When is a vacation rental not classified as residential real estate? When it’s a short-term rental leased out for less than 30 days at a time, it’s recognized as nonresidential real property and therefore subject to a 39-year depreciation period, not residential real estate’s 27.5-year depreciation period. But since Sec. 179(b)(3) excludes property used to provide lodging (other than hotels) from being qualified for 179 energy deductions, short-term vacation rentals are ineligible for 179.
As a result, to mitigate tax liability, taxpayers would be wise to undertake a cost segregation study on their property so that they can (1) take bonus depreciation if possible, and (2) meet the passive activity loss (PAL) grouping rules, basis rules, at-risk rules and excess business loss to absorb the loss.
Residential or Nonresidential?
Most accountants consider a vacation rental residential real estate. After all, the IRS classifies vacation rentals as residential real estate, so CPAs depreciate their clients’ vacation rental properties over a 27.5-year depreciation period.
“How to Calculate Your Vacation Rental Property Depreciation,” an article published on Lodgify in March 2021, declares, “Vacation rental property tax depreciation is defined as recovering the cost of a property used as a business throughout its useful life (which is 27.5 years). [Emphasis added.]”
But there’s an exception. Under the transient rule delineated in Section 168(e)(2), if a vacation rental is leased for 30 days or less at a time to visiting tenants, it should be classified as nonresidential real estate. Under these special circumstances, the IRS now recognizes short-term vacation events as commercial real estate, which carries a 39-year depreciation. In other words, they’re not homes; rather, they’re classified in a similar fashion to hotels.
In the 2017 U.S. Master Depreciation Guide published by CCH Publications, the IRS, in paragraph 114, delivered this opinion on the status of vacation homes as nonresidential real estate:
“Condominiums and vacation properties. A condominium or other vacation property that is only rented for more than 30 days at a time by the owner should be treated as residential rental property as such use is not considered transient. However, in many cases a condominium or other vacation property is rented one or two weeks at a time to different persons. It appears in this situation such property should be treated as nonresidential real property, assuming that condominiums and other vacation properties (such as a lakefront home) are considered a type of ‘structure’ subject to the transient use limitation. [All emphasis added.]”
Here’s an example: A condominium is rented one week at a time to 12 different persons and is not used by the owner. In this case, there are 84 days of transient use (7 x 12) and no days of non-transient use. Since more than 50 percent of the total days of use is transient (100 percent are transient in this example), the condominium is considered rented on a transient basis and does not qualify as a residential rental building depreciable over 27.5 years.
The 179 Question
There’s another angle to this reclassification. If short-term vacation rentals are commercial real estate with a 39-year depreciation, wouldn’t they then also be eligible for IRS Section 179 deductions, like other commercial real estate properties? Regrettably, the answer is no. Section 179(b)(3) excludes property used to provide lodging, other than hotels, which immediately disqualifies short-term rentals.
How can taxpayers compensate for the loss of the 179 deduction? Commission a cost segregation study. Bonus depreciation could be a tax windfall that could dramatically offset tax responsibility. Your client may be able to receive a sizeable bonus depreciation in year one. Since bonus depreciation is allowable on any class life equal to, or less than, 20 years, by reallocating some of the building’s assets to a five- or 15-year lifespan, they would qualify for bonus depreciation. The 2017 Tax Cuts and Jobs Act allows for an immediate deduction for the full costs in the first year. Since many components can be written off after a cost segregation study, if your client’s purchase price was $10 million, they can deduct $3 to $4 million immediately (the 100-percent bonus depreciation signed into law by the Tax and Jobs Act).
Use Passive Activity Loss
Another method of counteracting the denial of 179 and taking the loss is for taxpayers to ensure they meet the passive activity loss (PAL) rules, as well as the basis limitation rules, at-risk rules and excess business loss rules. These rules can also limit the amount of any real estate tax loss.
The PAL rules were enacted in 1986 to prevent taxpayers from using real estate and businesses to generate huge losses to offset income taxes. Formerly, taxpayers could take any losses generated from passive income and apply them to offset taxes owed from nonpassive income. Now, if their modified adjusted gross income is less than $150,000 a year, they can report a passive loss up to $25,000. But if they earn over $150,000, the $25,000 deduction is denied them.
One way taxpayers can circumvent the passive activity loss rule is by grouping real estate gains and losses under Section 469 in one of two ways:
- First, they can group their rental property with other passive activities that produce income that they materially participate in if they share common characteristics, such as if their businesses are similar; if they share common control, common ownership, and/or geographical location; and if the activities are interdependent. To materially participate in an activity, a taxpayer must spend 100 hours a year on the activity, and the 100 hours must be more than any other person spends materially participating in the property.
