The short-term rental tax loophole is an often misunderstood and complex issue in the world of real estate investments. As a property owner, understanding the ins and outs of this tax regulation can make a significant difference in your financial bottom line.
To help you navigate this loophole, our expert CPAs shed light on the topic, providing you with valuable insights into how you can optimize your tax strategy for your short-term rental business while staying within the bounds of the law.
What Is the Short-Term Rental Loophole?
The short-term rental loophole is a provision within the tax code that offers property owners a unique opportunity to minimize their tax liability. Specifically, it can be found in Section 469(c)(7) of the Internal Revenue Code. This section defines exceptions that can allow income from rental activities to be treated as non-passive income.
If you currently own or are in the process of acquiring a short-term rental property in Florida, consult with Florida-based real estate CPA professionals to ensure you are taking advantage of all the tax benefits and tax deductions available to you through the short-term rental loophole.
Six Ways to Exclude Income from Rental Property
Under the short-term rental loophole, there are six strategic ways that income from short-term rental properties can be excluded from the definition of “rental income.” These methods enable property owners to optimize their tax burden:
- Short Stays. Customers typically use such property for an average period of seven days or less.
- Significant Personal Services. The typical duration of customer use for such property is 30 days or less, and substantial personal services are offered either by the property owner or on their behalf to facilitate its availability for customers. These substantial services may encompass provisions similar to those typically found in hotels, such as daily cleaning, linen changes, and meal services.
- Extraordinary Personal Services. These personal services are extended by the property owner or their representatives in the process of making such property ready and accessible to customers, irrespective of the typical duration of customer use.
- Considered Incidental. The renting of such property is considered a minor aspect of the taxpayer’s non-rental activities.
- Not Exclusive. The taxpayer typically offers the property for use during defined business hours, making it accessible for nonexclusive use by a variety of customers.
- Business Activities. Making the property available (without rental payment) for use in an activity carried out by a partnership, S corporation, or joint venture, in which the taxpayer holds a stake.
The Seven Material Participation Tests
The material participation tests are a crucial element of the short-term rental loophole. To benefit from this loophole, property owners must meet at least one of these seven tests to prove that they materially participate in their short-term rental properties.
Each test evaluates your level of involvement in the rental activity. While meeting any one of these tests can classify your investment property income as non-passive, the specific test you qualify for will depend on your level of engagement.
- More Than 500 Hours. You and/or your spouse participate in the short-term rental business activity for more than 500 hours during the tax year.
- Substantial Participation. You substantially participate in all the work for the rental activity.
- More Than 100 Hours and No One Else Does More. You participate for more than 100 hours during the tax year, and no one else (including hired professionals) participates more than you do.
- Significant Participation Activity. You participate in multiple significant participation activities and your aggregate participation exceeds 500 hours.
- Material Participation for Five Out of the Last Ten Years. You have materially participated in the rental activity for any five of the last ten taxable years.
- Personal Service Activity. For those engaged in a personal service, such as in the fields of law, health, engineering, accounting, and architecture, if you have materially participated in the rental activity for any three of the previous taxable years, you qualify for this test.
- Regular, Continuous, and Substantial Activity. This test applies if your involvement in the rental activity is regular, continuous, and provable. You must work more than 100 hours in the tax year, nobody can work more hours than you in the rental activity, and no one else gets paid to manage the rental activity.
The first three tests are those that most short-term real estate investors can meet. Once you satisfy one of these criteria, your short-term rental no longer falls under the definition of rental activity, and rental income from this property is categorized as non-passive income.
Examples
To illustrate how these concepts work in practice, let’s consider two short examples.
Example 1
John owns a short-term rental property and actively manages it, spending over 600 hours per year on various tasks related to the property’s upkeep and guest interactions. By meeting the “More than 500 hours” test, John can exclude his earnings from the definition of rental income.
Example 2
Sarah, who holds real estate professional status, owns three short-term rentals that she actively manages. She spends approximately 300 hours per year on her rental activity outside of her real estate business. Her assistant spends approximately 125 hours per year directly related to rental activities. Sarah meets the “More than 100 hours and no one else does more” test, so she can classify her rental income as non-passive.
Explore the Short-Term Rental Tax Loophole With a CPA
The short-term rental tax loophole can provide property owners with valuable opportunities to optimize their tax strategies and reduce their tax burden. By understanding the provisions within the tax code, such as the material participation tests and other exclusion methods, property owners can make informed decisions to enhance their financial well-being.
When claiming the short-term rental tax loophole, it’s essential to work closely with a qualified CPA to ensure compliance with all relevant tax regulations and to tailor these strategies to your unique circumstances. With expert guidance, you can navigate the intricacies of Section 469(c)(7), make the most of your real estate investments, and potentially reduce your tax bill.
