Tax Guide for Vacation Rentals

If you own a condominium, cottage, cabin, lake or beach home, ski lodge, or similar property, tax law might consider your property a hotel. You generally get hotel treatment when the average period of customer use is seven days or less.

The purpose of this article is to alert you the tax issues that surround a vacation-home hotel.

Average Rental Seven Days or Less

If the period of average rental is seven days or less, and you provide significant services, like clean sheets, towels, and maid services, you have a vacation hotel. We reviewed the IRS audit guide for some tips on how the vacation hotel classification brings good news and bad news, as follows:

Good News

• The law treats your hotel as a business, not as a rental property.
• You report the income and deductions on schedule C of your tax return.
• Losses are fully deductible if you “materially participate” in the activity.
• Your losses reduce the self-employment taxes you pay on your other Schedule C businesses.
• You can have personal use of your vacation hotel for up to the greater of two weeks or 10% of the days rented and still retain your vacation hotel status.
• Sale of a vacation hotel is the sale of Section 1031 business asset, giving you the best of both worlds: If you sell at a profit, your profit is a capital gain; if you sell at a loss, your loss is an ordinary loss.

Bad News

• If you fail the ” material participation” test for your vacation hotel business, your losses on this hotel are not deducible against your ordinary income. Instead, the losses go into a passive-loss suspension bucket and carry forward for possible use the following year and years after. At the time of sale, any suspended losses may be deducted.
• The rental deduction of up to $25,000 for “active participation” in a rental property is not available for a vacation hotel.
• Operating profits are subject to the self-employment tax.
• If personal use exceeds the greater of 14 days or 10% of the days rented, your hotel loses its business status and becomes a personal residence.
• If anyone other than unrelated paying customers use your vacation hotel, you need to learn the personal-use rules. The law considers use by your relatives, even those relatives who pay fair market rent, as personal use by you, Further, charity use of your unit counts as personal use by you.
• If the passive loss rules destroy your loss deductions, the IRS does not allow you to change your mind and move your mortgage interest and property taxes from Schedule C business expenses to Schedule A as itemized deductions for a second home.

Material Participation Issues

• You must materially participate to deduct any tax losses from your hotel activity.
• Use of a management firm makes material participation less likely.
• Use of a management firm increases the possibility that you will not be involved in day-to-day activities, and that lack of involvement will cost you any claim of investor time for material participating purposes.
• The IRS questions whether drive time counts for material participation purposes, and the court in Toups denied drive time as material participation time. In its audit guidelines, the IRS instructs its agents and auditors to check with the chief counsel’s office for guidance. Consider meeting the material participation tests without drive and travel time.

IRS Audits Tactics

• The IRS uses the initial interview to secure a statement from you as to hours worked and activities performed on you vacation hotel. This means the initial interview is perhaps your most important interview in this audit.
• You need to get your proof of material participation time in good order and technically correct before your first audit interview.
• You should have a record of the time you spent on this hotel activity.
• Your record of time spent should be made on a timely basis (kept at least weekly).
• As you do for the mileage record on your vehicle, you can keep a test record for three months in a row if that record reflects the average time spent during the year.
• In the initial interview, the IRS is going to scrutinize your travel time to ensure that the primary purpose of your travel is business. Make sure that your travel records are in good shape.
• You will make a major mistake if you wait until after the initial interview to learn the rules.
• The hours you spend as an investor reading reports and otherwise monitoring operations does not count for material participation purposes UNLESS you are directly involved in day-to-day management operations.
• The IRS has learned that taxpayers seldom study the rules until after the initial interview, meaning that poorly informed taxpayers admit much in the first interview and then pathetically try to change their stories after they learn the rules (this is usually too little, too late).