By: Andrew Dickens, AIF®, CEXP™, CVBS™
Director of Pension Services
The explosion in short-term rental properties set off by Airbnb and VRBO has had many landlords re-thinking their long-term tenancies, especially for properties that can attract those clients. With its beaches, tourism, and wildlife, Florida offers unique opportunities for landlords to consider short-term rentals.
Traditionally, landlords file rents and expenses under Schedule E of the 1040, as is required. Profits are treated as passive income and losses as passive losses.
Start with narrowing down a specific time for your exit. If I had a nickel for every time a business owner told me they wanted to bow out in 3-5 years, I’d be at least $50 richer. Planning an exit starts with getting specific but also with understanding that you may need to be flexible on the timing. It makes a difference in how you approach the planning process when you stick a pin on a calendar as a way of saying, “This is the day I start doing something different with my life.”
Passive income is taxed like ordinary income, based on the tax bracket you fall into with all your other income. Passive losses offset passive income, or they can be carried forward to the next tax year if there isn’t enough passive income to offset.
Passive losses can only offset ordinary income under two circumstances: (1) you or your spouse is a “real estate professional” or (2) your modified adjusted gross income (MAGI) is less than $100,000, in which case you can deduct up to $25,000 in passive losses against ordinary income; there is a phase-out up to $150,000. (I’ll leave real estate professional tax considerations for another article.)
Whether or not clients need to offset ordinary or passive income depends on their personal tax situation, but an interesting planning opportunity exists for landlords with short-term rental properties. In some cases, it’s possible to treat passive income as self-employment income under Schedule C. Schedule C losses will offset ordinary income.
Substantial or not?
The IRS specifies that any rental property with an average tenancy of more than 30 days during the year should be filed under Schedule E. This would include pretty much all long-term rentals and even some short-term rentals.
If the average tenancy during the year is under 7 days, any income/loss should be filed under Schedule C. It’s in the “between 7 and 30 days” spot where things get interesting, and you might be able to file under Schedule C or E. The difference mainly comes down to providing “substantial services.”
Definitions of substantial services are a little vague, but in general, they may include housekeeping services during the stay, changing linens, providing meals and/or entertainment, and concierge services. Cleaning common areas and taking out trash would not be considered substantial, but it might be a matter of opinion whether other services (such as providing coffee and accessories) are substantial or not.
If you are providing substantial services with average rentals of between 7 and 30 days, you would file under Schedule C, and if not, you would file under Schedule E. This provides a planning opportunity where your accountant can determine under what schedule you might want to file.
A hole in one!
Another interesting option is to use the Masters Rule 280(A)(g), but it applies to your primary residence. If you rent it out for up to 14 days during a tax year, you are not required to report that income to the IRS. It’s called the Masters Rule because of its association with the influx of golf enthusiasts to Augusta, Georgia for the Masters Tournament. During that event, many locals take advantage of it to rent out their homes (or rooms in their homes).
The Masters Rule can be used by business owners as well. Let’s assume business owner Jane has monthly sales meetings with her staff at a local restaurant or hotel convention center. Instead of paying the restaurant or hotel, she could use her own home and pay a “reasonable” expense to herself from the business for each monthly meeting. In doing so, she would shift taxable business income to unreportable income under the Masters Rule and legitimately avoid taxes on those payments to herself. Now that’s a hole in one!
