TurboTax is not permitting me to deduct short-term rental losses against W2 income

[EricUT03]

I purchased a short-term rental property in 2022 which I self-manage. Based on the research I've completed, I believe I should be using Schedule E and any losses from last year can be used to offset my W2 income since I materially participate in the management of the property and the average guest stay was below 7 nights.

I have populated Schedule E in TurboTax however none of my losses are being applied against my other income. I see no option in TurboTax to change this within Schedule E. I have shared this issue with three different TurboTax CPA's, and no one has been able to help me. I do not believe I should be using Schedule C because I do not provide substantial services to guests, but it is a non-passive activity which should be reported on Schedule E and as a result the losses should be carried over to my 1040. Can anyone help me with this?

[Mike9241]

You rent out your property to earn supplemental income, but you don’t put enough work into it for the IRS to consider you a self-employed rental property manager it goes on schedule E and if AGI is over $150,000 you are subject to the passive loss rules even with material participation and no loss is allowed.

*

You provide “substantial” services for your guests’ convenience during their stay (i.e., regular cleaning, linen service, or housekeeping).  then you report on schedule C and there is no passive loss limitation. 

[EricUT03]

What is the Short Term Rental Tax Loophole?

The short term rental loophole has saved people thousands of dollars a year in taxes because it doesn’t require you to be a real estate professional. It can be found in the tax code under Reg. Section 1.469-1T(e)(3)(ii)(A), and defines exceptions to the definition of “rental activity”.

We mentioned before that earning a real estate professional status is one way to turn losses on rental properties. However, this isn’t typically an option for highly paid professionals like doctors or lawyers, because they don’t have half of their working time to work in a real estate business. The good news is that the short term rental tax loophole can help.

The exceptions to the definition of rental activities in the tax code listed above can also turn losses non-passive if you, the short term real estate investor, meet one of seven material participation criteria. These tests will determine whether you qualify based on your use of and involvement in your short term rental property.

Here they are:

1. Spend more than 500 hours on the short term rental business
2. Do substantially everything for the STR business
3. Spend more than 100 hours on the activity and no one other individual spends more time than you do
4. Significant participation activity for more than 100 hours, and your combined activity in all significant participation activities exceeds 500 hours
5. Participating in the business for five of the 10 previous taxable years
6. Personal service activity (non income-producing) for three of the previous taxable years
7. Regular, continuous, provable participation in the business for more than 100 hours

The first three are the ones the majority of short term real estate investors qualify for. 

Once you meet one of these tests, and your short-term rental is excluded from the definition of a rental activity, then it is considered non-passive.

[Critter-3]

I just had an update class with a tax attorney teaching it and he brought up this situation as a cautionary tale  and said how the IRS almost always wins in an audit when folks try this non passive "loop hole".  If you want to use it you must use the downloaded TT program and make an override in the FORMS mode.  And prepare now for the audit with detailed contemporaneous records of the time you spent and anyone else working on the property which includes the cleaning crew, repairman  and management company.

[EricUT03]

“Loophole” may not be the right word for it. The tax code clearly states that an individual materially participating in a short-term rental property can and should apply any losses to W2 income. Anyone who clearly meets the material participation requirement shouldn’t be concerned.

[Critter-3]

Anyone who clearly meets the material participation requirement shouldn’t be concerned.   I agree but they also need to be prepared for the IRS audit that may happen.  Those not prepared sufficiently will lose big time... the stories he told were fascinating. 

[Rick19744]

You are attempting to accomplish something that you are not able to accomplish.

You need to keep in mind that the passive activity regulations apply to many different trades or businesses, one of which is real estate.

The material participation rules you cite are the general rules.

Additionally, the regulation you included is an exception for tangible property rentals.

Rental activities are passive regardless of participation, except if you qualify as a real estate professional; which is a separate standard that needs to be addressed.

IRC Section 469(c)(4) essentially states that Section 469(c)(2) applies regardless of whether or not the taxpayer materially participates.  The only exception is the Section 469(c)(7); professional real estate.

Having said that, there is the $25,000 rental loss allowance, but that is phased out depending on a taxpayers income level.

You may be cutting and pasting material from a seminar that is overly aggressive; there are many out there.

To quote a noted tax commentator.......after reading every single real estate professional case, he states he is confident that no one understands the tax law.....not taxpayers, not tax advisors, not the IRS and not even the Tax Court.

[EricUT03]

I assure you this information is not from an overly aggressive real estate seminar. This is coming from multiple qualified CPA’s who work solely with real estate investors. This Information is well known across the real estate investor community. I am quite shocked, to be honest, at how many CPA’s are unfamiliar with this regulation.

[Critter-3]

It is your return and you can do whatever you want to do ... just be aware the TT program will not do it for you.  This requires a program calculation override which will void the accuracy guarantee and keep you from efiling. 

[EricUT03]

I understand this, but I don’t understand why the TurboTax software will not permit me to do this since it is a legitimate deduction.

[Critter-3]

The program is written for the masses following the rules for 98% of the population and not for the 2% that fall outside of the norm.  The downloaded program will let you do anything you want in the FORMS mode if you override the caculated amount. 

