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Tax Implications for Short-Term Rental Property Owners

With the advent of online marketplaces like Airbnb that connect property owners with short-term renters, property owners have undoubtedly found an effective and profitable method for cutting out the middleman, such as a property manager, who was traditionally responsible for the listing and maintenance of the property.

In today’s age, an owner can single-handedly list a property on a hosting site and handle the maintenance or outsource it to a maintenance contractor for a fraction of the cost a property manager would charge for the very same services. What the average property owner likely does not realize is that the decision on whether or not to contract a management company actually has significant tax implications. The tax implications were recently highlighted in a U.S. District Court Case, Eger v. U.S., 124 AFTR 2d 2019-5717.

Rental Activity Case

In the case, a district court determined that a taxpayer’s rental activity was passive, even though the taxpayer was a real estate professional. As a refresher of the general rules as applicable in this case:

  • Code Sec. 469(j)(8) defines rental activity as any activity where payments are principally for the use of tangible property.
  • Code Sec. 469(a)(1) limits passive activity loss deductions to the extent they exceed passive income.
  • Code Sec. 469(c)(2) treats rental activities as generally passive activities.
  • Code Sec. 469(c)(7)(A) allows materially participating real estate professionals to treat their real estate activity and, more importantly, their otherwise passive losses as non-passive. Furthermore, this code section allows taxpayers to elect to group multiple real estate activities as one activity for purposes of meeting the material participation tests.
  • Code Sec. 469(c)(7)(B) generally requires taxpayers to devote more than half of their personal services to real estate activities AND devote more than 750 hours to real estate activities for purposes of satisfying the real estate professional requirements.

The taxpayer in the case owned numerous rental real estate properties including three short-term rental properties which the court referred to as “resort properties”. The resort properties were properties located in Mexico, Hawaii, and Colorado, all three in vacation hotspots, and as such were rented on a short-term basis through management companies contracted by the taxpayer. The management companies were responsible for managing and renting out the resort properties to third parties throughout the year. One major stipulation of the management agreements was that the taxpayer reserved rights to reserve the resort properties in advance for their own personal use at their own discretion, otherwise known as “blackout dates”. During the blackout dates, the management companies would not be able to rent out the properties to vacationers.

Safe Harbor Requirements

The Seven-Day Exception

As a qualified real estate professional, the taxpayer had made a grouping election to treat all the real estate properties, including the resort properties, as one rental activity for the purpose of deducting the net loss generated by all the rental properties. Without the grouping election, the losses would have ultimately been suspended as passive losses, i.e. non-deductible, and carried forward to be applied against future passive income. The IRS contended however that the resort properties were not eligible to be included in the grouping election as they did not meet the definition of a rental activity due to the “seven-day exception” of Treas. Reg. Sec. 1.469-1T(e)(3)(ii)(A). The seven-day exception states that an activity is not a rental activity if the average period of customer use for the property is seven days or less. Period of customer use is defined in § 1.469-1(e)(3)(iii)(D) as “each period during which a customer has a continuous or recurring right to use (the property)”. The IRS argued that the average period of customer use for the resort properties was less than seven days, as the customers were vacationers who generally occupied the properties for a few days at a time. The taxpayer countered that the customers were not the vacationers but the three management companies were that they contracted to manage and rent the properties.

To substantiate their argument, the taxpayer relied on two court cases, White vs Commissioner of Internal Revenue 11 AFTR 985 (1932) and Hairston vs Commissioner T.C. Memo. 2000-386, in which the courts determined that the taxpayers’ agreement with management companies to sublease their property constituted a rental activity as the agreements gave the management companies “possession, dominion, and control” over the property AND exclusive rights to lease the property. The IRS then argued that the taxpayer’s case differed from these two cases in that by reserving the right to use the resort properties at his own discretion, the taxpayer’s management agreements did not convey exclusive access rights to the management companies, nor would the average use of the property by the management companies exceed seven days – since the taxpayer reserved the right to reserve the properties at his own discretion, he could have reserved the properties for two days out of every week, for example, thereby proving that the average use or right to use could never exceed seven days.

Ultimately, the District Court agreed with the IRS’ arguments and concluded that the taxpayer’s resort properties did not meet the definition of a rental property. The losses generated by those properties were therefore passive losses as the properties were ineligible to be grouped for purposes of the real estate professional grouping. The Court also validated the IRS’ assessments of additional tax and accuracy-related penalties on the taxpayer.

Are You Properly Structuring Your Rental Activities?

What this Case highlights is that taxpayers and tax practitioners alike should be very wary when it comes to short-term rentals and the language used in property management agreements as there can evidently be serious tax implications if not planned properly. If you own or are thinking about operating a short-term rental business, contact a member our Real Estate Services Team to ensure you are properly structuring your rental activities.

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