Homeowner Tax Topics SIX WAYS YOU CAN HELP CUT YOUR HOMEOWNER’S TAXES
By Jon Cunningham, CPA
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roperty managers get all kinds of questions from homeowner clients, and sometimes these are tax and financial questions. Homeowners may share tax-relevant information with you. Listening for a few key topics or phrases may help guide them to a much better financial result—and that is what great property management is all about.
This guide introduces a few critical and advanced tax topics that often affect vacation rental owners. Vacation rentals are particularly complex from a tax perspective, so be sure you or your clients engage a CPA or other qualified professional for advice specific to their situation. This introduction is intended to help recognize potential opportunities and initiate a discussion rather than reach any conclusions or recommendations.
The article is written from the perspective of individuals who own property directly or through a single-member LLC (including LLCs owned by married couples). Partnership tax often has similar implications, but partnership taxation is even more complex, beyond the scope of this article. S corporations are not covered because, as you will read, real estate should (almost) never be held in an S corporation.
1. Should they be taxed as a business or as an investment? Believe it or not, property managers often make decisions and set policies that cause a vacation rental to be classified as a business instead of an investment. The tax implications for the owner can be substantial. A rental will be considered a business, and it will be filed on Schedule C in the following situations. Otherwise, they will be taxed as an investment using Schedule E. (See IRS Publication 925 for more).
Rule
Average Length of Stay (ALOS)
Nature of Personal Services Provided
7-Day Rule
7 days or less
Any
30-Day Rule
Open Rule
52
30 days or less
Any
Significant—Significant personal services would include things like laundry services, towel service, and cleaning and linen service during the stay. The more it “feels” like a hotel instead of a condo, the more likely the services are to be viewed as “significant.” Extraordinary—Extraordinary personal services generally cover situations like hospitals or dormitories where the lodging is incidental to the larger purpose of providing medical care or education.
VRM Intel Magazine | Summer 2021
Generally, vacation rental owners will fall under the 7-day rule or 30-day rule. The open rule typically will not apply to vacation rentals. Property managers can affect the tax treatment their homeowners face by setting the average rental duration to be over or under seven days. They may also adjust the service bundle to be significant or not. Generally speaking, owners of a property operating at a loss will prefer to be taxed as a business, whereas those reporting a profit will prefer to be taxed as a rental or investment. The difference can be substantial. Taxed as a Business (Schedule C)
Taxed as an Investment (Schedule E)
Loss Making
Losses reduce other income, including W-2 wages, dollar for dollar. Noncash expenses such as depreciation count.
Losses offset only other investment income. Losses greater than investment income, plus $3,000 of ordinary income, must be carried forward to a future year.
Profit Making
Profits are fully taxable at the taxpayer’s highest tax bracket. And the taxpayer must pay self-employment tax (15.4 percent of the first $137,700 in 2020).
Profits are fully taxable at the taxpayer’s highest tax bracket. Net investment income tax may apply for income over certain thresholds (3.8 percent rate).
2. Help Them Qualify For a 20% QBI deduction The 2017 Tax Cuts and Jobs Act created a significant 20 percent deduction for most income generated by entities other than C corporations. Rental real estate considered a “trade or business” qualifies for QBI, assuming the other general requirements are met. However, as discussed above, determining if a vacation rental is a trade or business is not always easy. In 2018, the IRS published regulations clarifying a QBI Safe Harbor that, if met, allows most vacation rentals to receive the QBI deduction. The safe harbor requires the following:
B The taxpayer (your client or you on their behalf ) must keep separate books and records of income and expenses.
C 250 or more hours of rental services are performed annually, by the owner or someone working on the owners’ behalf—such as housekeeping, property management, supervision, maintenance work, billing, booking, or collection of payment.
D The 250 hours must be documented with contemporaneous records showing hours of service, description of service(s), the dates of service, and the person(s) who performed the service. E Hours may be aggregated across multiple properties that have been designated in advance as a group by the taxpayer.