Short-Term Rental Investments and Taxation

Updat­ed Sep­tem­ber 2024

The rise of short-term rental plat­forms, includ­ing Airbnb and Vrbo has changed and rev­o­lu­tion­ized the real estate mar­ket, giv­ing rise and oppor­tu­ni­ty to a poten­tial­ly lucra­tive sec­tor (along with many pit­falls): short-term rentals. For many investors, the appeal of earn­ing sub­stan­tial income through vaca­tion rentals or tem­po­rary hous­ing solu­tions is strong.

How­ev­er, like any invest­ment, div­ing into short-term rentals requires a sol­id under­stand­ing of the industry’s intri­ca­cies, from legal require­ments and finan­cial ben­e­fits to poten­tial risks. This com­pre­hen­sive guide will explore every­thing investors need to know to suc­cess­ful­ly nav­i­gate the short-term rental mar­ket.

1. Understanding Short-Term Rentals

Short-term rentals (STRs), often referred to as vaca­tion rentals, are prop­er­ties rent­ed out for a short dura­tion, typ­i­cal­ly rang­ing from a sin­gle night to a few weeks, and gen­er­al­ly less than 30 days (and there is a 7 day aver­age stay rule as well that investors need to be aware of). Unlike tra­di­tion­al long-term rentals, Short-term rentals cater to tourists, busi­ness trav­el­ers, and indi­vid­u­als seek­ing tem­po­rary hous­ing. The flex­i­bil­i­ty and con­ve­nience of short-term rentals make them a pop­u­lar choice for trav­el­ers and a poten­tial­ly prof­itable ven­ture for prop­er­ty own­ers.

Types of Short-Term Rentals:

• Entire Homes/Apartments: Rent­ing out an entire prop­er­ty, pro­vid­ing com­plete pri­va­cy to guests.
• Pri­vate Rooms: Rent­ing out a room with­in a prop­er­ty where oth­er parts of the prop­er­ty, such as the kitchen or liv­ing room, may be shared with the host or oth­er guests.
• Shared Spaces: Guests share com­mon areas with the host or oth­er guests, typ­i­cal­ly at a low­er cost.

2. Legal and Regulatory Requirements

Invest­ing in short-term rentals requires care­ful atten­tion to local laws and reg­u­la­tions, which can vary sig­nif­i­cant­ly depend­ing on the loca­tion.

Zon­ing Laws and Reg­u­la­tions:

• Zon­ing Restric­tions: Many cities have spe­cif­ic zon­ing laws that dic­tate where short-term rentals can oper­ate. Some areas may pro­hib­it STRs in res­i­den­tial zones or require spe­cial per­mits.
• Licens­ing and Per­mits: Some juris­dic­tions require prop­er­ty own­ers to obtain licens­es or per­mits to oper­ate short-term rentals. These can range from a basic busi­ness license to spe­cif­ic STR per­mits that may involve inspec­tions and fees.
• Occu­pan­cy Lim­its: Reg­u­la­tions may lim­it the num­ber of guests that can stay in a short-term rental at one time. These lim­its are often based on the size of the prop­er­ty or the num­ber of bed­rooms.

Tax­a­tion:

• Local Tax­es: Many areas and juris­dic­tions impose tran­sient occu­pan­cy tax­es (TOT) or sim­i­lar levies on short-term rental income. These tax­es are typ­i­cal­ly cal­cu­lat­ed as a per­cent­age of the rental rate and must be col­lect­ed from guests and remit­ted to the local gov­ern­ment. It’s also impor­tant to note that mul­ti­ple juris­dic­tions may have an occu­pan­cy tax.

Such as one for the local city, one for the coun­ty, one for a spe­cial tax dis­trict (gen­er­al­ly near major sport’s are­nas), and anoth­er for a state.

• Income Tax: Income gen­er­at­ed from short-term rentals is sub­ject to fed­er­al and state income tax. Investors must keep detailed records of their earn­ings and expens­es to accu­rate­ly report this income. As described in the fol­low­ing, the nature of the income for short-term rentals also depends on many fac­tors that need spe­cial con­sid­er­a­tion BEFORE mak­ing an invest­ment.

Home­own­ers Asso­ci­a­tion (HOA) Rules:

• HOA Restric­tions: Prop­er­ties with­in an HOA may be sub­ject to addi­tion­al rules regard­ing short-term rentals. Some HOAs may pro­hib­it STRs entire­ly, while oth­ers may have spe­cif­ic guide­lines that must be fol­lowed.

