Short-Term Rentals Classified as Passive Activity Losses

BY CYNTHIA BOLT LEE

Individuals who own vacation homes or condominiums frequently rent them out to others. These short-term rentals often last seven days or less. Owners typically hire a property management company to oversee rental reservations, promotions, housekeeping, maintenance and general accounting functions. The owners make incidental repairs, meet with management and perform investment activities related to the property such as paying bills and analyzing financial reports but otherwise leave most of the work to the property manager.

Walter and Mary Sue Barniskis owned a condominium they rented out through a professional management group. The typical rental was for a stay of less than seven days. The management company performed most rental-related jobs. The Barniskis made occasional repairs, paid bills, organized records and prepared their tax return. For tax years 1991 through 1993, the IRS denied the business losses the Barniskis claimed for their condominium rental.

Result. For the IRS. The Tax Court determined that the Barniskis’ rental of their condominium was a passive activity in which they did not materially participate. It cited IRC section 469, which says passive activities are (1) those in which the taxpayer does not materially participate and (2) those defined as rental activities. According to temporary Treasury regulations, the definition of rental activities excludes properties where the average period of customer use is seven days or less. For losses to be currently deductible on such short-term rentals, the taxpayer’s hours of participation in the activity must meet the material participation requirements.

From their personal records, the Barniskis documented more than 100 hours of activity related to the property, which they claimed exceeded the time spent by any other individual for the years being examined. The president of the property management company testified—in support of the Barniskis’ claim—to the number of hours his employees spent renting the unit. The court discredited his testimony, however, due to his “personal and business interests in the outcome of the case.”

Included in the Barniskis’ time records were several hours of investor activities such as preparing their tax returns and paying bills. However, according to the temporary regulations, time spent performing investor activities is not treated as material participation unless the individual is directly involved in the activity’s daily management.

The Tax Court determined that management’s participation was greater than the owners’ and ruled that material participation did not take place. The losses from the rental were classified as suspended passive activity losses because the taxpayers failed to participate

  • More than 500 hours for the years in question.
  • More than 100 hours where such participation was more than that of any other individual.

The IRS classifies taxpayers as engaged in a trade or business if they own rental property where the customer stays an average of seven days or less. To receive a current deduction for losses incurred in such an activity, the taxpayer must meet all of the material participation requirements found in section 469 related to passive activities. A taxpayer must participate in the activity more than any other individual and must maintain accurate records of participation, excluding investor-related activities.

  • Walter A. Barniskis and Mary Sue Barniskis v. Commissioner, TC Memo 1999-258

Prepared by Cynthia Bolt Lee, CPA, assistant professor of business administration, the Citadel, Charleston, South Carolina.

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