The Sharing Economy – Tax Implications of Short-Term Rentals
Kory Reynolds, Tax Manager
Technology has developed an avenue to create income streams from assets that we originally acquired for our enjoyment – all a part of the developing “sharing economy.” The sharing economy allows us to take advantage of capital intensive luxury assets by offsetting some of the costs of ownership. Primary examples are vacation homes and vehicles, where companies such as Air BnB, VRBO, Turo, and GetAround make it easy to rent out a second home or vehicle. These emerging industries provide an excellent way to create income from assets we hold for recreation, but owners should be aware of their tax implications.
Is It Taxable?
Renting out either a home or a vehicle through one of these companies or independently is taxable unless the activity meets an exception. The revenues of a business activity can be offset with related expenses. However, personal expenses are not deductible, and taxpayers must identify or allocate outlays between personal and business expenses. Rules on how expenses should be allocated will differ between real estate and personal property.
Allocation of rental expenses and whether or not rental revenue is taxable at all are dependent on a taxpayer’s level of personal use of the property, and specifically, whether a dwelling unit is used personally as a residence.
Taxpayer’s “residence” defined
A dwelling unit is considered to be used as a taxpayer’s residence if used personally for more than the greater of (1) 14 days, or (2) 10% of the total days rented to others at fair market value. Personal use days include days used by the owners, family members, friends, or anyone else where use of the dwelling unit is provided for less than fair market rent. Personal use days do not include days spent at the property where the primary purpose is maintenance, repairs, or otherwise managing the unit.
Minimal business use: Income is not taxed
If a dwelling unit is rented at fair market value for less than 15 days, and is also used as a residence, the income is not taxable or reportable.
Minimal personal use: Expenses may be fully deductible
If it is determined that the unit is not used as the taxpayer’s residence (using the test described above), then all expenses incurred can be recorded against rental income (assuming they otherwise qualify).
Significant business use and personal use: Expenses must be allocated
If the unit is classified as a residence and rented out for more than 14 days, then the taxpayer will be required to allocate expenses between uses, and will not be able to use any resulting rental losses to offset other sources of income. These disallowed losses will generally be carried forward to offset future income from that property, or realized upon the disposition of the property.
There are several considerations for allocating expenses between personal and rental use. Several types of expenses are incurred only as a result of the rental activities and can be allocated against rental income without allocation, such as management fees, occupancy taxes, commissions, amenities for renters, and cleaning fees directly related to occupancy. For expenses that cannot be directly allocated to either personal or rental use the expenses must be allocated based on a ratio of days rented at fair market value to personal use days. The denominator in this calculation would be the days used for any purpose (personal or rental), and the numerator would be the days rented at fair market value. There is an alternative method which has not explicitly been supported by the IRS, but it has been successfully defended in the 9th and 10th circuit courts. This ‘Tax Courts’ method is to allocate select expenses – real estate taxes and mortgage interest expenses - on a ratio of days rented at fair market value plus days available for rent over the total days the property was held during the year. A taxpayer can utilize the ‘Tax Courts’ method to allocate real estate taxes and mortgage interest, while using the IRS prescribed method for all other allocated expenses. A brief example to illustrate these two methods would be as follows:
- A property is rented at fair market value for 90 days, utilized personally for 35 days, and vacant but available for rent 240 days. Utilizing the IRS methodology, expenses would be allocated by a ratio of 90 days over 125 days (90 days rented plus 35 used personally), for 72% of expenses to be allocated to the property. The ‘Tax Courts’ method for real estate taxes and mortgage interest will yield 90% business use, calculated as 330 days rented and available for rent over 365 total days the property was held.
This ratio would be applied to each expense that needs to be allocated to determine the amount that is deductible against rental income received. Expenses that are allocated to personal use may not necessarily be entirely lost. For example, the personal portion of real estate taxes and mortgage interest may be deductible on Schedule A as itemized deductions.
Vehicles and Other Personal Property
While it has been common for taxpayers to rent out their vacation homes when not in use, the new peer to peer accommodation companies have streamlined this process. In contrast, renting out personally owned vehicles represents a much newer opportunity. Relative to real estate, it also comes with fewer tax rules. For example, where the rental of real estate may not be taxable if the number of days rented is less than 15 days and it is also a personal residence, no such exception currently exists for the rental of personal property. The result is that all activity should be reported on a tax return, and all related expenses should be tracked.
