Written by Sammy Habbaz, Senior Accountant
At LMC, we are constantly working with our clients to find ways to lower their taxes. A common method of doing so is investing in real estate, where taxpayers can take advantage of the “phantom expense” of depreciation. This allows taxpayers to have positive cash flow from their investment but report a lower taxable income to the IRS. The downside of real estate investing is that the income or loss, by default, is treated as coming from a passive investment in the eyes of the IRS, regardless of the work the owner performs. This means that any losses generated can’t offset active income such as wages earned as an employee or flow through income as a business owner.
However, there is a way for investors to make their real estate income or loss active and get the full tax benefits. This will occur if a person qualifies as a real estate professional (REP). To do so, a taxpayer must overcome certain tests:
- They need to spend more than half of their work time during a year in real property trade or business (RPTB).
- They need to spend more than 750 hours during the year in a real property trade or business (RPTB) , unless the taxpayer makes a grouping election.
- They need to materially participate in each rental, unless the taxpayer makes a grouping election.
The first test is usually the hardest for taxpayers to overcome, especially high net worth individuals who make a living in other sectors. For example, imagine a lawyer who invests in real estate and works 40 hours a week, for 50 weeks out of the year. That’s 2,000 hours of working as a lawyer. In order to pass the first test, they need to work 2,001 hours in a RPTB, for an average work week of 80 hours over the course of a year, which is difficult to achieve.
However, not all hope is lost. Let’s dive deeper into section U.S. Code section 1.469-T(e), which discusses the concept of passive activity.
Passive Activity and Material Participation
An activity is considered passive if the taxpayer does not materially participate in the trade or business, or the activity is a rental. To materially participate, a taxpayer must meet any one of seven tests. The three most commonly met tests are:
- Taxpayer works more than 500 hours in the activity.
- Taxpayer does substantially all of the work of the activity;
- Taxpayer works more than 100 hours in the activity and no one else works more than the taxpayer, including non-owners or employees.
Other tests involve significant participation activities, participation over a number of years and a facts and circumstances test.
Example: Taxpayer is asked by a friend to invest in a restaurant. All our taxpayer is doing is providing the capital. Any income from this restaurant is considered passive, because our taxpayer did not pass any of the material participation tests.
While rental activity is passive by default, there are two exceptions:
- The average customer use of the property is 7 days or less. Or
- The average customer use of the property is 30 days or less and the taxpayer provides substantial services.
If either of these exceptions are met, the activity is considered a trade or business and not a rental, and if the owner materially participates in the investment, the income/loss is deemed to be active.
Tax Court Case – Bailey v. Commissioner, T.C. Memo. 2001-296
In Bailey v. Commissioner, the taxpayers had 4 rental properties, and wanted to qualify as a real estate professional by grouping all the rental activities together. This is usually done to ease the burden of qualifying for material participation, which is normally a per property test. The Tax Court ultimately ruled that all income deriving from these properties was passive. The court explained, the Taxpayers did not provide reasonable time logs so they couldn’t prove they satisfied any of the 3 REPs tests. The interesting part of this case is, even if the taxpayers did have accurate records, they still wouldn’t have qualified.
While analyzing the 4 properties, the court noted one of them had an average customer stay of 7 days or less. As a result, they disallowed the hours spent on that property, and reclassified it as time spent on a trade or business, causing them to fail the hourly requirements. They may have been able to make the losses active from that one property if they proved material participation, but the court didn’t find their records credible.
Additional Tax Benefits of Short-Term Rentals:
In the eyes of the IRS, there is a significant difference between residential property and nonresidential property. The classification is not as simple as one may think. The IRS defines a residential rental property as a “building or structure if 80 percent or more of the gross rental income from such building or structure for the taxable year is rental income from dwelling units”. Dwelling units exclude properties where more than half of the units are occupied for 30 days or less. This means that short term rentals, regardless of zoning or structure, are considered nonresidential for tax purposes. Why is this important?
While nonresidential properties are depreciated over 39 years, instead of 27.5 years for residential, the subsequent improvements to those properties can potentially fall into a special bucket called Qualified Improvement Property (QIP). A Qualified improvement property is an improvement made by the taxpayer to an interior portion of a nonresidential building if the improvement is placed in service after the building was first placed in service. Examples include the installation or replacement of drywall, interior doors, lighting, flooring, ceilings, fire protection, and plumbing. However, any enlargement of a building, installation of an elevator or escalator, or improvements to the internal structural framework do not meet the requirements of qualified improvement property. The big advantage of designating improvements as QIP is that QIP is depreciated over only 15 years and is eligible for bonus depreciation (80% if placed into service in 2023). For a residential property, those same improvements, would be depreciated over 27.5 years, with no bonus depreciation allowed.
The Bottom Line
Use of the short-term rental strategy, coupled with qualified improvement property, can be very beneficial to real estate investors. The law is not straight-forward and there are many factors to be considered, so feel free to reach out to your LMC professional to strategize and clarify any questions.