Short-Term Rentals: 3 Tips to Avoid Tax Traps

A short-term rental property can be a highly profitable investment option, even for individuals who are new to real estate investing. 

Short-term rentals have become a popular way to earn extra cash. However, before you rush off to drop hundreds of thousands of dollars on that condo in Albuquerque, expecting a lucrative passive income stream, you should know that there are many challenges and factors to consider.

Not least among them are the federal and state tax implications; taxes on short-term rentals are not the same as on long-term rental properties, and the rules can be complex. Without the right information, you may find yourself at the bottom of a financial hole. 

Before you invest your money in a short-term rental property, take the time to consider these 3 tips that will help you avoid falling into common tax traps as a result of your investment. 

What is a short-term rental?

A short-term rental, sometimes called a vacation rental, transient rental, or resort dwelling unit, is generally defined as the rental of any property with a lease term of fewer than the standard length of twelve months. The exact maximum duration of the stay can vary based on the location, but often stays of less than thirty days fall under this category.

Property types can include single rooms, accessory dwellings like garage apartments or guest houses, condominiums or townhomes, or even entire single- or multi-family homes. Owners typically purchase these properties to rent them out for short stays and never intend to reside on the property. However, the IRS still considers a rental property a short-term rental if the owner does live there but occasionally rents it out for short periods of time.

AirBnB and Vrbo are popular examples of short-term rental services, but anyone can get into the game. In fact, there are many advantages to short-term rentals as opposed to other forms of real estate investment.

For example, you will usually get your money upfront as a direct cash transaction, which reduces the risk of tenants not paying rent. Additionally, you don’t have to deal with long-term tenants. The average monthly income can be higher than long-term rental properties, and you can market your property on existing platforms, like AirBnB.

Managing a rental property can become comparatively low-hassle over time with the proper maintenance team in place. On the other hand, short-term rentals require a significant amount of work up-front before you can hope to reach a stage of more passive income.

You can take steps to make things easier for yourself, such as…

Understand the 14-Day Rule

The 14-day rule is one of the most critical tax exceptions for a short-term rental property owner to understand.

To put it simply, this rule exempts you from tax liability on income you earn from your rental property, provided that you rent the property for no more than fourteen days during the course of the year and also use the property yourself for either fourteen days or more during the year, or at least 10% of the total days you rent it to tenants.

In this case, you don’t need to report any of the rental income (and cannot deduct any expenses as rental expenses). Expenses such as mortgage interest and real estate taxes that are allowable as itemized deductions on your tax return are still deductible.

Keep Excellent Records

Good record-keeping and documentation will make your life easier in almost any tax-related situation, and this case is no different. You should treat your short-term rental as a business, which means documenting every rental.

Whether your rental period is less than 14 days or more, be sure to carefully track each date on which a tenant occupied the property and any dates on which you occupy the residence yourself for personal use. This information is vital in separating personal from business expenses. (As I’ll discuss in the next section, you may be able to deduct most of your business expenses, but you’ll need to prove to the IRS that they are valid. It’s much easier to locate a record than it is to comb through a bank or credit card statement.)

In addition to proof of payment, you should also keep receipts, invoices, or any other written documentation of your purchases to show specifically what it was you were paying for.

It’s common to keep such records for at least three years from the date you file your first return as a short-term rental owner. You should also keep copies of your tax returns, 1099s, and W-2s indefinitely. If the IRS audits you, they could, in certain circumstances, choose to look at your expenses going up to six years back into the past, so having extensive records could prove essential to validating your deductions.

Utilize Deductions and Exceptions

You must report income and expenses related to the rental of your home, a room in your home, or a vacation home on your tax return. However, there are generally deductions available for “ordinary and necessary” costs that you incur while preparing and maintaining the property. Even better, if your property temporarily sits empty between tenants, you can still deduct those expenses while the rental is vacant.

Some deductible expenses include: 

  • Cleaning and maintenance
  • Insurance premiums
  • Property taxes
  • Utilities
  • Yard maintenance
  • Trash removal
  • Travel expenses
  • Advertising
  • Homeowner association or condo fees
  • Depreciation
  • Interest
  • …and more.

You can also generally deduct repairs. However, it’s important to note that there is a difference between repairs necessary to keep the property in good operating condition, like painting, fixing leaks, or repairing appliances, and home improvements, which add value to the property or prolong its life.

Examples of improvement include:

  • Adding a swimming pool.
  • Making additions to the structure.
  • Installing insulation or water filtration systems.
  • Modernizing the kitchen. 

Usually, you will have to capitalize and depreciate the cost of improvements over several years instead of deducting it in a given year. 

You must also allocate all expenses between personal and rental use. If rental costs exceed rental income, the ability to deduct a loss on your tax return depends on whether the property met the definition of a “home” for tax purposes. (You use a property as a home during the year if you use it for personal purposes more than the greater of 14 days, or 10% of the total days that you rent it to others at fair rental value.)

Suppose you used the property as a home. In that case, the IRS considers the property to be “mixed-use property” and limits the deduction for indirect expenses like insurance and utilities to rental income. Disallowed expenses carry over to the next tax year, and the limit remains even if you did not use the property as a home for that year. 

If the property had minimal personal use and qualifies as a rental property, an excess of expenses compared with income can generate a loss on your tax return. 

Finally, many short-term rental companies like AirBnB charge a guest-service fee, which they take from the rent paid by the guests. This fee is reflected in the 1099 form these companies prepare for the property owners and the IRS. If the number of days you have rented out your property in a year totals more than fourteen days, you can deduct this fee in its entirety from your reported rental income.

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Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.

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