Multifamily Developers May Want To Consider Short-Term Rentals

TAMARA PARTRIDGE, CPA, MST

Developers of multifamily projects are always looking for creative ways to maintain high occupancy and increase cash flow. Keen developers in urban markets with an oversupply of multifamily housing and/or an undersupply of hotel rooms can benefit from an attractive revenue opportunity to accomplish these goals: Short-term rentals.

Who benefits from revenue-sharing agreements?

Peer-to-peer service providers, like Airbnb and Vrbo, have used online tools to bring significant change to an already established industry. For example, in the hotel industry, business travelers and tourists who would not imagine staying in someone’s home are now choosing alternative accommodations that feel like a home with hotel-like amenities, such as gyms, pools and concierge services.

Airbnb and Vrbo properties are not limited to single-family homes with extra rooms, basements, guest houses and unused vacation homes. In 2018, the National Multifamily Housing Council estimated that nearly 65% of Airbnb rentals were in multifamily buildings.

What are the potential benefits for developers?

Developers of multifamily properties can leverage these trends by leasing out blocks of units to short-term real estate operators, such as Frontdesk and Sonder. The strategy helps expedite finding tenants, reduce or even eliminate vacancy loss and improve cash flow.

That means developers can more quickly pay off their high-interest loans, return equity to their investors and refinance at lower interest rates. The arrangements also reduce the cost of tenant turnover and the need for leasing agents.

How does it work?

For example, short-term rental operators may sign 15-year master leases for specific rooms in multifamily buildings, furnish those units under their brand, and then lease them out through Airbnb or Vrbo. To make the most of the opportunity, developers should get the operator involved early. That way, the operator can be a partner through the building’s life cycle, from preconstruction to lease-up and beyond.

Operators can share their knowledge on design (including layouts, materials and amenities), marketing and other critical issues that might not occur to developers who have more familiarity with long-term tenants. For example, short-term visitors generally require less space than someone who will live in a unit for a year or longer. Experienced operators can help you determine the right size to comfortably accommodate short-term renters.

Short-term guests may need more extensive signage when navigating the building. Operators might also recommend that you build separate entrances and luggage storage rooms for short-term guests.

Conduct due diligence

The field of short-term rental operators is getting crowded, so it is important to conduct due diligence before entering leasing agreements. Among other things, look for a proven track record, a solid balance sheet that shows the ability to meet long-term financial obligations and a clear breakdown of cost and liability between the developer and the operator.

In addition, find out how the operator will service and manage its short-term guests. Some operators will handle background checks, maintenance issues, the move-in and out process as well as other resident issues, whereas others may not. Will the operator use a third-party platform to manage rentals or offer short-term rentals directly to the public? There are various business models available so it is important to determine what is best for you. 

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

Renting Out Property on Airbnb? Be Sure You Understand the Tax Rules for Short-Term Rentals

RYAN A. KERTES, CPA

The advent of online booking platforms, such as Airbnb and Vrbo, has made it easy for property owners to get into the hospitality business. Desirable short-term rental properties often have greater income potential than long-term rentals. But they also present some complex tax issues that are fraught with traps for the unwary.

To keep things (relatively) simple, this blog focuses on properties used exclusively for rental purposes. Renting out property that you also use for personal purposes (for example, a vacation home or a room in your primary residence) raises additional tax issues.

Related Read: Mixing Business and Pleasure: Tax Implications of Personal Use Rental Properties

Passive Activity Loss Rules

To understand the tax implications of short-term rentals, you need to first familiarize yourself with the passive activity loss rules. These rules prohibit taxpayers from offsetting net losses from “passive” business activities against nonpassive income, such as wages, interest or dividends. Disallowed losses are carried forward to future years and deducted from passive income or recovered when the business activity is sold or otherwise disposed of.

A passive activity is an investment in a trade or business in which you do not materially participate. Participation is “material” if it is “regular, continuous and substantial.” Under IRS guidelines, you are deemed to materially participate in an activity if you satisfy one of the following seven material participation tests for the year:

1. Participate in the activity for more than 500 hours;
2. Your participation in the activity for the year constitutes substantially all of the participation in such activity of all individuals;
3. Participate in the activity for more than 100 hours during the taxable year, and no less than any other individual;
4. The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;
5. The individual materially participated in the activity for any five taxable years during the ten taxable years that immediately precede the taxable year;
6. The activity is a personal service activity and you materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
7. Participate in the activity more than 100 hours and based on all facts and circumstances, on a regular, continuous and substantial basis.

Note: To meet the hours requirement multiple short-term rentals can be grouped together to be considered one economic unit.  Reg. Sec. 1.469-4(c)(2) provides a facts and circumstance test to determine whether activities can be grouped.

Rental activities are considered passive, however, regardless of your level of participation (unless you are a “real estate professional”). That means you can not deduct rental losses from nonpassive income (such as wages), with one limited exception: If you “actively participate” in a rental activity and your modified adjusted gross income (MAGI) is $100,000 or less, you can deduct up to $25,000 in rental losses from nonpassive income. This loss allowance begins to phase out when MAGI exceeds $100,000 and is eliminated once it reaches $150,000. Active participation is a less stringent standard than material participation. Generally, you are deemed to actively participate if you make management decisions — such as approving new tenants, determining rental terms or approving expenditures — or arrange for others to provide services (provided you own at least 10% of the rental property and are not a limited partner).

Short-Term Rentals: Rental Activity or Business?

There are several exceptions to the general rule that rental activities are deemed to be passive, including two for short-term rentals. An activity can be excluded from the rental classification and bypass the default passive treatment, if:

1. The average rental period is seven days or less; or
2. The average rental period is 30 days or less, and significant personal services are provided.

Significant personal services go beyond those commonly provided with long-term rentals — for example, maid or laundry services during a stay, meals and entertainment, tours or outings, concierge services and transportation.

Treatment of short-term rentals as a nonpassive trade or business activity rather than a passive rental activity may offer significant tax advantages, including:

• The ability to immediately deduct certain remodeling expenses. (Short-term rentals treated as a trade or business are considered nonresidential property and, as such, are eligible for 100% bonus depreciation for “qualified improvement property.”)
• The ability to claim deductions available to otherwise qualifying businesses, such as the 20% qualified business income (QBI) deduction, the self-employed health insurance deduction, and deductions for certain retirement plan contributions.
• The ability to deduct rental losses against nonpassive income (provided you materially participate in the short-term rental business).

There are also some disadvantages to the nonpassive trade or business status, particularly self-employment (SE) tax. The SE tax is a 15.3% tax (reduced to 2.5% when combined wages, tips and earning exceed $142,800) — in addition to ordinary income tax — on your net earnings from self-employment. Note, however, that short-term rental income is subject to SE tax only if you provide substantial services to guests. This may provide a tax-planning opportunity: If you limit the average rental period to seven days or less and do not provide substantial services, it may be possible to avoid the passive activity loss rules and the SE tax.

The tax implications of short-term rentals depend on a number of factors, including the average rental period, the types of services you provide and whether your rentals earn a profit or generate a loss. The tax rules are quite complex, so be sure to consult your tax advisors to discuss potential strategies.

For more information about tax planning for short-term rentals, please contact Ryan Kertes. Visit ORBA.com to learn more about our Real Estate Group.