Airbnb and Taxes: What Future Landlords Need To Know.

So you looked around your house one day and noticed that you have extra room… an extra space to offer.

 

Then, you looked at your bank account 💸💸💸 and decided that you need to make good use of that extra space.

 

All of a sudden a light bulb appears above your head 💡… And you say to yourself – I’m going to rent this additional space on Airbnb, VRBO, Booking.com, Flipkey or something similar. Yea… that’s what I’ll do!

 

Well… that’s a great idea and it definitely will put some extra cash in your pocket, but for tax purposes… it’s not as simple as just renting out that extra space, deducting the expenses and reporting it on your tax return.

 

No buddy… not that simple at all.

 

When it comes to renting out a dwelling unit (just another fancy word for your home)… there are a few IFTTT’s (if this then that) rules that needs to be understood before the end results end up on your tax return.

 

So let’s dive on in shall we?

 

But, before we dive into all the juicy details about the all the rules and regulations… Let me give you some quick tips to get you started.

 

I still recommend, however, that you read this entire post as it will give you a lot of insights and understanding.

 

And here are the Quick Tips:

 

• If you are a “Host” you will receive a 1099-K.
• If you provide services like taking photos, translating, or anything other than renting the property, you will most likely receive a 1099-Misc
• For the 1099-K, you will report the total amount in box 1a as your gross income.
• For the 1099-Misc you will report the total amount in box 7 as your gross income.
• If you did less than $20,000 or 200 transactions, you may not receive a 1099-K. However, you are still required to report your income. Therefore, if you didn’t receive a 1099… Log into your Dashboard to get the amount of gross earnings to report.
• Keep impeccable records. Not just for receipts, but for days rented as well.
• Beware of Backup Withholding. If you fail to provide the companies adequate information, they are required by law to withhold up 24% of the payment. To avoid this, Fill out a form W-9 and submit it to them.
• Don’t forget to deduct your fees. Of course they charge fees – that’s how they make their money. Just make sure that what they charge you – you deduct!

 

Alrighty…

 

Now let’s get down to the nitty gritty.

 

The first item on the list is what is called the 14-day rule.

 

This rule states that if the home, room, property, etc is rented for less than 14 total days during the year… the income earned from that activity doesn’t have to be reported – not at all.

 

Yep. That’s exactly right.

 

That means that you can make money and not report it on your taxes legally. But, that also means that you cannot deduct any expenses associated with the rental as well. All regular expenses like mortgage interest, property taxes, etc can still be deducted, however.

 

So, the goal with this rule is to find someone who would be willing to pay you $1,000,000 for a 13 day stay at your location and you will be good to go!

 

Next is to determine which form needs to be used – either a Schedule C or a Schedule E.

 

By all accounts, a rental activity is considered to be a “passive” activity and 99.99% of the time is reported on a Schedule E.

 

However, if you provide what is called “substantial services” to your guest, the activity is no longer considered to be passive and therefore it needs to be reported on a Schedule C.

 

If you are curious to know the difference is between the two forms, seeing that they both will result in the same outcome, the answer is Self-Employment Taxes.

 

If you find that you need to report your rental income on a Schedule C, you will be paying self-employment taxes on the net income. As opposed to if you find that your income can be reported on a Schedule E, there will be no Self-Employment taxes.

 

So, now, you are asking yourself… what is considered to be “substantial services”? Well… let me tell you. 😁

Substantial services are services that include:

 

• Providing cleaning services while the guest is there
• Giving tours
• Providing meals and entertainment
• Providing transportation
• Providing concierge services
• Pretty much any services a Hotel would provide

 

However, providing the “necessary” services doesn’t count. Services like these are considered to be non-substantial:

 

• Free WiFi / Internet
• Heating and A/C
• Clean towels and soap
• General maintenance
• Trash collection
• Cleaning of the common areas
• You know… stuff that comes along with the home regardless

 

Also note that there is a provision in the tax law that states if the home was rented for an average period of less than 7 days during the tax year, it’s technically not considered to be a “rental property” and the taxpayer can choose whether or not to report the earnings or loss on a Schedule C or E. In my personal opinion, if, in this situation, there is a loss.. report it on a Schedule C. (Keep reading to find out why)

 

So, up to this point, if you have determined that either:

 

A) Your property was rented for less than 14 days during the tax year or

B) The income and expenses is going to reported on a Schedule C,

Then your reading ends here.

