Short-term rentals (STRs) offered through platforms such as Airbnb and VRBO have become a common part of vacation planning. If you have ever stayed in someone else’s home instead of a hotel, you may have thought about how you, too, could profit by renting out part or all of your own property. It may seem like relatively easy money, but you need to understand the tax implications before you jump in.

Rental Versus Residence

For some taxpayers, one of the primary appeals of going into STRs is the opportunity to deduct certain expenses, including mortgage interest, real estate taxes, casualty losses, maintenance, utilities, insurance and depreciation.

However, limitations may apply if you also use your STR as a residence. In the eyes of the IRS, a dwelling unit is considered a residence if you use it for personal purposes during the tax year for more than the greater of:

• 14 days; or
• 10 percent of the total days you rent it to others at a fair rental price (the price an unrelated person would be willing to pay)

Under IRS rules, a day of personal use is any day a unit is used by:

• You or someone else with an ownership interest in the unit;
• A family member of the above, unless the family member uses it as their main home and pays a fair rental price;
• Anyone under an agreement that lets you use some other dwelling unit; or
• Anyone at less than fair rental price.

A special rule applies when you use a dwelling unit as a residence and rent it for fewer than 15 days. You do not need to report such rental income. On the flip side, you also cannot deduct the related expenses in excess of your rental income to create a loss.

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

Deduction Allocation

If you have any personal use of an STR (including a vacation home), you can deduct rental-related expenses, but you must allocate the expenses between rental use and personal use. Your rental expenses can be no more than the total expenses multiplied by a fraction of the total days rented at a fair rental price over the total number of days the unit was used.

Expenses are divided between rental use and personal use based on the number of days used for each purpose. Any day in which the property is rented at a fair rental price is a day of rental use, even if you also used the unit for personal purposes for a portion of that day. Days that the property is available for rent but not rented are not considered days of rental use.

When only a portion of a property is rented out, such as a bedroom or floor in your home, there may need to be an allocation of expenses based on rental space versus total space. Indirect expenses such as real estate taxes, mortgage interest or utilities may be allocated using any reasonable method. Common methods include allocations based on the percentage of square footage or the number of rooms used as a rental.

The personal portion of some expenses such as mortgage interest and real estate taxes may be deductible if you itemize your deductions.

Passive Activity Income Rules

Passive activity rules play a vital role in the taxation of STR income. Generally, a passive activity is any business activity in which the taxpayer does not “materially participate.” The IRS has seven tests for material participation, and you need only satisfy one (for example, by participating in the activity for more than 500 hours during the tax year) for an activity to be considered non-passive. Rental real estate activities, however, are generally considered passive unless you qualify as a real estate professional.

There is a special allowance for non-passive treatment of rental loss for those who actively participate in the rental activity. Active participation occurs when you or your spouse own at least 10% of the rental property and you are involved in making management decisions or arrange for others to provide services. Management decisions may include approving new tenants, deciding on rental terms, approving expenses and other similar decisions. However, there are income limitations for this special exception.

Taxpayers with adjusted gross income (AGI) of $100,000 or less ($50,000 or less if single or married filing separately) are allowed a loss of up to $25,000 to offset non-passive income.  Taxpayers with an AGI between $100,000 and $150,000 ($50,000 to $75,000 if single or married filing separately) have their allowance increasingly limited.  Those taxpayers with AGI exceeding $150,000 ($75,000 if single or married filing separately) are not eligible for the allowance.

Some taxpayers may prefer their STRs to be non-passive because of the tax advantages. In a nutshell, net losses from non-passive activities offset ordinary income, such as wages. Passive activity losses can only be applied against passive income — so if passive losses exceed passive income in a tax year, you must carry forward the excess.

As stated above, rental activities are generally passive.  However, an STR may be considered as something other than a passive rental activity in certain situations.  This commonly occurs when the average period of customer use is 1) seven days or less, or 2) 30 days or less and significant personal services are provided.  In these circumstances, the activity should most likely be reported on Schedule C, “Profit or Loss from a Business (Sole Proprietorship),” instead of as a rental activity.  This would also leave you on the hook for self-employment taxes.

The Net Investment Income Tax

High-income earners mulling getting into the STR game should keep in mind the net investment income tax (NIIT). The NIIT is a 3.8% tax on certain net investment income, including rental income from passive activity.

The tax kicks in when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married filing jointly. Unlike other income thresholds in the tax code, these thresholds are not adjusted for inflation.

Look Before You Leap

The tax rules for STRs are complicated and can make what seems like a simple way to earn extra money into anything but. The federal tax issues discussed above represent only part of the picture — you also must consider state and local taxes. Your tax advisor can help you make the right choices to minimize the tax impact.

If you have questions, contact Tyler Adams at [email protected] or 312.670.7444 or your ORBA advisor.