Short-Term Rentals Preclude Use of Losses
CPA tax practitioners who have clients involved in a real estate rental trade or business are no doubt aware of the rule allowing $25,000 of passive losses from rental real estate to be deducted against nonpassive income and the 750-hour material participation rule for qualifying as a real estate professional under the passive activity loss rules.
However, practitioners might not realize that a rule that treats rentals shorter than eight days as nonrental activities may foil a taxpayer’s ability to meet the 750-hour material participation threshold. Earlier this year, taxpayers learned the hard way.
In 2004, Todd and Pamela Bailey owned three rental properties. Todd Bailey, a physician, did not participate in the rental property activities. His wife, Pamela Bailey, operated and managed all aspects of the properties. She performed all of the bookkeeping and banking tasks, fielded telephone calls regarding the rentals, and paid the bills. She also performed most of the necessary on-site tasks such as cleaning and arranging the units for viewing or rental. During 2004, she also invested many hours researching, negotiating and planning to acquire a fourth rental property and in researching other potential acquisitions.
When the Baileys’ 2004 joint income tax return was selected by the IRS for examination, Pamela Bailey provided a summary of 382 hours she spent on the two rental properties reported on Schedule E. She was further able to demonstrate that she had spent 192 hours researching potential acquisitions and 105 hours in activities related to the acquisition of the fourth property. While the two rental properties on Schedule E sought “year-to-year” tenants, the third property, which the Baileys called The Inn on Alisal Road, was furnished and offered for short-term rentals, with an average stay of only three days. Pamela Bailey established that she spent 324 hours with respect to the inn. That activity was reported on Schedule C. Including the hours expended to acquire the fourth property, Pamela Bailey reported a total of 1,003 hours spent on real estate rental activities in 2004.
As a result of the examination, the IRS disallowed various losses and deductions, resulting in an asserted tax deficiency of more than $19,000. The Baileys petitioned the Tax Court (Todd and Pamela Bailey v. Commissioner, TC Summary Opinion 2011-22 (3/2/11)), where after stipulations the sole issue remaining was whether the taxpayers could deduct a net loss of $16,822 as nonpassive on their Schedule E from the two rental properties. Since the Baileys’ combined adjusted gross income exceeded $150,000, the $25,000 loss allowance under section 469(i)(2) was phased out and not available. Therefore, the pivotal decision was whether all of Pamela Bailey’s hours counted toward the 750-hour material participation rule that would qualify her as a real estate professional under IRC § 469(c)(7). Under that rule, a taxpayer’s rental activities will not be treated as passive activities if:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
- Such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
Given Pamela Bailey’s involvement in the rental properties and the fact that she had no other occupation during 2004, she clearly satisfied the first requirement. At first glance, it may also appear that she met the second requirement. However, the IRS and Tax Court disagreed.
Because the average length of stay for the Inn on Alisal Road was less than eight days, the court held that Temp. Treas. Reg. § 1.469-1T(e)(3)(ii)(A) specifically excluded the activity as a rental activity, and therefore it could not count as a real property trade or business in computing material participation as a real estate professional. Consequently, the 324 hours that Pamela Bailey worked on the inn were disregarded for purposes of the 750-hour test, leaving only 679 hours. As a result, the loss as originally reported on her Schedule E was disallowed as a passive activity.
The temporary regulations also exclude from classification as a rental activity other uses of rental property, including those where “extraordinary personal services” are provided or those where the average period of customer use is 30 days or less and “significant personal services” are provided, or where rentals are treated as incidental to a nonrental activity of the taxpayer.
By Pamela L. Pierce, CPA, (ppierce@jessupllp.com) senior manager with Jessup, Ingram, Burns & Associates LLP, Tuscaloosa, Ala.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.
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