Webinar: Short-Term Rentals and the Use of Tangible Property Not Qualifying as a Rental Activity

Short term rental properties continue to be an attractive investment opportunity, but the associated taxes are getting more and more complex. Given the relevance of non-rental activity, we recently hosted an educational webinar titled Short-Term Rental Planning, presented by tax attorney Sam Boehr.

In this blog, we provide a summary of Mr. Boehr’s presentation on short-term rental planning taxation considerations.

The Basics: Defining Rental vs Non-rental Activity

The definitions for rental and non-rental activities can be found in the Form 8582 instructions for rental and non-rental activity.

What is a Rental Activity?

A “rental activity” occurs when tangible property connected to the rental activity is used by customers or held for use by customers and:

• Gross income attributed to the conduct of the activity represents amounts paid for the use of such tangible property.
• The use of the property does not have to be pursuant to any type of specific agreement to meet the definition of a rental activity. This definition will apply whether the use of the property is pursuant to a lease, service contract, or some other arrangement that is not denominated via a lease.

What is a Non-rental Activity?

There are various ways that an activity can be classified as a non-rental activity, including if any of the following circumstances are met:

• Short-term rental – The average period of customer use is:
  • 7 days or less, or
  • 30 days or less and significant personal services were provided in making the rental property available for customer use. Significant personal services include only services performed by individuals. To determine if a service is significant, all relevant facts are considered, including the frequency of the services, the type and amount of labor required to perform the services, and the value of the services relative to the amount charged for use of the property.
• Extraordinary personal services were provided in making the rental property available for customer use.
• The rental of the property is incidental to a non-rental activity, for example:
  • Investment Use
  • Trade or Business Use
• You customarily make the rental property available during defined business hours for nonexclusive use by various customers
• You provide property for use in a non-rental activity of a partnership, S corp, or a joint venture in your capacity as an owner of an interest in the aforementioned business structure.

Why Does Non-rental Activity Matter for Taxes?

Non-rental activity matters because of how the income and losses are treated under the IRS’s criteria used to determine the degree of active or passive participation in the activity. A taxpayer who is considered to be materially participating in an activity is allowed to deduct the total amount of losses when filing taxes. Conversely, a taxpayer who is passively participating in an income-generating rental activity is limited in the deductibility of losses.

In his webinar, Mr. Boehr explained the following key points:

• Material participation rules differentiate for uses of tangible property based on whether the activity is a rental or non-rental activity.
• Non-rental activities have less stringent material participation rules than rental activities.
• If you meet the material participation requirements for the specific activity, it will be considered a non-passive activity.
• Having a non-passive activity means that passive activity loss limitations and net investment income tax will not apply, however, non-passive activities may be subjected to self-employment taxes. 
• Excess business loss rules are still applicable to non-passive activities if the EBL threshold is met.
• Active Participation Rule for Special Allowance of Losses: If you have a passive activity or activities, the passive losses you can claim are limited to the amount of passive income you report. The passive activity loss rule is subject to the active participation exception, but most taxpayers fail to meet this exception due to an income threshold that phases them out.

A Deeper Dive into Material Participation Rules

Detailed recordkeeping is recommended to show the IRS that their requirements are being met for purposes of material participation in the case of an audit.

Overview of Rental Activity Material Participation Requirements

You must be designated as a “real estate professional” for the tax year and materially participate in your real estate activity if you want the rental activity to be considered non-passive. Real estate professionals meet these requirements only if:

• More than half of the personal services you performed in trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated, AND
• You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

Note: For purposes of whether you materially participated, each interest in rental real estate is a separate activity unless you elect to treat all interest in rental real estate as one activity (see schedule E 1040 instructions for making the election).

Non-rental Activity Material Participation Requirements

If your rental property meets the non-rental activity exception, then the normal material participation rules apply (i.e., you do not have to meet the real estate professional requirements). Under these rules, you materially participated for the tax year in an activity if you satisfy at least one of the following tests:

• You participated in the activity for more than 500 hours
• Your participation in the activity for the tax year was substantially all of the participation in the activity of all individuals
• You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual for the year
• The activity is a significant participation activity for the tax year, and you participate in all significant participation activities during the year for more than 500 hours.  A significant participation activity is any trade or business activity in which you participate for more than 100 hours during the year and in which you didn’t materially participate under any of the other tests. This test can be very confusing, please read TR 1.469-5(f)(1) for more detail.
• You materially participated in the activity for any 5 of the 10 immediately preceding tax years.
• The activity is a personal service activity in which you materially participated for any three preceding tax years. Personal service activity involves personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor
• Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the tax year. You don’t meet this test if you participated in less than 100 hours during the tax year. Your participation in managing the activity doesn’t count in determining whether you materially participated under this test if any person received compensation for performing service in managing the activity or if any individual spent more hours during the tax year performing services managing the activity than you did.

Additional Considerations

In the full webinar, Mr. Boehr covered the additional topics related to short-term rentals. 

• Bonus depreciation: Your ability to accelerate cost recovery on depreciable assets with a class life of 20 years or less. 
• Cost segregation studies: These can identify assets in the property that have a different class life than the main structure and are, therefore, eligible for bonus depreciation.
• State laws differ from federal rules: For example, certain states may partially disallow or not allow bonus depreciation, and some states may not allow the non-rental activity exception.

Want to watch the full webinar?

Click here to gain free access to the Short-Term Rental Planning webinar. 

Tax related services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances.