There was a time when owning a rental property was strictly the domain of the well-to-do. But with hotel roomrates skyrocketing, many travelers would sooner take their chancescrashingonthe floor of amethdenthanshell out$200 for a night at theLa Quinta.
Seeking to remedy this disparity between consumer demand and affordable supply, Airbnb was launched in 2008. The App connects anyone with space to offer -- from aspare bedroom to an extravagant vacation home -- with the legion of travelers looking for a budget-friendlynight's rest.
Thanks toAirbnb, everyone can find that affordable night'ssleep, andanyone can become a landlord.But there's more to rentingout your extra space than making some cash, meeting interesting people, and then watching them slowly succumb to yourH.H. Holmes-inspiredhostel of horrors. There are, of course,taxes to consider.
And as if often the case, understanding the tax consequences of renting property -- whether just a portion of your home oran entire residence -- is not a straightforward process. Section 280A of the Internal Revenue Code, which governs the treatment of homes that are used for both personal and rental purposes, is a complicated tangle of definitions, designations, and resulting consequences.But if you're going to start renting out a property on Airbnb or Craigslist, you're going to need to know the rules, so let's take a deep dive into Section 280Aand see if we can't help all ofyou newly-minted slumlords sort throughyour tax considerations.
Personal versus Rental Use
In order to properly report the tax implicationsof renting your home, you must determine if it is a "rental" or a "residence" -- or both.The first step towards accomplishing that, however, is to identify when the home is used for "rental purposes" versus when it is used for "personal purposes."
In general, a home is treated asbeing used for rental purposes for any day it is rented for fair market value. However, if you rent your home to a family member, those days will only be treated as rental days if the family member pays fair market valuefor the use of the propertyand the home is used by the family member as his or her primary residence. If these two requirements are not met, the days the home is rented by the family member are considered "personal use" days to the owner.
In addition, you are generally considered to have used a house for personal purposes for a day if, for any part of the day, thehome is used for purposes reasons by:
- the owner of the home;
- the brothers and sisters, spouses, ancestors or lineal descendants of the owner of the home (with one exception for FMV rent of a primary residence,as discussed above);
- any individual who uses the home under a reciprocal arrangement; and
- any other individual who uses the home during the day unless for that day the unit is rented for a fair rental.
Keep in mind, if multiple people co-own a property, each owner is treated as having used the home for personal purposes for any day any owner uses the home for personal purposes.
You are not treated as using a home for personal purposes, however, for any day you spend a normal workday cleaning, painting, repairing, or otherwise maintaining the home. In fact, these days are not counted as either rental or personal use; rather, the home is treated as not being used at all for those days.
Example: A owns a rental home which A rents to S, A's sister, at FMV for 10 days. A also rents the home to unrelated C at FMV for 11 days as a part of an arrangement whereby A is entitled to use D's home for 6 days. As a favor, A rents the home to F at a discount for 15 days. While it appears A has "rented" the home for 36 days, all 36 days constitute personal use of the home by A based on the rules discussed above. As a result, for purposes of Section 280A -- discussed more fully below -- A is treated as having 36 personal use days and 0 rental days for the year.
Example 2: A owns a vacation home in Steamboat Springs. A rents the home to unrelated parties for 48 days at FMV during the winter, but also vacations at the home for 21 days in the summer. A also allows her brother and his wife to use the house forseven days for freeeach winter. A spendstendays each fall repairing the home and getting it ready for another season of use. None of the seven maintenance days involve any personal vacation time. As a result, for purposes of Section 280A, the vacation home is used 48 days for rental purposes and 28 days for personal purposes (A's 21 days of use and the seven days the home is used by A's brother). Theten maintenance days are not counted as either rental or personal use days.
Based on the previous discussion, one thing should quickly become clear: if you use Airbnb to rent out a room in your principal residence while you continue to reside there, you will be attributed a personal use day for every day of the year, even the days the home was rented.
Example: A lives in a condo as her principal residence for the entire year. A uses Airbnb to rent out a room in her condo for 28 days during the year. For purposes of Section 280A, the home is used 365 times for personal purposes and 28 days for rental purposes.
As you will soon see, as a result of this treatment, when your rental activity is limited to sharing a room within your primary residence, you will never be allowed to deduct a loss from your rental activity.
Scenario 1: You Have Fewer than 15 Rental Days During the Year
With Airbnb and Craigslistopening the rental market to hundreds of thousands of sporadic landlords, many people will find themselves in a position where they have rented their property for fewer than 15 days during the year. Just because your rental income isn't substantial, however, doesn't mean you don't have to pay tax on it; there are no freebies in the tax worl....oh wait...scratch that. There is a freebie in the tax world, and it works like this: if you rent your home for fewer than 15 days during the year, you can simply ignore the rental activity, pocket the cash, and not report the income.
You read that right.Anyone canenjoy tax-free rental income, and frankly, it's about damn time. You see, this rule is nothing new, but until the advent of Airbnb, this tax-free rental income would strictlyinure to the rich. It's not that middle and lower-class taxpayers were forbidden from claiming therental exemption, it's just that realistically speaking, few homeowners in non-destination resorts had people knockingdown their doors asking to spend a night or two.As a result, it's always beenwealthy homeowners in locations like Augusta, Georgia who have reaped the benefits of the 15-day exclusion, because they could rent out their pads for the four-day Masters golf tournament and pocket tens, if not hundreds, of thousands of tax-free cash. With Airbnb bringing short-term rentals to every corner ofAmerica, however, more taxpayers than ever can now share in the fun.
Make no mistake, however; if you choose to exclude your rental income (and you will), you cannot deduct any expenses attributable to the rental activity other than those expenses that are otherwise deductible as they relate to the use of a home; i.e., mortgage interest and real estate taxes.
Of course, themortgage interest deduction is subject toits own set of limitations. Namely, you can only deduct the interest on up to $1.1 million of
Example: A owns only one home, her personal residence. She participates in Airbnb and rents a room in her home for 12 days in 2015. The tenants pay her a total of $2,000. A may exclude the $2,000 from her taxable income, and may not deduct any of the "typical" rental expenses; i.e., repairs, depreciation, insurance, etc.. It's as if the rentals never happened. A may deduct 100% of her mortgage interest (assuming it is on less than $1.1 million of debtand qualifies as acquisition or home equity debt).
Scenario 2: Rental Days Exceed 14 Days, and Your Personal Use DaysDo Not Exceedthe Greater Of 1) 14 days, or 2) 10% of Total Rental Days
If you rent a second (or third, or fourth...) home, and your personal use days as determined above do not exceed the greater of 1) 14 days, or 2) 10% of total rental days, then the property is considered a rental and not a residence. As a result, this is the one situation in which you may generate and deduct a lossfrom your rental activites(subject to the passive activity rules, as discussed below).
All rental income must be reported, and any expenses attributable to the rental may be deducted, withtwo important caveats.First, there is a defined order in which the rental expenses must be deducted. It goes like so:
Step 1: deduct the mortgage interest and real estate taxes attributable to the rental;
Step 2: deduct all otheroperating expenses other than depreciation, and
Step 3: deduct depreciation.
Example: A owns a second home. On Airbnb, A rents the home for100 days during 2015, and uses the home for personal purposes for 12 days. A collects $20,000 from the rental of the home. Because the 12 personal use days do not exceed the greater of 1) 14 days or 2) 10% of rental days (10), the home is treated asa rental property, and not a residence. As a result, A must include in income the $20,000 of rental income, but may deduct the expenses attributable to the rental activity. Assume for the full year, A had the following expenses attributable to the home:
Mortgage interest and taxes: $40,000
Repairs, management fees, utilities, insurance: $15,000
Depreciation: $10,000
Under Section 280A(e), A must allocate the $65,000 of rental expenses between the rental and personal use. This is done by dividing the 100 rental days by the 112 total days the homewas rented or used for personal purposes. Thus, A may allocate $58,035 of the expenses to the rental activity, and will report a rental loss of $38,035. This loss is fully deductible, subject to the passive activity limitations of Section 469.
In the example above, it's important to note that because the house does not meet the definition of a residence under the meaning of Section 280A (because of the insufficient personal use), any mortgage interest expense not allocatedto the rental use of the home may not be deducted on Schedule A as an itemized deduction. The real estate taxes not allocated to rental use may be deducted, however, on Schedule A.
Scenario 3: Rental Days Exceed 14 Days, and Your Personal Use DaysExceedthe Greater Of 1) 14 days, or 2) 10% of Total Rental Days
This is where things get interesting. If you rent a home for more than 14 days, and you also use the home for personal purposes for more than the greater of 14 days or 10% of rental days, the home is once again deemed to be a residence. Because the home is a residence, and not a rental,just as in Scenario 1, no rental loss is permitted (though under Section 280A(c)(5), any excess loss can be carried forward) Unlike Scenario 1, however, the rental income must be recognized and reported; it's just that the rental expenses attributable to the rental can only reduce the income to zero.
Here's where tax planning can become important. As a reminder, there is a distinct order in which rental expenses must be deducted against rental income: first mortgage interest and real estate taxes, thenoperating expenses, and then lastly, depreciation expense. And while the IRS maintains that all three categories should be allocated between rental and personal use based on the total number of days the home was rented and used for personal purposes during the year -- with no consideration given to days the home sits open -- the Tax Court has a different view.
In the1982 Tax Court case Bolton v. Commissioner, the court permitted the taxpayer to allocate Category 1 expenses -- mortgage interest and real estatetaxes --to rental use by using the full 365 days in the year, even if the home was not used for either rental or personal purposes for some of these days. This results in a lower allocation of mortgage interest and real estate taxes to the rental activity.
Now, why would anyone want that? Wouldn't you want to allocate MORE of your expenses to the rental activity to offset the income?
Remember, because the house is now a residence under Section 280A, any mortgage interest -- and of course, any real estate taxes --not allocated to the rental activity will be deductible on Schedule A as an itemized deduction (provided the mortgage debt limitation is not exceeded and the residence is not your third home). As a result, if you can allocate less mortgage interest and taxes to the rental activity, the remainder will be deducted elsewhere, and it frees up more of the other two categoriesof expenses to be deducted against rental income before the income is zeroed out. You have thus increased your total deductions on your tax return.
Example: A owns a vacation home.During 2015, the home was rented for 91 days at FMV for $2,700. During the year, A also used the home for personal purposes for 30 days. The vacation home was vacant for the other 244 days. During 2015, A incurrent the following expenses:
- mortgage interest: $2,854
- property taxes: $621
- operating expenses: $2,693
- depreciation deductions: $3,500.
Under the method prescribed under Section 280A(e), the IRS would allocate all expenses 75% to rental use (91/121) and 25% to personal use. By contrast, if A can use the Bolton method to allocate the mortgage interest and real estate taxes, A would allocate only 25% of mortgage interest and real estate taxes to rental use (91/365) and would allocate the remaining expenses 75% to rental as required by Section 280A(e). Look how different the tax consequences would be in the two scenarios:
| IRS | Bolton | |
| Rental Income | $2,700 | $2,700 |
| Less: Category 1 expenses | ||
| mortgage interest ($2,854) | ($2,140) | ($713) |
| real estate taxes ($621) | ($466) | ($155) |
| Remaining income after Category 1 expenses: | $94 | $1,832 |
| Less: Category 2 expenses | ||
| operating expenses | ($94) | ($1,832) |
| Net Income | $0 | $0 |
In both scenarios, the net rental income is zero, as it should be. Remember, because the house is a residence (due to the personal use), no rental loss can be recognized. The difference, however, is that under the Service's method, only $714 of mortgage interest and $155 of real estate taxes are allocated to the personal use of the home and may be deducted on Schedule A. Using the Bolton method, however, $2,140 of mortgage interest and $466 of real estate taxes are allocated to the personal use of the home and may be deducted on Schedule A. As a result, by using the Bolton method, A is able to deduct an additional $1,737 of interest and taxes. If that doesn't sound like much, tack a zero onto all of the numbers in our example, and the Bolton method becomes very advantageous.
Of course, if for some reason the mortgage interest allocated to personal use would not be deductible on Schedule A as an itemized deduction -- because, for example, the total debt exceeded $1.1 million or the vacation home was your third home -- you would prefer to use the IRS method, because any Category 2 or 3 losses in excess of income could be carried forward to a future year. Although from a practical perspective, because most small, residential rental activities tend to generate a loss each year or, at best, break even, it is unlikely the carryover loss will ever be recognized.
It is also important to note that the Bolton method must be applied consistently; if you use it for mortgage interest, you must use it for real estate taxes. And if you use it for a property in one year, you should use it in all years going forward.
