Latch onto deductions for short-term rentals

The tax law generally treats rental real estate properties as “passive activities” that are, by definition, subject to the passive activity limits on losses (the so-called PAL rules). Under a special exception, a property with an average rental period of seven days or fewer (a short-term rental property”) is not considered a rental activity for purposes of the PAL rules. Therefore, losses from a short-term rental property are exempt from the PAL rules if you can show that you “materially participate” in the activity.

Strategy: Pay close attention to the length of rental periods to benefit from the exception for short-term rental properties.

To treat a loss from a rental property as a nonpassive loss (i.e., a loss exempt from the PAL rules), you must materially participate in the activity (see box below). However, if the property is a personal residence that is rented for fewer than 15 days during the year, no rental deductions are permitted.

To complicate matters, a loss can’t be deducted on the rental of a vacation home if personal use of the home exceeds the greater of 14 days or 10% of the rental time.

A new case points out the potential pitfalls.  

Facts: In 2004, a taxpayer used a local real estate agency to rent out a three-bedroom cabin in a resort area of California. The cabin was rented three times for a total of 12 days and nine nights. On his 2004 tax return, the taxpayer deducted $20,000 in rental expenses.

But the IRS disallowed the deductions. And the Tax Court generally went along with the IRS.

First, the Tax Court determined that the taxpayer rented out the cabin for fewer than 15 days in 2004. So he isn’t able to deduct any of the expenses attributable to the rental period. But he can still write off mortgage interest and real estate taxes attributable to the rental as itemized deductions on Schedule A.

Note that the taxpayer would not have been able to deduct the rental expenses even if he had rented out the cabin for more than 14 days. Because his personal use exceeded the 14 days/10% limit, the cabin is treated as a “personal residence” for tax purposes.

Therefore, any rental expenses exceeding the amount of rental income would not have been deductible in 2004. The amount would have been carried over to 2005. (The exact amount of rental income was not indicated in the Tax Court opinion.)

Even if his personal use of the cabin wasn’t a problem, the Tax Court ruled that the taxpayer did not satisfy the “material participation” test. He did not work 500 or more hours at the rental activity or work more hours than the real estate agency.

Finally, the taxpayer couldn’t prove his claim that he spent more than 100 hours inspecting and maintaining the property.  

Tip: On the flip side, none of the income from the short-term rental activity was taxable in this case because the property was rented out for fewer than 15 days.

Who is a ‘material participant’?