Vehicle expenses must be allocated between personal use and business use. Expenses directly related to the rental of the vehicle, such as management costs, cleaning, parking, or amenities provided to the renter, can be allocated fully to business use. The general expenses of operating the car such as maintenance and repairs, fuel, insurance, and registration require special consideration.
The deduction for vehicle operating expenses can either be accounted for through the actual expenses method or the standard mileage method. To properly utilize either method the taxpayer must track (1) total miles driven during the year, and (2) miles utilized for business purposes. Business purpose miles includes miles driven by renters, trips to pick up or drop off the vehicle for rent, or miles driven for cleaning and other activities directly related to the rental.
The actual expenses method involves keeping record of all the vehicle’s operating expenses incurred during the year. These operating expenses and depreciation based on the purchase price or fair market value when it was placed into service will then be allocated between personal use and business use based on the ratio of business miles driven over total miles driven for the year. While most of the allocated personal costs are not deductible, excise taxes paid when registering a vehicle may qualify as an itemized deduction. If the actual expenses method is used in the first year the vehicle is in service, it must be used for the life of that vehicle. In contrast, if a taxpayer uses the standard mileage method the first year a vehicle is in service, each year a taxpayer can calculate the deduction from both methods, and follow the one that provides the greatest deduction.
The standard mileage method simplifies this calculation by allowing the taxpayer to apply a standard mileage rate determined by the IRS (54.5 cents per mile for 2018) to the number of business miles driven, resulting in a deduction of that amount. If the standard mileage rate is used, no deduction will be allowed for vehicle operating expenses such as depreciation, repairs, maintenance, fuel, insurance, or registration. It is important to note that if the taxpayer is operating a fleet in excess of 5 vehicles the standard mileage rate may not be available.
Exposure to Self-Employment Taxes
When a taxpayer is activity involved with a business endeavor, he or she may be exposed to self-employment taxes. The traditional rental of real estate is often shielded from self-employment taxes because Treasury Regulation 1.469-1T defines a passive activity as including rental activities without regard to the extent that the taxpayer participates in that activity. This definition further goes on to include all tangible property that is held for use by customers, where customers pay specifically for the use of that property. At a first pass this would appear to allow us to classify all of the rental activities discussed previously as passive, and not subject to self-employment taxes.
There are several exceptions to this regulation that need to be considered by a taxpayer renting out real estate or personal property through a peer to peer service. The first exception is that if the average period of customer use for the property is 7 days or less it is no longer considered a rental activity. In the realm of Air BnB or Turo it would be very common for customers to rent the taxpayer’s property for only several days at a time, quickly creating an average rental usage of under 7 days. The same regulations note that if the average rental period ranges from 8 to 30 days, the rental of the property will not be considered a rental activity if there are significant personal services provided to the customers. There are additional exceptions that may need to be considered but these are the two most applicable to one participating in peer-to-peer transactions.
To determine if there are significant personal services provided, the taxpayer needs to examine all relevant facts and circumstances, such as the frequency of services, amount of labor required, and value of these services relative to what is charged for the use of the property. For real estate, these significant personal services could include a maid or cleaning service during the stay, concierge services, a stocked kitchen, or additional amenities such as the use of a vehicle or boat. For a vehicle, significant services could include pick up, drop off, vehicle delivery, or additional amenities provided with the rental.
If the rental of the property is not classified as a rental activity based on the categories discussed above, a taxpayer may still avoid self-employment taxes by not materially participating in the activity. For the rental of real estate this may be achieved by using a property manager to direct the day to day operations of the dwelling unit. While possible, similar arrangements are less likely to exist in the context of vehicle rentals.
Other potential issues should be reviewed, such as the applicability of the net investment income tax to real estate rentals, state and local occupancy taxes, the impact of selling the property in the future, and the potential need for business licenses. Each of these areas has its own complexities that should be considered when participating in these types of transactions. The issues discussed above, however, are some of the broader-reaching ones that affect the taxability of day-to-day operations of peer-to-peer renting services, and those interested in providing these services should become familiar with their impact.
If you have any questions regarding status as a real estate professional, please contact Kory Reynolds or your BNN tax advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.