How Short-Term Rentals are Taxed

Short-term rental properties are becoming a popular addition to many real estate investment portfolios. However, investors often have questions about how these properties fit into their tax and legal structures. Understanding how short-term rentals are taxed is crucial for maximizing benefits and ensuring compliance with IRS regulations.

IRS Classification of Short-Term Rental Properties

The IRS recognizes four (4) types of short-term rental properties:

1. Business Short-Term Rentals with Material Participation

2. Passive Short-Term Rentals Without Material Participation

3. Passive Rentals with Material/Active Participation

4. Passive Rentals Without Material/Active Participation

These classifications depend on three key factors, which directly impact how your short-term rental income is taxed:

1. Average Rental Days per Tenant

The IRS uses a seven-day rule to classify rental income:

• If the average stay is less than 7 days – You can report the rental income on Schedule E (like a long-term rental). The income is not subject to Self-Employment Tax (FICA). If you meet material participation requirements, you may qualify for Ordinary Loss Treatment.

• If the average stay is more than 7 days – The income is still reported on Schedule E and not subject to Self-Employment Tax. However, Ordinary Loss Treatment is not available, even if material participation is demonstrated.

Example: If you rented out your cabin 21 times in a year for a total of 108 days, you would divide 108 by 21 renters, resulting in an average stay of 5.14 days. Since this is under seven days, it falls into the less than seven-day rental category.

2. Substantial Services and Business Classification

Providing substantial services to guests can change your tax obligations:

• If you provide substantial services, you must report your rental income on Schedule C, and it will be subject to Self-Employment Tax (FICA). In this case, forming an S-Corporation can help mitigate FICA tax liability.

• If you do not provide substantial services, you can report income on Schedule E, which is not subject to Self-Employment Tax. You may also qualify for Ordinary Loss Treatment if you meet material participation rules.

Examples of Substantial Services:

• Daily cleaning of the rental while occupied

• Changing linens daily for the same guest

• Concierge services, tours, or entertainment

• Providing meals or transportation

• Offering hotel-like services

Since the IRS has limited guidance on what constitutes substantial services, investors should be cautious when adding guest amenities to avoid triggering business taxation.

3. Material Participation and Passive Loss Treatment

To deduct rental losses as ordinary losses, a taxpayer must meet at least one of the seven IRS material participation tests:

1. 500+ hours of active participation in the rental activity during the year.

2. Substantially all of the participation in the rental comes from the owner.

3. 100+ hours of participation, more than any other individual.

4. Significant participation across multiple rental properties, totaling 500+ hours.

5. Material participation in the activity for five of the last ten years.

6. Material participation in a personal service activity for three years.

7. Regular, continuous, and substantial participation based on all facts.

Meeting one of these criteria allows rental losses to be deducted against other income, enhancing tax benefits.

Short-Term Rentals on Schedule E or 8825

If you do not provide substantial services, you can report your income as passive income on Schedule E, which is advantageous because:

• Income is not subject to self-employment tax.

• You can provide certain insubstantial services without losing Schedule E status:

  • Heating, air conditioning, and utilities

  • Internet and Wi-Fi

  • Cleaning of common areas

  • Routine maintenance and trash collection

  • Payment of HOA dues

Personal Use of the Property

Personal use does not automatically disqualify a rental property from tax benefits. However, if personal use exceeds 14 days or 10% of total rental days, the property is considered a personal residence, limiting deductions.

Important Tip: If you stay at the property for maintenance or upgrades, keep detailed records of tasks completed. These "fix-up days" are not considered personal use and may allow deductions for travel, dining, auto expenses, and tools.