Insur­ance Require­ments:

• Insur­ance Cov­er­age: Stan­dard homeowner’s insur­ance poli­cies gen­er­al­ly do not cov­er short-term rental activ­i­ties (depends on the nature of the rental ie a room in your pri­ma­ry home vs anoth­er prop­er­ty). Investors should con­sid­er spe­cial­ized Short-Term Rental busi­ness insur­ance poli­cies that cov­er poten­tial lia­bil­i­ties, such as prop­er­ty dam­age or guest injuries.

3. Financial Benefits of Short-Term Rentals

The finan­cial ben­e­fits of short-term rentals can be sub­stan­tial, mak­ing them an attrac­tive option for real estate investors.

High­er Income Poten­tial:

• Pre­mi­um Pric­ing: A main attrac­tion is the appeal that Short-term rentals often com­mand high­er night­ly rates com­pared to long-term rentals, espe­cial­ly in high-demand areas or dur­ing peak sea­sons. This can result in sig­nif­i­cant­ly high­er annu­al income com­pared to tra­di­tion­al leas­ing.
• Sea­son­al Pric­ing: Investors can adjust pric­ing based on demand, charg­ing high­er rates dur­ing hol­i­days, spe­cial events, or peak tourist sea­sons.

Flex­i­bil­i­ty and Con­trol:

• Per­son­al Use: Own­ers have the flex­i­bil­i­ty to use the prop­er­ty them­selves when it’s not rent­ed out, offer­ing a dual ben­e­fit of income gen­er­a­tion and per­son­al vaca­tion use.
• Ten­ant Con­trol: Unlike long-term rentals, where ten­ants may stay for a year or more, short-term rentals allow own­ers to choose when and who to rent to, min­i­miz­ing the risk of deal­ing with prob­lem­at­ic ten­ants.

Tax Deduc­tions:

• Deductible Expens­es: Many expens­es asso­ci­at­ed with main­tain­ing and man­ag­ing a short-term rental can be deduct­ed from rental income, includ­ing prop­er­ty man­age­ment fees, main­te­nance costs, and even cer­tain trav­el expens­es relat­ed to prop­er­ty upkeep.

• Depre­ci­a­tion: Investors can also ben­e­fit from depre­ci­a­tion deduc­tions, which can off­set tax­able income from the prop­er­ty over time. The depre­ci­a­tion sched­ule may change if the rental is a clas­si­fied as a busi­ness (ie com­mer­cial) vis-a-vis habi­ta­tion­al.

Prop­er­ty Val­ue Appre­ci­a­tion:

• Long-Term Invest­ment: In addi­tion to the rental income, prop­er­ty val­ues in desir­able loca­tions tend to appre­ci­ate over time, pro­vid­ing investors with long-term cap­i­tal gains when the prop­er­ty is even­tu­al­ly sold.

4. Challenges and Risks of Short-Term Rentals

While the poten­tial rewards of short-term rentals are entic­ing, investors must also be aware of the asso­ci­at­ed chal­lenges and risks.

Reg­u­la­to­ry Risk:

• Chang­ing Laws: Reg­u­la­tions sur­round­ing short-term rentals are con­stant­ly evolv­ing. Cities, munic­i­pal­i­ties, and HOAs may impose new restric­tions, increase tax­es, or even ban short-term rentals alto­geth­er, which can impact an investor’s abil­i­ty to oper­ate.

• Com­pli­ance Costs: Keep­ing up with reg­u­la­to­ry require­ments can be time-con­sum­ing and cost­ly. Fail­ing to com­ply with local laws can result in fines, legal action, or the forced clo­sure of the rental.

Mar­ket Com­pe­ti­tion:

• Sat­u­ra­tion: In pop­u­lar tourist des­ti­na­tions, the mar­ket for short-term rentals can become sat­u­rat­ed, lead­ing to increased com­pe­ti­tion and poten­tial­ly low­er occu­pan­cy rates. Investors must care­ful­ly research mar­ket demand and con­sid­er the poten­tial for over-sat­u­ra­tion in their cho­sen loca­tion. As of 2024, we’ve seen this play out in many areas of the coun­try, espe­cial­ly in the Flori­da mar­ket.

