Satisfying the Short-Term Rental “Loophole” Requirements

Generally, if you rent your property for more than 14 days in a year, you are required to report the income. Otherwise, the Augusta Rule may apply. Read more about that here.

Beyond the 14-Day Rule: Short-Term Rental

While this strategy is often called a loophole, it is laid out directly in the tax code in relatively plain language. However, achieving the requirements can be nuanced and offer significant tax advantages, such as deducting losses against active income (like W-2 wages). The possibility of subjecting your rental income to self-employment taxes is also a factor. Generally, for your short-term rental to be treated considered a short-term rental for tax purposes, you need to meet two main criteria:

1. Average Period of Customer Use

The IRS looks at the average period of customer use to determine if the activity is truly "short-term" or more akin to a hotel.

• Average stay of 7 days or less: If the average period of customer use for your property is seven days or less, the IRS generally does not consider it a "rental activity" for passive loss limitation purposes. This is a common threshold for many short-term rentals.

2. Material Participation

If your rental activity falls under the "trade or business" classification (due to the average period of customer use), you then need to "materially participate" in the activity. Material participation means you are involved in the operations of the activity on a regular, continuous, and substantial basis. The IRS provides seven tests to determine material participation, and you only need to meet one of them:

• More than 500 hours: You participate in the activity for more than 500 hours during the tax year. This is often the most straightforward test for active hosts.

• Substantially all participation: Your participation constitutes substantially all of the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.

• More than 100 hours and no one else participates more: You participate in the activity for more than 100 hours during the tax year, and your participation is at least as much as any other individual's (including non-owners or employees).

• Significant Participation Activities (SPA) aggregate: The activity is a "significant participation activity," and your aggregate participation in all significant participation activities exceeds 500 hours for the year. (An SPA is one in which you participate for more than 100 hours but do not materially participate under any other test).

• Prior participation (5 out of 10 years): You materially participated in the activity for any five of the preceding ten taxable years.

• Personal service activity (3 prior years): The activity is a personal service activity (e.g., health, law, accounting, etc.), and you materially participated in it for any three preceding taxable years. This generally doesn't apply to most short-term rentals unless there's a specific personal service component.

• Facts and circumstances: Based on all the facts and circumstances, you participate in the activity on a regular, continuous, and substantial basis during the year. This is a catch-all and often harder to prove.

Important Note on Material Participation: When tracking your hours for material participation, keep detailed records. Activities that count include managing bookings, communicating with guests, cleaning, maintenance, marketing, and record-keeping. Activities that generally don't count as material participation are those related to an investor role, such as studying financial statements, preparing summaries for personal use, or monitoring finances in a non-managerial capacity.

Substantial Services

If your average period of customer use is between 8 and 30 days, providing "significant personal services" can help you qualify your short-term rental as a trade or business. These services go beyond what a typical landlord provides for a long-term rental. Examples include:

• Daily maid service (cleaning during a guest's stay)

• Concierge services

• Providing meals or entertainment

• Transportation services

• Organized tours or outings

• Changing linens and providing fresh towels during a guest's stay

• Providing hotel-like amenities beyond basic utilities (e.g., providing coffee and a coffee maker, recreational equipment)

Services typically provided in connection with a long-term rental, like initial cleaning, trash collection, basic utilities (water, gas, electricity, internet), and repairs/maintenance, are generally not considered "substantial services."

Tax Implications

• Substantial Services: It’s important to note that, while “substantial services” can help you qualify your short-term rental as a trade or business, typically they will trigger self-employment tax regardless of the average length of stay.

• Self-Employment Tax: Your net income from the rental may be subject to self-employment tax (Social Security and Medicare taxes), which is an additional 15.3% on your net earnings. Depreciations and other deductions may still be utilized to reduce this amount.

• Depreciation: Short-term rentals are generally depreciated over 39 years if they are considered nonresidential property (average stay of 30 days or less).

• Net Investment Income Tax (NIIT): If your modified adjusted gross income (MAGI) exceeds certain thresholds, your rental income might be subject to the 3.8% NIIT, especially if it's considered investment income and not an active trade or business.

Key Takeaways and Recommendations:

• Record Keeping is Crucial: Meticulously track all rental days, personal use days, hours spent on the activity (including specific tasks), and all income and expenses. This documentation is vital for substantiating your tax position to the IRS.

• Understand Average Stay: Calculate your average period of customer use carefully. This is often the first hurdle in determining your rental's classification.

• Assess Services Provided: Clearly distinguish between "insubstantial" and "substantial" services. This can impact whether your income is subject to self-employment tax.

• Meet Material Participation: If you want to deduct losses against active income, focus on meeting one of the material participation tests.