Application of Section 280A to the Rental of A Room In a Single Residence
Airbnb has greatly enhanced the ability of a homeowner to rent a single room in his or her primary residence. If this sounds like you, you must remember that you are treated as using the home for personal purposes each day of the year, regardless of how many days you might have rented it. As a result, your personal use will always exceed the greater of 14 days or 10% of the rental days, and thus no loss will be allowable on the rental.
When it comes time to allocate your rental expenses between rental and personal days, however, each day the home is rented is counted as a rental day, even if it is also counted as a personal day for purposes of determining if the home is a residence.
Example: A lives in a condo, and spends all 365 days in 2015 there. A also rents a spare room for 20 days to one tenant. For purposes of determining which scenario applies, A is deemed to have 365 personal days and 20 rental days. As a result, the home is a residence, and Scenario 3 applies. For purposes of allocating A's rental expenses, however, the expenses attributable to thehome must be allocated to the rental in two different ways. First, expenses attributable to the entire residence -- like insurance, interest, or utilities -- must be allocated to the spare room based on the relative square footage of the house. Next, the expenses must be allocated between rental and personal use. For these purposes, A's rental days are treated as being 20, and personal days are only 345. Thus 20/365 of each category of prorated expenses are allocated to the rental activity.
Limitations on Rental Losses
For ease of use, let'ssummarize the discussion above:
Scenario 1: Rental use is less than 15 days -- exclude rental income, deduct no rental expenses.
Scenario 2: rental use is greater than 14 days, and personal use does not exceed the greater of 1) 14 days or 2) 10% of rental days -- this is the one scenario where you may deduct rental expenses in excess of income.
Scenario 3: rental use is greater than 14 days, and personal use exceeds the greater of 1) 14 days or 2) 10% of rental days -- rental income must be recognized, and rental expenses can only reduce rental income to zero, they cannot generate a loss.
Thus, Scenario 2 is the only situation in which you can recognize a loss.Before that loss will actually become useful on your tax return, however,there are additionalhurdles that must be overcome.
Section 469 provides that aloss from a "passiveactivity" can only be used to offset income from a passive activity. Passive activities include all rental activities, regardless of how active the taxpayer may be in conducting the rental activity. This means that in general, your rental losses do you little good unless you have passive income -- either rental income or other income from an activity in which you do not materially participate -- from other sources.
There are threeexceptions, however, that may enable you to benefit from the rental losses stemming from Scenario 2.
First, the regulations provide that an activity is not a "rental activity" for purposes of the passive activity rules if the average period of customer use is less than seven days. This is determined by dividing the aggregate number of days of customer use by the periods of customer use. Each period during which a customer has continuous or recurring right to use an item of property held in connection with the activity is treated as a separate period of customer use. For many Airbnb landlords, this exception to the "rental activity" designationmay well be achievable.
Example: A owns a vacation home and rents it during 2015 for a total of 70 days to 14 different customers. Pursuant to Section 469, because the average period of customer use is less than 7 days (70/14 = 5) the home is not considered a rental activity. Provided A materially participates in the activity (under the meaning of Reg. Section 1.469-5T), the activity would not be passive, and the entire loss would be deductible without limitation.
Next, even if an activity is considered a rental under Section 469, f you "actively participate" in the management of the rental activity, you can deduct up to a $25,000 loss from the rental. This $25,000 allowance, however, is reduced by 50% of the amount by which your adjusted gross income exceeds $100,000. As a result, the benefit is completely lost once adjusted gross income reaches $150,000.
The "active participation" standard is less stringent than the "material participation" standard of Reg. Section 1.469-5T. It simply requires participating in management decisions or arranging for others to provide services (such as repairs) in a significant and bona fide sense. The types of decisions that are relevant in the vacation home context include approving new tenants, deciding on rental terms, approving capital or repair expenditures, and other similar decisions. To meet the active participation standard, however, you must own at least 10% of the value of the interest of the activity.
Finally, if you can qualify as a "real estate professional" under the meaning of Section 469(c)(7), and you can establish that you materially participate in your rental activities, they will not be treated as passive. For a full discussion of the real estate professional rules, read this.
As this discussion revealed, deciphering the tax consequences of a part-time rental is no picnic. You could wind up with tax-free cash, a disallowed loss, or something in between. Hopefully this primer clears up some of the confusion, so you can stop scouring the internet for tax advice and return to installing a two-way mirror in your spare bathroom. Pervert.
follow along on twitter @nittiaj