 

However…

 

If you have determined that neither one of the above apply to you, then you must read on.

 

Sorry. 😶

 

Ok, now that we know that we must report our earnings and expenses on a Schedule E, the next thing to determine is if the property is considered to be a rental property, personal property of both.

 

What’s the difference you ask? Let me explain:

 

A rental property is a property that is used 100% for rental purposes. Meaning that it is available to be rented for all 365 days (366 for leap years) at Fair Market Value. There are none to very few personal use days of that property. And if there are personal use days, they do not exceed the greater of 1) 14 days or 2) 10% of the rental days. This is also known as the Vacation Home rules (explained later).

 

Note: Renting to family and friends at less than FMV is considered to be a personal use day by the homeowner. Also if you rent to a family member for FMV on a temporary basis… that is also considered personal use.

 

Personal property is when you… well… use the property personally. Meaning that your personal use of the property exceeds the greater of 1) 14 days or 2) 10% of the rental days.

 

And Both is when you are using the home as both a rental property and as a personal property. This is when you occupy the property for all 365 days (366 for leap years) and you rent out a room at the same time. And this is where we really see the Vacation Home Rules come into play.

 

Now, let me explain the Vacation Home rules:

In a nutshell, the Vacation Home Rules states that you must prorate and allocate the expenses you incur between the personal and rental use when there is mixed use of the property. And if the amount of the expenses exceed the amount of the income (you take a loss), your expenses will be further limited.

 

To be honest with you… all of these rules are in place to limit the amount of losses you can take from a rental property / activity. So if you have a gain or a profit, you really don’t have to worry about most of this. The only thing you have to worry about if you have a profit is the proration of the expenses.

 

But, if you are projecting a loss… again… read on.

 

Ok, so now that we know all the rules and what they limit and how they work, the next thing to do is to see them in action!

 

Let’s look at some scenarios:

 

Scenario #1: Your rental days exceed the 14 day (sorry no tax free money), but your personal use days do not exceed the greater of 1) 14 days, or 2) 10% of total rental days.

 

In this scenario, your property would be considered to be a rental because you have very few personal use days.

 

This is the only scenario in which you are allowed to claim a loss (subject to the passive activity loss rules *explained later*)

 

All the rental income and expenses must be reported on the Schedule E and, of course, the expenses are going to have to be prorated between the personal use and rental use of the property.

 

Here are the formulas for getting the prorated amount:

 

1. Days Rented % = (Rental Use) / [(Rental Use + Personal Use)]
2. Area Rented % = (Sq. Footage Rented) / (Total Sq. Footage of Home)
3. Rental Use % = (Days %) x (Area %)

 

Note: Each scenario will determine which formula to use. You might use only one or all three.

 

Example: You own a second home. You use Airbnb to rent the home for 100 days and you use the home personally for only 13 days.  You get paid $20,000 from Airbnb for the rental. The home was vacant the rest of the 252 days.

Because the 13 personal use days was less than the greater of 1) 14 days or 2) 10% of the rental days (10 days), your home is considered to be a rental.

 

As a result, you will report the full $20,000 as income on the Schedule E and prorate the expenses accordingly. We will use the Days Rented % to determine the prorated amount.

 

Let’s assume for the year you had the following expenses for the entire home:

 

– Mortgage Interest & Property Taxes: $30,000

 

– Operating Expenses: $15,000

 

– Depreciation: $10,000

 

– Grand total for the entire home: $55,000

 

In this example you would only need to determine the percentage based on the days actually rented (because you did not use the home personally for all 365 days).

