Short-term rental properties: 4 tax issues to consider
By Jennifer Larson, CPA and Christopher Davis, CPA
As a surprise to few, the short-term rental market is booming. Our client base has certainly become much more involved in these types of investments over the last several years, and we suspect, even with higher interest rates, that their involvement will continue to grow. This article briefly addresses four income tax issues for an owner of a short-term rental property to consider, as follows:
1) How much can I use the property?
While allowed, your personal use (which includes family use and when leased to charity or through auction) can impact the treatment of the rental property for tax purposes. Expenses from the property may be limited if the owner uses the property more than 14 days or 10 percent of the total days it’s leased out – whichever is greater. This means that if an owner plans to use their property for 20 days, you’d have to lease it out for 200 days during the rest of the year to avoid limitations. Interestingly, if you rent your personal or vacation home for 14 days or less, the rental income earned is generally not taxable. The catch is that the expenses are not deductible other than what is allowed as itemized deductions.
2) Your participation level matters.
The tax treatment of your rental income and expenses depends on your participation in the rental activity. Rental properties are generally considered a passive activity, and if you don’t qualify for one of the exceptions (qualifying as a materially participating real estate professional, for example), your net passive rental losses can only offset income from other passive activities.
Considerations such as your level of involvement in making significant management decisions (decide on rental terms, approve expenditures, and new tenants) and the amount of hours you participate in rental activities will make a difference between treating the rental activity as passive or non-passive on your tax return. Another point to consider: Passive income is also subject to an additional 3.8 percent net investment income tax for higher-income individuals.
Practically speaking, current rules make it a challenge for higher-income owners to meet the passive activity rule exceptions if they have a day job outside of real estate activities. Short-term rentals caught in the passive activity rules don’t lose the unused passive losses; they get carried forward to future tax years to reduce future sources of passive income or can also be released when the property is sold.
If instead, you operate your short-term rental more like a bed and breakfast, your rental activity is treated as non-passive and is not subject to the passive activity loss rules. Non-passive losses can be used to offset other sources of your income, such as wage income.
3) How to treat the costs that go into the property.
In general, the cost of a residential rental structure, whether a new purchase or a conversion of a personal use property, is depreciated over 27.5 years. The cost of the property should be split between the structure and land (even if a condo). Generally speaking, the costs of major renovations are capitalized and depreciated over this same 27.5-year life.
Other costs, such as routine repair and maintenance, HOA fees, utilities, insurance, and property taxes, are fully deductible when paid (subject to the passive activity rules). Depending on the size of the property and amount invested, a cost segregation study may be merited to determine if certain parts of the property can be separated and depreciated over shorter lives (5, 7 or 15 years) that would also qualify for special “bonus” depreciation (a 100-percent immediate depreciation expense in 2022).
4) What is the average rental term of your property?
Your short-term rental property could have a different treatment for both tax and depreciation purposes if the average lease term is seven days or less. If you materially participate in the activity, the net income is generally not subject to the passive activity limitations discussed earlier. And if you provide substantial services, similar to a hotel, the rental income may become subject to an additional 15.3 percent self-employment tax.
The tax rules for short-term rentals are complex, and this article only serves to skim the top of a few major considerations. Make sure to keep your tax advisor up to date on your investments to make sure you’re doing everything you can to maximize this investment.
The professionals at Sol Schwartz & Associates are ready to help. Jennifer Larson, CPA, and Christopher Davis, CPA, work extensively on real estate matters. Contact them at 210.384.8000.