How Are Short Term Rentals Taxed?
Make sure you skim the answers to the following questions on our FAQ Page so that you have full context:
“Do I Have to Pay Self-Employment Tax on my Short Term Rental Income?”
“What is the ‘Short Term Rental Loophole?’”
And for extra clarity:
“What is the Passive Activity Loss Limitation and Special Allowance for Real Estate?”
“What is Material Participation?”
First things first. Why it matters.
Generally, on an individual’s tax return, if income is reported on Schedule C there is an additional 15.3% tax owed off-the-top when compared to income reported on Schedule E. This is sometimes referred to as “FICA” (Federal Insurance Contributions Act) and consists of Social Security and Medicare tax. For many taxpayers, this is a cost that they wish to avoid.
So Schedule E is what we want, right? Often, yes, and most short term rentals (STRs) qualify for that treatment, but it can get nuanced.
Schedule E is generally subject to passive activity loss limitations, unlike Schedule C, so even though we may prefer Schedule E for when we’re reporting a profit, there may be years with more expenses resulting in a loss where we want to avoid those limitations. This can include a year when you have a cost segregation study performed. That’s where the Short Term Rental “Loophole” comes in.
Before we explain the loophole, let’s make sure we know why STRs are usually safe on Schedule E.
Although there’s some confusion out there, even among many tax professionals, most STR income belongs on Schedule E and the reasoning is actually quite straightforward because of something called “substantial services.”
Treasury Regulation §1.1402(a)-4(c)(2) declares that income from lodging rentals that include certain kinds of services do not constitute “rentals from real estate” (we use the term “rental income” elsewhere on our website). The intent of this regulation is to define businesses such as hotels and motels as businesses with non-passive income to be reported on Schedule-C.
The reason this doesn’t apply for most STRs is because, although the regulation is a bit vague, we have a good amount of what’s called “substantial authority” from the federal government giving us a better idea of what kinds of services count. While not substantial authority itself, IRS Chief Counsel Advice Memorandum 202151005 is a recent internal publication from the IRS and offers a good summary of the relevant case law, regulations, and revenue rulings. It lays out a definition for substantial services which disqualify income as rental income.
That definition is as follows: “the services rendered (1) are not clearly required to maintain the space in a condition for occupancy, and (2) are of such a substantial nature that the compensation for these services can be said to constitute a material portion of the rent”
The below examples are derived from substantial authority and show us that most modern STRs do not provide substantial services, meaning that their income does, in fact, constitute rental income.
Examples of substantial services include:
Concierge service
Meals, entertainment, or transportation
Turndown service
Tours or excursions
Examples of services which are not substantial include:
Any cleaning in between reservations
Maintenance, including yard or pool upkeep
Cleaning common areas
Utilities and most amenities
Now, what exactly is this “loophole,” and is it really a loophole?
Separate from the matter of whether income is rental income, the tax code also discusses rules regarding rental activities.
Unlike most trades or businesses, IRC §469(c) (2) & (4) states that any rental activity is a “passive activity,” even if the taxpayer materially participates in the activity. This means that income from a rental activity is subject to passive activity loss limitations as mentioned earlier on this page. So that just leaves us stuck, right? The tax code seems pretty clear. Well, not quite…
In Treasury Regulation §1.469-1T(e)(3)(ii)(A) an exclusion is made for any activity where “the average period of customer use … is seven days or less.” This means that if a STR has an average length of stay of seven days or less then it is not a rental activity at all! So, like any other trade or business, if the taxpayer meets the length of stay exclusion and also materially participates in the activity, it is considered non-passive for the purpose of contributing losses towards other non-passive income. This can include other business income and W-2 income.
The reason this is often considered a loophole is because it means that many STRs are earning rental income while also not being considered a rental activity. While the best of both worlds for investors, it is most likely an unintended consequence of separate attempts to make sure hotel owners pay FICA tax.
Confused yet?
That was a lot of information and pretty technical, too. The main purpose of all of that was to “show the receipts,” so to speak, for anyone who may rightfully be a bit skeptical of these seemingly too-good-to-be-true tax positions. To simplify it, we’ve made a flowchart and put it at the bottom of this page. If you have any questions or want to make sure that you are taking advantage of these helpful strategies, please consider reaching out. We would be happy to help.
STR Taxation Flowchart
Please keep in mind that the tax code and regulations can be very complex. This flowchart is not (and cannot be) perfect. Taxpayers should consult a tax professional before taking any complex tax positions.