 

Using the Days Rented formula we would calculate the percentage like this – Rental days (100) + Personal days (13) = Total use days (113)

 

Therefore, the formula is this: 100 ÷ 113 = 88.49% (rounded)

 

So, therefore, you would be allowed to deduct 88.49% of the $55,000 which = $48,669.5

 

We can see that the allowable deductions would result in a loss that is fully deductible subject to the passive activity loss limitations (Discussed Later). Note that this is the only scenario in which you can deduct a loss.

 

Scenario # 2: Your rental days exceed 14 days and your personal use days is more than the greater of 1) 14 days or 2) 10% of the total rental days.

 

Here is where things get rather interesting. Because you rented your home for more than 14 days and used it personally for more than the greater of 14 days or 10% of the rental days, your home is now considered to be a personal residence.

 

And because of that, you cannot take any losses. Your expenses can only reduce your rental income to zero and not a penny below.

 

The good news is that the excess can be carried forward. The bad news is that in order to determine the amount that can be carried forward, there is a distinct order in which rental expenses can be deducted.

 

Here is the order:

 

1. First, deduct the mortgage interest, property taxes and insurance attributable to the rental (Category 1 expenses)
2. Then, deduct all the other operating expenses attributable to the rental except depreciation (Category 2 expenses), and finally
3. Deduct depreciation.  (Category 3 expense)

 

Example: You own a second home. You use Flipkey to rent the home for 75 days and you use the home personally for only 30 days. You get paid $10,500 from Flipkey for the rental. The home was vacant the rest of the 260 days.

 

Because the 30 personal use days was more than the greater of 1) 14 days or 2) 10% of the rental days (7.5 days), your home is considered to be a personal residence.

 

As a result, you will report the full $10,500 as income on the Schedule E and prorate the expenses accordingly. Again, we will use the Days Rented % to determine the prorated amount.

 

Let’s assume for the year you had the following expenses for the entire home:

 

– Mortgage Interest: $11,385

 

– Property Taxes: $2,539

 

– Operating Expenses: $1,980

 

– Depreciation: $4,167

 

– Grand total for the entire home: $20,071

 

In this example you would only need to determine the percentage based on the days actually rented (again because the personal use was not all 365 days).

 

Using the Days Rented formula we would calculate the prorated percentage like this – Rental days (75) + Personal days (30) = Total use days (105)

 

Therefore, the formula is this: 75 ÷ 105 = 71.43% (rounded)

 

So you would be allowed to deduct 71.43% of the $20,071 which = $14,336.72

 

However, that $14,336.72 will be limited to only the amount of income of $10,500. Meaning that only $10,500 of the $14,336 will be allowed as a deduction… which is where the deduction order comes into play.

 

Using the prescribed order, we would determine the allowable deduction and carry the remaining over as follows:

 

– Mortgage Interest: $11,385 x 71.43% = $8, 132 (Category 1)

 

– Property Taxes: $2,539 x 71.43% = $1,814 (Category 1)

 

– Operating Expenses: $1,980 x 71.43% = $1,414 (Category 2)

 

– Depreciation: $4,167 x 71.43% = $2,976 (Category 3)

 

Now that we have the figures for each category, we now apply each one against the income like so:

 

$10,500

– $9,946 (total category 1 expenses)

_______________________

= $554 (remaining to deduct)

– $554 (from category 2 expenses)

_______________________

= 0

 

Therefore, the carry over amount is going to be as follows:

 

– Category 1 = $0

 

– Category 2 = $860 ($1,414 – $554)

 

– Category 3 = $2,976

 

– Grand total carried forward = $3,836

 

There is another method in which this can be applied.

 

It’s called the Bolton method. Named after the 1982 Tax Court case Bolton v. Commissioner.

 

Under the Bolton method, the same exact rules apply, with the exception of how the prorated amounts are figured.

 

Using the Bolton method, as opposed to figuring out the proration using:

 

(Rental Days) ÷ [(Rental days) + (Personal Days)]

 

You’ll use:

 

(Rental Days) ÷ (365 days)

 

The benefit of doing it this way is that it is allowing you to have less category 1 expenses allocated to the rental income so that you can deduct more on your Schedule A. But as you can see… this requires some very serious tax planning. 🙂 

 

Scenario # 3: You reside in your home all year (365 days) and you just rent a room.

