see what all the hype is about. If you structure your trip right, you might even be able to deduct the stay on your taxes.
|Sam Shafer is an Advisor at Abacus CPAs, LLC. Sam specializes in business and income tax preparation and has five years of experience in public accounting. He is passionate about providing the best tax advice to help people achieve their business and life goals. Sam is terrific at juggling rapidly changing priorities, which makes him flexible with a practical bend.|