Over the past few years, we’ve seen a huge uptick in the number of clients renting out their homes (or second homes) as vacation rentals. The growth of the sharing economy has catapulted vacation rental sites -- Airbnb, HomeAway, VRBO, etc. -- and led to an increase in property owners in popular vacation spots listing their homes as a way to earn extra money while saving on taxes.
Unfortunately, as the summer rental season winds down, many vacation homeowners are realizing that the tax savings they’re going to see may not be as good as they first expected.
Property owners often think that renting out their homes is, in essence, a passive second business, eligible for the qualified business income deduction (QBI) -- or Section 199A in the Tax Cuts and Jobs Act. That’s certainly logical, but it’s just not that simple.
The idea of designating your rental home a “business” is a new idea. Before the TCJA, most property owners didn’t want their rentals to be considered a business because doing so would have subjected them to self-employment taxes -- at a hefty 15.3% tax on net income. Vacation homeowners did virtually everything they could to avoid being labeled a business, including not providing substantial services to guests.
The QBI deduction changed their perspective. Under Section 199A, a business owner can realize a tax savings of up to 20% on business income, and half of the 15.3% self-employment tax can be claimed as a deduction on the owner’s income tax return. Qualifying for the QBI safe harbor was suddenly very attractive.
But, here is where it gets complicated: Barely anyone in the rental game does the work necessary to prove they are a trade or business.
To qualify for the QBI safe harbor, you have to meet some rigorous requirements, including a mandate that vacation rental owners spend at least 250 hours in the calendar year providing rental services (see below). You must log all the hours spent in the home by the various parties, as well as all services performed with respect to the rental and who performed them. In cases where vendors are hired — think landscapers, housekeepers, and maintenance companies — the property owner should file a Form 1099 for each vendor (for payments of $600 or more) if trade or business status is desired.
Rental services can be performed by the owners or by their employees, independent contractors, or agents and would include things like:
- General operation, maintenance, and repair of the property
- Purchasing materials
- Property management activities
- Supervising employees and contractors
- Advertising the property for rent
- Tenant selection and background checks
- Negotiating and executing leases
- Collecting and depositing rent
Activities excluded from the definition of rental services include:
- Time spent traveling to and from the property
- Reviewing financial statements or operational reports
- Financial or investment management (for example, financing)
- Procuring or acquiring property to rent
- Planning, managing, or constructing long-term capital improvements
Who keeps track of all this? Virtually no one. So, when tax time comes, we simply don’t have the paper trail necessary to claim the deduction. Clients sometimes think we can just set up an S corp or LLC to operate the vacation property, but that won’t automatically qualify the home rental “business” as a business in the eyes of the IRS.
Pro tip: Don’t fudge it. IRS can request to view these records, and you’ll be in a heap of trouble if you get caught falsifying your time. If you own property and aren’t hitting the 250-hour threshold, or if you’re not putting in the work to prove the property’s business status, look for tax savings somewhere else. The IRS is getting better and better at identifying “side hustles” in the sharing economy. Do not claim any deductions on the hope you won’t be audited.
By all means, take deductions, including QBI, where you can, but always put in the work necessary to substantiate them. You can’t just list your house on Airbnb, collect rent, and think you’re entitled to a huge tax break. Rental taxes and deductions are far more complicated than that.
If you need help, we’re here for you.