Oper­a­tional Chal­lenges:

• Man­age­ment Inten­sive: Short-term rentals require ongo­ing man­age­ment, includ­ing clean­ing, main­te­nance, guest com­mu­ni­ca­tion, and mar­ket­ing. This can be time-con­sum­ing, espe­cial­ly for investors man­ag­ing mul­ti­ple prop­er­ties. One of the ques­tions involved includes “Sub­stan­tial Ser­vices.”

Sub­stan­tial Ser­vices pro­vid­ed can change the nature of the short-term rental from a typ­i­cal res­i­den­tial rental into a busi­ness activ­i­ty, which is the goal of many investors, albeit doing so must be planned and exe­cut­ed cor­rect­ly to avoid unex­pect­ed sur­pris­es come tax time.

• Turnover Costs: The fre­quent turnover of guests can lead to high­er main­te­nance costs and wear and tear on the prop­er­ty. Reg­u­lar deep clean­ing, restock­ing of sup­plies, and repairs are nec­es­sary to main­tain a high stan­dard and good reviews. Gen­er­al­ly, new short-term rental own­ers often find the expens­es are far greater than expect­ed, and this becomes even more the case for dis­tant short-term rentals where the own­er must rely upon oth­ers to per­form all the work.

Taxation Rules for Short-Term Rentals

Tax­es on short-term rentals can be com­plex due to the vary­ing rules that apply to rental income, deduc­tions, and occu­pan­cy tax­es. Con­sid­er this as a start­ing point, and if I empha­size any­thing, let me high­light that this is not a “do it your­self” from a tax­a­tion point of view for the new real estate investor. Below are a few top-lev­el areas investors must con­sid­er when it comes to tax­a­tion:

Fed­er­al Income Tax Treat­ment:

• Rental Income: Income gen­er­at­ed from short-term rentals is typ­i­cal­ly con­sid­ered tax­able by the IRS and must be report­ed on your tax return. Even if you receive pay­ment through a third-par­ty plat­form like Airbnb, the IRS still requires you to report the rental income.

• Excep­tion for Short Rentals (14-Day Rule): Often called the Augus­ta Rule, albeit like­ly more often used in Cal­i­for­nia in the movie indus­try — If you rent out your prop­er­ty for few­er than 15 days in a year, and it’s used as a per­son­al res­i­dence for the remain­der of the year, the rental income is gen­er­al­ly exempt from fed­er­al income tax if all the require­ments are met. How­ev­er, you also can­not deduct expens­es relat­ed to the rental peri­od in this case. Also, there are many rules regard­ing the tax exclu­sion of the income and doc­u­men­ta­tion of fol­low­ing the require­ments are VERY impor­tant. Many busi­ness own­ers will rent their home for an annu­al meet­ing of a day or two in order to trans­fer funds from the busi­ness (cre­at­ing a deductible expense), to their per­son­al account for rent paid (which does not have to be count­ed as income) using this rule.

• Rental vs. Self-Employ­ment Income: Depend­ing on how involved you are in man­ag­ing the rental (such as clean­ing, pro­vid­ing ameni­ties, or reg­u­lar­ly inter­act­ing with guests), your short-term rental income may be clas­si­fied as “self-employ­ment” income. This is espe­cial­ly true if you pro­vide sub­stan­tial ser­vices to guests. In this case, you would need to pay self-employ­ment tax­es, which include Social Secu­ri­ty and Medicare tax­es. The IRS uses the dis­tinc­tion between pas­sive rental income and active par­tic­i­pa­tion to deter­mine whether you need to report this as self-employ­ment income.

• State Income Tax: In addi­tion to fed­er­al income tax, short-term rental income is also sub­ject to state income tax, depend­ing on the state in which your rental is locat­ed. You’ll need to check with your state tax author­i­ty to under­stand spe­cif­ic require­ments.

• Sales Tax: Some states treat short-term rental ser­vices as tax­able under their sales tax laws. Like occu­pan­cy tax­es, sales tax­es are gen­er­al­ly a per­cent­age of the rental rate charged to guests. It’s essen­tial to deter­mine if your state requires you to col­lect sales tax in addi­tion to occu­pan­cy tax­es.

Deduc­tions and Depre­ci­a­tion:

One of the most attrac­tive aspects of invest­ing in short-term rentals is the range of deduc­tions avail­able to off­set rental income. Here are some of the key tax deduc­tions investors can ben­e­fit from:

• Mort­gage Inter­est and Prop­er­ty Tax­es: Sim­i­lar to long-term rentals, mort­gage inter­est and prop­er­ty tax­es on a short-term rental can be deduct­ed. If you live in the prop­er­ty part-time, you like­ly need to pro­rate these deduc­tions based on the per­cent­age of time the prop­er­ty is rent­ed out ver­sus per­son­al use.