- Second, taxpayers can group their rental with other passive activities that produce losses. If your client or their spouse is a real estate professional and they file a joint tax return, they and/or their spouse must spend at least 750 hours per year solely focused on operating and managing their rental properties in a hands-on fashion, or they must spend 50 percent of their time on their real estate business. Because the IRS often questions time for investor activities and travel, taxpayers must be extra cautious when it comes to these activities.
However, under the PAL rules, a short-term rental can be classified as a business rather than real estate. Page 26 of The IRS Passive Activity Loss Audit Technique Guide states:
“Under Reg. § 1.469-1T(e)(3)(ii), six types of activities normally defined as rentals are treated as non-rentalactivities, i.e., as businesses, in most cases. As a result, the active participation standard and the $25,000 allowance do not apply. [Emphasis added.] If the activity falls outside the rental definition, it ispassive or non-passive based on whether the taxpayer materially participates. Following are the six exceptions:
1. The average period of customer use is seven days or less. For example: condo rentals, short-term use of hotel/motel rooms and businesses that rent videos/tuxedos/cars/tools, etc.
2. The average period of customer use is 30 days or less and significant personal services are provided with the rental. Examples: hotels and motels.
3. Extraordinary personal services are provided with the rental. Examples: hospitals, nursing homes and boarding schools.
4. The rental is incidental to a non-rental activity.
5. The taxpayer customarily makes the rental property available during defined business hours for nonexclusive use by various customers. Example: golf courses, health clubs and spas.
6. The taxpayer provides the property for use in a non-rental activity of his own partnership, S Corporation or joint venture. The key word here is “provides,” not “rents.” For example: a partner contributes property in exchange for an ownership interest. This non-leasing transaction with the partnership is not a rental. Reg. § 1.469-1T(e)(3)(vii) states: “Thus, if a partner contributes the use of property to a partnership, none of the partner’s distributive share of partnership income is income from a rental activity…”
As a result of this interpretation, a taxpayer would not be considered as absorbing rental income or losses subject to the PAL rules. They would be receiving business income or losses not subject to the PAL rules.
Complying With Basis Issues
In accounting, the term “basis issues” refers to the amount (the basis) of a property that’s subject to taxation under law. Basis issues can make it more difficult to sell a property, because your client might take a bonus appreciation sum so large, it dwarfs their property’s real value. If they took a bonus depreciation and no basis remains, they must pay back the bonus depreciation if they sell.
As a result, if your client is unwilling or unable to pay back the bonus depreciation, they either have to hold onto their property or undertake a 1031 property exchange, where they swap their property and essentially do a “trade-in” on it. Or, they can sell the property, then buy another one in the same tax year and use the depreciation to offset the capital gains and/or the recapture tax.
Complying With At-Risk Rules
At-risk rules are tax shelter laws that limit the amount of allowable deductions a taxpayer can claim from engaging in at-risk activities that can result in financial losses. The rules are designed to guarantee that losses claimed on returns are valid and that taxpayers aren’t trying to manipulate their taxable income using tax shelters. If your client’s property investment has no risk or limited risk, they may be unable to claim any losses incurred when filing an income tax return.
At-risk basis is calculated by combining the amount of an investment in a property with any amount borrowed or made liable for regarding that property. If your client bought a $10 million property with a $9 million mortgage and they’re not at risk for the $9 million loan, they can only take 10 percent of their loss and must write off the rest of the loss in succeeding years.
Complying With Excess Business Loss Rules
An excess business loss is the amount by which total deductions exceed total gross income and gains, plus $250,000 (or $500,000 in the case of a joint return). Let’s say your client buys a small apartment complex for $10 million, which is split between the land and the depreciable property (the building): both are worth $5 million.
By undertaking a cost segregation study, your client can write off at least one-third of that depreciable property; let’s say it’s $1.5 million. Of that $1.5 million, they would take out $500,000 (their maximum allowed excess business loss if they filed jointly) and roll forward the remaining $1 million, which becomes a net operating loss carryforward. Under Section 461 as modified by the Tax Cuts and Jobs Act of 2017, they’re only allowed to take up to 80 percent of that sum to mitigate their tax obligation for future income.
For example, let’s propose that in year two, your client reports a $500,000 gain in income. They could apply 80 percent of that taxable income ($400,000) to their existing $1 million net operating loss carryforward. Over the next few years, they could use up that remaining $600,000 in net operating loss carryforward to offset further taxable income.
The notable news here is that short-term vacation rentals are considered nonresidential real estate and hence subject to a 39-year depreciation period. But since 179 deductions are denied to the owners of these rentals, they can find tax relief in a cost segregation study—as long as they satisfy the PAL rules, the basis rules, the at-risk rules and the excess business loss rules.