Short-term rental properties are more popular than ever. Online services like Airbnb have made this possible. But how are tax losses from short-term rentals handled? Can the taxpayer use the rental losses to offset their non-rental income for tax purposes? The court addresses one aspect of these rules in Eger v. United States, 18-cv-00199-DMR (N.D. Cal. 2019).
Facts & Procedural History
This case involved a dispute over rental real estate expenses for the 2007-2009 tax years. The taxpayer owned several rental properties.
The properties produced tax losses in 2007-2009. Presumably the losses were used to offset the taxpayer’s non-rental income.
This was possible as the taxpayer (1) qualified as a real estate professional for the passive activity loss rules and (2) elected to group his rental real estate so they counted as one property for the passive activity loss rules.
The IRS typically challenges the real estate professional tax election. It also challenges the taxpayer’s passive activity loss grouping decisions. In this case, the IRS just challenged the taxpayer’s grouping decisions. It only did so for three of the taxpayer’s properties, however.
The three properties involved in the dispute were subject to management agreements. The agreements basically provided that the property managers were to rent out the properties and the taxpayer reserved a very limited ability to use the properties. Despite having some ability to use the properties, the taxpayer only used one of the three properties and only for a few days.
The IRS argued that these three properties did not qualify as rental properties and, as such, they could not be grouped with the other rental properties.
The question for the court is whether short-term rentals, such as Airbnb rentals, can be grouped with other long term rental properties.
The Passive Activity Loss Rules
The passive activity loss rules were enacted in the late 1980s in response to the perception that wealthy taxpayers were using real estate to produce artificial tax losses.
The income tax rates were much higher. Those with high incomes had a significant incentive to hire tax attorneys to find creative ways to reduce their taxes. Many of these solutions involved debt-financed real estate.
The passive activity losses are nuanced, but many taxpayers can plan around them. Many of the planning opportunities require the taxpayer to make an election to group properties. This allows the taxpayer to treat the grouped rental properties all as one property for purposes of the passive loss rules.
The Passive Loss Grouping Election
The general grouping rule is pretty simple. It says that rental properties can be grouped together if they form an appropriate economic unit for purposes of determining gain or loss. What is an appropriate economic unit?
The regulations provide a number of factors that are to be considered. The factors consider:
- Similarities and differences in the types of activities,
- Extent of common control,
- Extent of common ownership,
- Geographic location of the activities, and
- Interdependence between activities.
All of the factors are not necessary and whether activities are grouped as an economic unit depends upon the facts and circumstances.
Limited Use, Not a Rental Activity
The passive activity loss rules go on to say that a rental activity is not treated as a rental activity if the average period of customer use of the property is seven days or less. These short-term rental activities are not treated as rental activity. But this limit only applies if the “customer” does not use the property for an average of seven days. Who exactly is the “customer?” This is the question answered in the Eger court case.
In Eger, the taxpayer argued that the “customer” was the property manager for his three properties. This argument is premised on the property manager having a contractual right to access and use of the three rental properties. This use was to rent the properties to others and it also included a few days of personal use for the property managers.
The IRS argued that the term “customer” means the end users who rented the properties. The IRS discounted the property manager’s right to use the property by characterizing the contracts between the taxpayer and the properties managers as marketing agreements.
The court agreed with the IRS. It reasoned that the property managers did not have the continuous right to use the properties. The court noted this language in the property management agreements. The court also noted that the taxpayer retained significant rights to use the properties–concluding that the taxpayer did not convey exclusive access rights to the property managers.
Planning for Sort-Term Rental Properties
This court case sheds light on how to treat tax losses from properties that happen to be rented for short periods of time, such as Airbnb rentals.
With the taxpayer’s setup in Eger, the short-term rentals should have been handled by a property manager. That part was done. According to the court case, the property manager should have been assigned exclusive right to use the properties. Also, the taxpayer should not have retained rights to use the properties personally.
Given the court’s analysis, it would seem that these changes would allow the rental properties to count as rental properties for the passive loss rules and to be grouped with other loss-producing real estate in which the taxpayer qualifies as a real estate professional.
This case shows that a little tax planning can go a long way in avoiding tax disputes.