• Oper­at­ing Expens­es: Many oper­at­ing expens­es direct­ly relat­ed to run­ning a short-term rental can be deduct­ed from your rental income. There are many involved and beyond the scope of this overview.

• Repairs and Main­te­nance: Expens­es relat­ed to nec­es­sary repairs and reg­u­lar main­te­nance to keep the prop­er­ty in rentable con­di­tion are deductible. This can include paint­ing, plumb­ing repairs, land­scap­ing, and appli­ance ser­vic­ing.

• Depre­ci­a­tion: The IRS allows prop­er­ty own­ers to depre­ci­ate the val­ue of the rental prop­er­ty over 27.5 years, which can sig­nif­i­cant­ly reduce tax­able income. Depre­ci­a­tion applies to the struc­ture itself (not the land), and it spreads out the cost of the prop­er­ty over time. How­ev­er, if you use the prop­er­ty for per­son­al pur­pos­es, the depre­ci­a­tion must be pro­rat­ed accord­ing to the per­cent­age of time the prop­er­ty is rent­ed ver­sus per­son­al use.

Short-Term Rental Loss­es:

For many short-term rental investors, espe­cial­ly those start­ing, the prop­er­ty may incur loss­es due to sig­nif­i­cant upfront costs like ren­o­va­tion or fur­nish­ing. The IRS has rules about when and how you can deduct these loss­es:

• Pas­sive Activ­i­ty Loss Rules: Gen­er­al­ly, short-term rental activ­i­ties are con­sid­ered pas­sive invest­ments under IRS rules. This means that rental loss­es can only be used to off­set oth­er pas­sive income. If you don’t have oth­er pas­sive income to off­set, the loss­es can be car­ried for­ward to future tax years.

• Mate­r­i­al Par­tic­i­pa­tion Excep­tion: If you mate­ri­al­ly par­tic­i­pate in the man­age­ment of your short-term rental (spend­ing at least 100 hours annu­al­ly and more than any oth­er per­son), the rental may be con­sid­ered non-pas­sive, allow­ing you to deduct rental loss­es against oth­er types of income (such as wages).

• Lim­i­ta­tions on Deduc­tions: Deduc­tions for short-term rental loss­es are sub­ject to lim­i­ta­tions. Unless you qual­i­fy for bet­ter treat­ment, for exam­ple, as a Real Estate Pro­fes­sion­al, the IRS impos­es a $25,000 lim­it on rental loss deduc­tions for indi­vid­u­als with an adjust­ed gross income (AGI) of $100,000 or less. For every $2 of income over $100,000, the $25,000 lim­it is reduced by $1, and it phas­es out entire­ly at an AGI of $150,000.

Self-Employ­ment Tax Con­sid­er­a­tions:

As men­tioned ear­li­er, if your involve­ment in man­ag­ing the short-term rental is sig­nif­i­cant, called the Sub­stan­tial Ser­vices test, the IRS may clas­si­fy your activ­i­ty as a busi­ness rather than a pas­sive invest­ment. In this case, your rental income will be sub­ject to self-employ­ment tax, in addi­tion to fed­er­al and state income tax.

How does one demon­strate Sub­stan­tial Ser­vices? Gen­er­al­ly, if the ser­vices pro­vid­ed are akin to a hotel stay, then the tax­pay­er may be able to demon­strate they are pro­vid­ing sub­stan­tial ser­vices. These include as exam­ple:

• Clean­ing of the rental each day while the prop­er­ty is occu­pied by the same guests.
• Chang­ing bed sheets and oth­er linens each day while the prop­er­ty is occu­pied by the same guests.
• Concierge ser­vices.
• Con­duct­ing guest tours and out­ings.
• Pro­vid­ing meals and enter­tain­ment (includ­ing pro­vid­ing break­fast each morn­ing and/or enter­tain­ment at night).
• Pro­vid­ing trans­porta­tion.
• Pro­vid­ing oth­er com­mon “hotel-like” ser­vices.

A key fac­tor is that chang­ing the nature of the short-term rental into a busi­ness may have a pos­i­tive or high­ly neg­a­tive impact on your tax oblig­a­tions with­out prop­er plan­ning.

What about Mate­r­i­al Par­tic­i­pa­tion?

