A recent article about vacation home rentals elicited a response from a New York CPA regarding short-term rentals. As our loyal reader pointed out, there's a creative way that some vacation-home owners may be able to avoid adverse tax consequences.
First, let's briefly recap the basic rules. If you limit your personal use of a vacation home, you can write off costs associated with renting out the place. However, under the passive activity loss (PAL) rules for investors, expenses from an activity in which you do not "materially participate" can only offset income from other passive activities. Material participation is based on several tax law tests (e.g., spending more than 500 hours during the year on the activity).
In other words, the PAL rules prevent you from claiming an overall loss for the year. Significantly, rental real estate activities are automatically treated as passive activities.
However, a special provision in the tax law allows you to claim an offset against non-passive activity income of up to $25,000 if you actively participate in the activity. For this purpose, "active participation" is more than just signing the rental agreements. To qualify, you must have "regular, continuous and substantial" involvement in the activity, like making management decisions, approving tenants, handling repairs, deciding on rental terms, etc. This exception is available only if you own at least a 10 percent interest in the property.
Nevertheless, the $25,000 offset is phased out for someone with an adjusted gross income above $100,000. It disappears completely once you exceed an AGI of $150,000. So upper-income clients would seem to be out of luck even if they qualify as active participants in the activity.
But there 's another little-known tax break: If you engage in short-term rentals averaging seven days or less, the IRS may treat the activity as a business, not an investment activity, if you meet the material participation test. This removes the entire rental activity from the PAL rules. Because your vacation home in this scenario is more akin to a hotel or bed-and-breakfast than a typical residence, you can deduct expenses relating to the rental on Schedule C. Providing a few extra amenities—like clean sheets, towels, and housekeeping services—will support your position.
Remember that you aren't able to claim the $25,000 offset if you go this route. What's more, if you flunk the material participation test, any loss is dumped into a bucket of suspended passive losses. You can't benefit from the loss until a subsequent year, if ever.
Inform your clients who rent out vacation homes about this tax nugget. And, to the CPA who drew our attention to this tax break, thanks and good luck with your audit!