[Rick19744]

A couple of snippets:

• From an IRS CCA (Chief Counsel Advice) - Section 469(c)(2) provides that except as provided in section 469(c)(7), the term “passive activity” includes any rental activity. Section 469(c)(7)(A)(i) provides that section 469(c)(2) shall not apply to any rental real estate activity of a taxpayer for a taxable year if the taxpayer meets the qualification test in section 469(c)(7)(B). Section 469(c)(7)(B) provides the following requirements: (i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. An individual taxpayer who owns an interest in rental real estate and also meets these requirements is commonly referred to as a “real estate professional,” although the term used in Treas. Reg. §§ 1.469-9(b)(6) and (c)(1) is “qualifying taxpayer.”
• And commentary from a noted tax professional -

Under the general rule of Section 469, all rental activities are treated as passive, regardless of the individual owner’s extent of participation. As a result, rental losses can only be used to offset other sources of passive income. If the owner doesn’t have any passive income—or enough to fully offset the losses--the excess losses cannot be used currently, and instead are carried forward to future years.

An exception is carved out, however, for so-called “real estate professionals,” the idea being that someone who truly earns their living in real estate trades or businesses should be free to use rental losses without limitation.

[EricUT03]

Passive vs. Non-Passive Activity

Unlike traditional long-term rental properties that are considered passive activities by default, short-term rental properties are not considered rental activities if one of the following tests are met:

• The average period of customer use for such property is seven days or less;
• The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers

This means that if you have losses from a short-term rental business, and materially participate in the activity, you can use those losses to offset non-passive income (e.g. salary from a W-2 job) without qualifying as a real estate professional.

https://www.stessa.com/blog/short-term-rentals-and-related-taxes/

[MichaelG81]

Yes, you can take a credit/deduction meeting certain qualifying factors and it would count to make credits/deductions against W2 non passive income on taxes you may owe, only if you meet certain requirements.

Per IRS:

Special $25,000 allowance 

If you or your spouse actively participated in a passive rental real estate activity, the amount of the passive activity loss that’s disallowed is decreased and you therefore can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing the passive activity loss. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.

If you’re married, filing a separate return, and lived apart from your spouse for the entire tax year, your special allowance can’t be more than $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you can’t use the special allowance to reduce your nonpassive income or tax on nonpassive income.

The maximum special allowance is reduced if your modified adjusted gross income exceeds certain amounts. See Phaseout rule, later.

Example.

You are a single taxpayer. You have $70,000 in wages, $15,000 income from a limited partnership, a $26,000 loss from rental real estate activities in which you actively participated, and you aren’t subject to the modified adjusted gross income phaseout rule. You can use $15,000 of your $26,000 loss to offset your $15,000 passive income from the partnership. You actively participated in your rental real estate activities, so you can use the remaining $11,000 rental real estate loss to offset $11,000 of your nonpassive income (wages).

Important keep in mind: Please see Publication 925 for 2022 for requirements and general information on (non)passive Income. I did an example with a W2 employee who had taxes due, and after entering expenses on schedule e for short term rental, it decreased taxes owed and increased refund based upon the steps outlined.

One way to do so:

• Type "Schedule E" and click the jump to blue link to take you to the form that asks if you had rental or royalty expenses in 2022?
• Answer Yes, if it applies.
• For real estate professional, answer none of the above if it applies. Click continue. (Sounds like your a W2 worker too)
• Is this a rental property or royalty? Select rental property and enter description.
• On what type of rental is it, you must choose Vacation or short term, if this applies. Click continue and select all that apply.
• When you get to was this property rented for ALL of 2022, answer no if that is the case or yes. Enter number of days rented and personal use days.
• Property ownership if you owned 100% or not, if not you would have to allocate expenses to others.
• You must be an active participant to qualify for this credit/deduction.
• Enter 1099-NEC generated from property, or select no.
• Where you enter rental info for you, you can import from Quicken, QuickBooks, TXF file, or enter yourself. Select enter yourself if this applies, or import.
• If your property was in any designated areas? Select none of the above if they do not apply.
• Then it will ask you questions about being your property in the past, please answer.
• How did you acquire property? Please answer.
• If you answer I bought this rental or it was inherited, for example: Next it will ask you to gather important documents such as purchase paperwork, improvements, basis information, etc. Click continue you will need purchase price, rental available date, and purchase date, escrow fees, and any seller-paid points on the next few pages if you selected I bought this rental. These pages will calculate your depreciation.
• Once you get to the review "Your ________  Rental Summary", you are good to go and enter income/expenses like real estate taxes.

@EricUT03

[Mike9241]

@EricUT03 

The IRS classifies taxpayers as engaged in a trade or business if they own rental property where the customer stays an average of seven days or less. To receive a current deduction for losses incurred in such an activity, the taxpayer must meet all of the material participation requirements found in section 469 related to passive activities. A taxpayer must participate in the activity more than any other individual and must maintain accurate records of participation, excluding investor-related activities.

*

The IRS has denied the deduction in cases where taxpayers failed to maintain records supporting material participation. 

*

Turbotax has a defect in that even if you check material participation, there is no question about short-term rentals so it's treated s any other rental real estate as passive.  the trick is to check the other passive exception box.

*

note that if you provide significant services like an AirBNB the reporting is done on schedule C not E.