I wrote an arti­cle regard­ing Real Estate Pro­fes­sion­al Sta­tus that you may also find help­ful -> https://robertwlaw.com/property-law/real-estate-professional-status/96/

The IRS has a test for deter­min­ing Mate­r­i­al Par­tic­i­pa­tion. A tax­pay­er gen­er­al­ly must meet at least ONE (not all, or even more than one) of the mate­r­i­al par­tic­i­pa­tion tests in order to demon­strate mate­r­i­al par­tic­i­pa­tion and are as fol­lows:

1. The tax­pay­er investor par­tic­i­pates in the activ­i­ty for more than 500 hours dur­ing the year.
2. tax­pay­er investor’s par­tic­i­pa­tion in the activ­i­ty for the tax­able year con­sti­tutes sub­stan­tial­ly all of the par­tic­i­pa­tion in such activ­i­ty of all indi­vid­u­als (includ­ing indi­vid­u­als who are not own­ers of inter­ests in the activ­i­ty) for any giv­en year. If you hire oth­ers, that counts against this test.
3. The indi­vid­ual par­tic­i­pates in the activ­i­ty for more than 100 hours dur­ing the tax­able year, and such an tax­pay­er investor’s par­tic­i­pa­tion in the activ­i­ty for the tax­able year is MORE than the par­tic­i­pa­tion in the activ­i­ty of any oth­er indi­vid­ual (includ­ing indi­vid­u­als who are not own­ers of inter­ests in the activ­i­ty) for such year.
4. The activ­i­ty is a sig­nif­i­cant par­tic­i­pa­tion activ­i­ty for the tax­able year, and the individual’s aggre­gate par­tic­i­pa­tion in all sig­nif­i­cant par­tic­i­pa­tion activ­i­ties dur­ing such year exceeds 500 hours.
5. The tax­pay­er investor mate­ri­al­ly par­tic­i­pat­ed in the activ­i­ty for any five tax­able years (whether or not con­sec­u­tive) dur­ing the ten tax­able years that imme­di­ate­ly pre­cede the tax­able year
6. The activ­i­ty is a per­son­al ser­vice activ­i­ty, and the indi­vid­ual mate­ri­al­ly par­tic­i­pat­ed in the activ­i­ty for any three tax­able years (whether or not con­sec­u­tive) pre­ced­ing the tax­able year.
7. Based on all of the facts and cir­cum­stances, the indi­vid­ual par­tic­i­pates in the activ­i­ty on a reg­u­lar, con­tin­u­ous, and sub­stan­tial basis dur­ing such a year.

In order to qual­i­fy, it’s very impor­tant to under­stand what par­tic­i­pa­tion means and does­n’t mean. One ques­tion I receive often is “does search­ing for prop­er­ties in the Mul­ti­ple List­ing Ser­vice (or oth­er places count?) Search­ing for new prop­er­ties to buy gen­er­al­ly does NOT count, and doc­u­men­ta­tion is once again, very impor­tant.

• Social Secu­ri­ty and Medicare Tax­es: Self-employed indi­vid­u­als must pay both the employ­er and employ­ee por­tions of Social Secu­ri­ty and Medicare tax­es (total­ing 15.3%). This can sig­nif­i­cant­ly impact your tax lia­bil­i­ty if your rental is clas­si­fied as self-employ­ment income. Again, it’s a poten­tial “gotcha” for those that don’t prop­er­ly plan and exe­cute the plan.

As you like­ly can tell, there are many fac­tors to nav­i­gate, and often tim­ing is an impor­tant cri­te­ria. For exam­ple, buy­ing a short-term rental near the end of the year can pos­si­bly make it eas­i­er for a giv­en tax­pay­er to meet at least one of the tests, while also enabling the same tax­pay­er to piv­ot away from all the work in future years.

Under­stand­ing depre­ci­a­tion treat­ment is impor­tant because the depre­ci­a­tion sched­ule depends on how the prop­er­ty is char­ac­ter­ized for any giv­en year. For exam­ple, the tax­pay­er may want to take greater depre­ci­a­tion against oth­er active income, and under­stand­ing HOW to enable it is one of the keys of suc­cess. Even if the depre­ci­a­tion changes in sub­se­quent years, prop­er plan­ning may be high­ly advan­ta­geous to a tax­pay­er who does­n’t oth­er­wise qual­i­fy to take pas­sive loss­es against active income, and/or wants to deduct more than $25,000 in a giv­en year.