Taking a Closer Look at Short-Term Rentals

Anita S. Wescott, CPA

Short-term rentals (STRs) are appealing for a wide variety of property owners. For one thing, STRs typically produce more rental income than a standard 12-month lease. Would-be hosts need to consider a variety of issues before moving forward, though, including the following.

Average Stay Duration

The IRS generally treats rental activities as passive. Under the passive activity rule, any net losses from passive activities can be applied against only passive income.  If your passive losses are greater than your passive income in a tax year, the excess must be carried forward until the loss can be used against passive income.

Tax regulations provide an alternative for this limitation for STR income. Income from a rental activity may be treated as non-passive if the average period of customer use is seven days or less in the tax year. The calculation is straightforward: divide the total number of days the property was rented by the number of stays.

Many STR hosts understandably prefer long-term stays, but it is worth remembering the implications under the passive activity rules.

Depreciation Deductions

The average stay length also affects the amount of depreciation deductions in a year because the depreciation period depends on the character of the rental property. Residential rental property is depreciated over 27.5 years, while the recovery period for commercial rental property is 39 years. (Note: Keep in mind that depreciation deductions must be adjusted for the percentage of space rented out and the number of rental days compared to the total days of use.)

A property is not considered residential rental property unless 80% of the gross rental income comes from the leasing of “dwelling units.” Units that are rented on a “transient basis” do not qualify as dwelling units. The IRS generally treats rentals of 30 days or less as transient. As a result, STRs with average rentals of 30 days or less are classified as commercial rental property, and depreciation must be spread over 39 years, with smaller annual deductions.

The good news is that the rental may be eligible for accelerated depreciation on qualified improvement property (QIP) in STRs that are commercial rental properties. QIP generally refers to interior improvements — including roofs, HVAC, fire protection systems, alarm systems and security systems — placed in service after the building is placed in service.

These improvements qualify for bonus depreciation, meaning greater depreciation in the first year placed in service. For 2024, bonus depreciation allows a deduction of 60% of the purchase price in the first year. The percentage is scheduled to drop by 20% each year until the bonus depreciation provision expires in 2027 (absent congressional action). QIP may also be eligible for immediate expensing under Section 179 of the Internal Revenue Code, subject to certain limitations.

Even absent bonus depreciation, QIP can be depreciated more quickly because, by definition, it has a recovery period of 15 years.

In limited cases, an owner may want to explore converting a STR to a traditional long-term rental — with a recovery period of 27.5 years — after taking advantage of accelerated depreciation deductions. The income from long-term rentals is deemed passive, but that factor might be outweighed by other advantages. For example, long-term rentals do not carry many of the expenses associated with STRs, and the income stream is more predictable and reliable.

Business Owner or Investor?

An owner can claim depreciation deductions only if the STRs qualify as a business — investors are not eligible for such deductions. Both a profit motive and working “regularly and continuously” on the rental will help qualify STR’s as a business.

While short-term rentals with average stays of seven days or less are not automatically considered a passive activity, you must “materially participate” in the rental activity to deduct losses against non-passive income. The IRS has several tests for material participation, which it defines as being involved in the activity “on a regular, continuous, and substantial basis.” Investors generally do not satisfy any of the tests.

Tax Reporting

Your level of involvement also affects your tax reporting. Rental income from STRs generally is reported on Schedule E, “Supplemental Income and Loss,” even if the rental activity also is a business activity and you materially participate. However, you must report rental income on Schedule C, “Profit or Loss From Business,” if you provide “substantial services” beyond those necessary to maintain the space in a condition suitable for occupancy, such as:

• Daily maid services, including the delivery of individual use toiletries and other sundries;
• Access to dedicated Wi-Fi services for the rental property;
• Access to recreational equipment; and
• Prepaid vouchers for ride-share services between the rental property and the nearest business district.

The IRS reasons that such services are more akin to a hotel than a rental and may impose the 15.3% self-employment tax on the income. Local hotel regulations may also apply.

Some taxpayers might find it advantageous to report their STR activities by forming a partnership to own their rentals.

Proceed with Caution

The appeal of STRs is apparent, but the tax rules are complex and can mitigate some of the expected benefits. Consult with your ORBA advisor to ensure you understand the ultimate implications for your bottom line.

For more information, please contact Anita Wescott at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.