Make Sure Your Rental Activities Qualify as a Business
Section 179 can only be used if your rental activities qualify as a business for tax purposes. You can't use it if your rental activity is an investment, not a business. Owning rental property qualifies as a business if you do it to earn a profit and work at it regularly, systematically, and continuously—either by yourself or with the help of a manager, agent, or others. Rental ownership, on the other hand, is an investment, not a business, if you do it to earn a profit but don't work at it regularly, systematically, and continuously. There is no set number of rental units you must own to qualify as a business. The courts have held that ownership of a single rental unit can be a business.
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2. Substantial Services and a “Business” Short-Term Rental
The IRS has deemed that if you provide substantial services to your guests, then the income you make needs to be reported on a Schedule C, the end. This essentially means you have a “Business Short-term Rental”. You’ve elevated your activity to that of a business (think of it like a hotel).
IF you provide Substantial Services – You must report the operations on Schedule C and the net-income is subject to Self Employment Tax, and your only salvation would be to implement an S-Corporation to mitigate the FICA tax. ALSO BEWARE! This does not mean you get Ordinary Loss Treatment…you still MUST show Material Participation (see below).
IF you DON’T provide Substantial Services – You may report the operations on Schedule E (just like a typical long-term rental) and the income is NOT subject to Self-Employment Tax (FICA)…ALSO, you STILL have the opportunity for Ordinary Loss Treatment if you can show Material Participation (see below).
Examples of Substantial Services:
Cleaning of the rental each day while the property is occupied by the same guests.
Changing bed sheets and other linens each day while the property is occupied by the same guests.
Concierge services.
Conducting guest tours and outings.
Providing meals and entertainment (like providing breakfast each morning).
Providing transportation.
Providing other “hotel-like” services.
Regrettably, the IRS hasn’t provided much guidance other than the few items above. There aren’t any court cases, Revenue Rulings, or Treasury Regs on this topic. We expect to have more clarity on what constitutes ‘substantial services’ in the near future.
But a word of caution. I know some educators on this suggest aggressive tactics to provide more benefits for your tenants in order to increase demand for your property and even daily rates, but be careful not to get too close to meeting the definition of substantial services – the tax result could be devastating.
3. “Personally” Serving with Material Participation
This is where things get interesting. Typically, in order to take flow-thru passive rental losses as ordinary losses, one has to qualify as a real estate professional. See (“The Tax Strategy of being a Real Estate Professional.”). However, under essentially ‘outdated’ Treasury Regulations (that were put in place by the IRS far before the onset of the ‘Airbnb’ concept, there is a unique loophole related to how short-term rentals are taxed.
Under this seemingly aggressive provision, if an owner can show personal material participation. That way then the rental losses on a short-term rental “morph” into ordinary losses.
In order to qualify as Materially Participating in the operations of your rental, a taxpayer must meet (1) of the following (7) tests. NOT ALL 7, but just one. We have found over the years that clients generally find it easier to qualify under tests 1, 2, or 3 (highlighted in ‘red’ below). Here are the tests directly quoted from the IRS code:
7 Tests of Material Participation
The individual participates in the activity for more than 500 hours during the year.
The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year.
The individual participates in the activity for more than 100 hours during the taxable year, and such an individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year.
The activity is a significant participation activity for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours.
The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year
The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.
Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such a year.
How it Works
Again, by qualifying under one of the tests above, essentially any net-loss on the operations of the property is considered an ordinary loss and is also deductible against any other income as an above-the-line deduction on your tax return.
The Short-Term Rental Taxation Matrix
To help simplify the analysis when considering the 4 types of short-term rentals and the 3 phases of analysis, I created the following matrix. Hopefully, this assists you in your decision-making for yourself, and/or your clients.
Notice the new term, material participation, I introduce in this matrix. This is a unique rule in the Internal Revenue Code related to the strategy for real estate professionals.
Short-Term Rentals on Schedule E
If you do not provide substantial services then you can report your income from your short-term rental as passive income. Passive Schedule E income isn’t subject to self-employment taxes (which is a big advantage).
Does this mean you can’t provide any perks or benefits for your tenants during their stay? Absolutely not! The following is a list of insubstantial services that you can provide without jeopardizing your Schedule E status:
- Heating and air conditioning
- Water and gas
- Internet and Wi-Fi
- Cleaning of common areas
- Customary repairs and maintenance
- Trash collection
- Payment of HOA dues
source for the above
https://markjkohler.com/how-short-term-rentals-are-taxed/#:~:text=The%20IRS%20has%20deemed%20that%20...
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if that isn't confusing enough I've read some professionals state that even when S-T rental is properly reported on schedule E, if the taxpayer meets the safe harbor requirements for claiming QBI, then they are taking the position the rental activity is a business and should qualify for the 179 deduction to the extent of business income.
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Others state income derived from the active trade or business for the 179 test if the taxpayer meaningfully participates in the the rental's management or operation REG 1.179-2(c)(6)(ii)
(ii) Active conduct. For purposes of this section, the determination of whether a trade or
business is actively conducted by the taxpayer is to be made from all the facts and
circumstances and is to be applied in light of the purpose of the active conduct
requirement of section 179(b)(3)(A). In the context of section 179, the purpose of the
active conduct requirement is to prevent a passive investor in a trade or business from
deducting section 179 expenses against taxable income derived from that trade or
business. Consistent with this purpose, a taxpayer generally is considered to actively
conduct a trade or business if the taxpayer meaningfully participates in the
management or operations of the trade or business. Generally, a partner is considered
to actively conduct a trade or business of the partnership if the partner meaningfully
participates in the management or operations of the trade or business. A mere passive
investor in a trade or business does not actively conduct the trade or business.
(iii)Example. The following example illustrates the provisions of paragraph (c)(6)(ii) of
this section.
Example. A owns a salon as a sole proprietorship and employs B to operate it. A periodically
meets with B to review developments relating to the business. A also approves the salon's annual
budget that is prepared by B. B performs all the necessary operating functions, including hiring
beauticians, acquiring the necessary beauty supplies, and writing the checks to pay all bills and
the beauticians' salaries. In 1991, B purchased, as provided for in the salon's annual budget,
equipment costing $ 9,500 for use in the active conduct of the salon. There were no other
purchases of section 179 property during 1991. A's net income from the salon, before any section
179 deduction, totaled $ 8,000. A also is a partner in PRS, a calendar-year partnership, which
owns a grocery store. C, a partner in PRS, runs the grocery store for the partnership, making all
the management and operating decisions. PRS did not purchase any section 179 property during
1991. A's allocable share of partnership net income was $ 6,000. Based on the facts and
circumstances, A meaningfully participates in the management of the salon. However, A does
not meaningfully participate in the management or operations of the trade or business of PRS.
Under section 179(b)(3)(A) and this paragraph (c), A's aggregate taxable income derived from
the active conduct by A of any trade or business is $ 8,000, the net income from the salon.
(iv)Employees. For purposes of this section, employees are considered to be engaged in
the active conduct of the trade or business of their employment. Thus, wages, salaries,
tips, and other compensation (not reduced by unreimbursed employee business
expenses) derived by a taxpayer as an employee are included in the aggregate amount
of taxable income of the taxpayer under paragraph (c)(1) of this section.
What iv means is that business income for the purpose of the 179 deduction not only includes income loss from the 179 activity but als0 W-2 wages reported on line 1 of the 1040.
