The Basics of Short-Term Rental Taxation

As short-term rental properties grow in popularity among real estate investors, so do the questions surrounding how they are taxed and structured. These properties receive unique tax treatment from the IRS, offering significant benefits. But understanding the rules is essential for effective tax planning and long-term success.

If you’re feeling confused about where short-term rentals fit into your tax and legal strategy, you’re not alone. The tax rules for these properties are unlike any other type of real estate investment. To make the best decisions for your portfolio, it’s critical to learn how short-term rentals are taxed. Keep reading to gain clarity on this topic and discover how our team at KKOS can assist you in optimizing your tax strategy.

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What Does the IRS Consider a Short-Term Rental?

According to the IRS, short-term rental properties fall into four main categories based on how they are operated and managed:

1. Business short-term rentals with material participation.
2. Business short-term rentals without material participation.
3. Passive short-term rentals with material participation.
4. Passive short-term rentals without material participation.

The classification of your property depends on three key factors, which also dictate how it will be taxed. Let’s break these factors down.

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Factor 1: Average Rental Days Per Tenant

The average length of stay at your rental property plays a significant role in its classification. The IRS uses a seven-day rule as a benchmark:

• If the average stay is less than seven days

Report the income on Schedule E, similar to long-term rentals. The income will not be subject to Self-Employment Tax (FICA). Plus, you may qualify for ordinary loss treatment if you meet the material participation criteria (explained below).

• If the average stay exceeds seven days

You still report the income on Schedule E, and it will not be subject to FICA. However, you’ll lose eligibility for ordinary loss treatment, even if you can show material participation.

Example:

If your property is rented 21 times during the year for a total of 108 days, you divide 108 by 21, resulting in an average stay of 5.14 days. This qualifies it as a short-term rental under the seven-day rule.

Factor 2: Substantial Services Provided

The IRS requires income from properties offering “substantial services” to be reported on Schedule C as business income, which is subject to Self-Employment Tax. Essentially, this elevates your operation to the level of a business similar to a hotel.

If you provide substantial services:

• Report on Schedule C.
• The net income becomes subject to Self-Employment Tax.
• You’ll need an S-Corporation setup to mitigate FICA taxes.
• Material participation is required for ordinary loss treatment—but only if this can be demonstrated.

If you don’t provide substantial services:

• Report on Schedule E.
• Income will not be subject to FICA.
• You’ll still have an opportunity for ordinary loss treatment if material participation is evident.

Examples of substantial services include:

• Daily cleaning while the same guests are staying.
• Changing linens during a guest’s stay.
• Offering meals, entertainment, or transportation services.
• Acting as a concierge or conducting guided tours.

Caution: While offering significant perks can enhance rental rates, crossing into “substantial services” territory could significantly alter the tax implications for your property.

Factor 3: Material Participation in the Rental Activity

To claim certain tax benefits, particularly ordinary loss treatment, you’ll need to demonstrate material participation in managing your rental property. This means actively and personally taking part in the operation, as defined by one of seven IRS tests.

7 Tests for Material Participation:

1. You participate in the activity for more than 500 hours during the year.
2. Your participation constitutes nearly all the involvement in the activity for the year.
3. You participate for more than 100 hours, and no one else exceeds your participation.
4. The activity qualifies as significant, and your total participation exceeds 500 hours across all such activities.
5. You’ve materially participated in the activity for five years (within the previous ten years).
6. The activity is a personal service, and you’ve materially participated for three years.
7. Based on all facts, your participation is regular, continuous, and substantial.

Qualifying under one of these tests allows your property’s net losses to be treated as ordinary losses, deductible against other income.

Pro Tip: Investors who qualify often use strategies like cost segregation analysis to front-load depreciation, leading to significant tax deductions in the first year of service.

Warning: These rules rely on outdated IRS regulations that predate modern rental platforms like Airbnb. While they present tax opportunities, they may also attract audits. Proceed carefully and consult a professional.

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Tax Reporting for Short-Term Rentals

Here’s a simplified breakdown of how short-term rentals should be reported for tax purposes:

Schedule E (Passive Income):

• Best for rentals where no substantial services are provided.
• Not subject to Self-Employment Tax.
• Ordinary loss treatment is possible if criteria for material participation are met.
• Permissible “insubstantial services” include:
• • • Basic utilities like water, gas, and Wi-Fi.
    • Cleaning common areas between stays.
    • Routine repairs and maintenance.

Schedule C (Business Income):

• Required for rentals offering substantial services.
• Income is subject to Self-Employment Tax.
• S-Corporation strategies may help mitigate tax liabilities.

Remember, personal use of the property is limited in order to maintain its rental status. Staying at the property for more than 14 days or 10% of the total rental days could disqualify it as a rental property for tax purposes. If you use the property for maintenance, ensure you document your work clearly.

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Key Takeaways

Short-term rentals can be a lucrative addition to your real estate portfolio. They offer distinct advantages, but navigating their unique tax treatment requires careful planning. From understanding average stay lengths and service classifications to meeting material participation standards, each decision impacts your taxation strategy.

If you’re unsure how to get started or need personalized advice, our team at Manna Wealth Management can help you make the most of your short-term rental investments. Contact us today to learn more and ensure your properties are optimized for success.