 

In this scenario, things are pretty much the same as they are in scenario # 2. You will not be allowed to take a loss and you still are going to have to figure out your rental use percentage, apply that percentage to all of your expenses and then deduct those expenses in order (category 1, then 2, then 3).

 

The only difference is the fact that for allocating the expenses, you now have to also figure the percentage based on square footage and then to rental expenses. So the formula is going to be in the following order:

 

1. Area Rented % = (Sq. Footage Rented) / (Total Sq. Footage of Home)
2. Days Rented % = (Rental Days) / (365 Days or 366 if Leap Year)
3. Rental Use % = (Days %) x (Area %)

 

Using the same information from scenario # 2 this is how it would look if you rented a space that was 120 sq. ft  and the entire home was 1000 sq. ft:

 

Total percent based off of Square Footage = 12% (120 ÷ 1000)

Total percent based off of Days Rented = 20.5% (75 ÷ 365)

 

So what that is saying is that you are only going to be allowed to deduct 20.5% of the allowed 12%.

 

Here is what that looks like mathematically:

(using the same numbers from scenario # 2)

 

– Mortgage Interest: $11,385 x 12% = $1, 366, then x 20.5% = $280 (Category 1)

 

– Property Taxes: $2,539 x 12% = $305, then x 20.5% = $63 (Category 1)

 

– Operating Expenses: $1,980 x 12% = $238, then x 20.5% = $49 (Category 2)

 

– Depreciation: $4,167 x 12% = $500, then x 20.5% = $103 (Category 3)

 

Now that we have the figures for each category, we now apply each one against the income like so:

 

$10,500

– $343 (total category 1 expenses)

_______________________

= $10,157 (remaining to deduct)

– $49 (from category 2 expenses)

_______________________

= $10,108

– $103 (from category 3 expenses)

_______________________

= Profit of $10,005

 

As you can see, from the calculation above, there will not even be a loss. You will actual have a gain.

 

The good news is that you will be able to deduct the remaining mortgage interest, property taxes and private mortgage insurance (Category 1 expenses) on your Schedule A.

 

Now, let me explain what the Passive Activity Loss Limitations Rules are.

 

In short, the passive activity loss limitations rules simply state that any activity that is a “passive” activity and generates a loss can only deduct that loss against passive income.

 

And since the tax code generally places all rental activities under that “passive” activity umbrella… all rental activities are subject to those rules.

 

There are exceptions to these rules however.

 

The first, is if you are a Real Estate Professional. If you are titled as such, you are allowed to take a full loss on your rental activities regardless of the amount.

 

A Real Estate Professional is defined as someone who meets both of the following requirements:

 

• More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate.
• You perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate.

 

The second, is if you “actively” participated in the management of the rental. If this is you, then you are allowed to take a loss of up to $25,000. Please note, however, that this loss is reduced by 50% of the amount by which your adjusted gross income (AGI) exceeds $100,000. As a result… the loss is completely eliminated when your AGI reaches $150,000.

Active participation is defined as participating in management decisions like:

 

• Approving new tenants
• Approving or denying rental terms
• Approving repairs and capital expenditures
• That kind of stuff.  

 

Ok… let’s take a deep breath!!!

 

I know that was a lot to take in.

 

So let me try to summarize all these rules and scenarios.  

 

Start Here: If you rented the property for 14 days or less, it’s considered to be a Non-Taxable Rental. The income from that rental is not reported and the associated expenses are not deductible.

 

Scenario # 1: If you rented the property for 15 days or more and your personal use days did not exceed the greater of 1) 14 days, or 2) 10% of total rental days, then you must report all the rental income and you can deduct the expenses in excess of income. Meaning you can take a loss subject the passive activity loss limitations rules.

 

Scenario # 2 & 3: If you rented the property for 15 or more and your personal use exceeded the greater of 1) 14 days, or 2) 10% of total rental days, then you must report all the rental income and the expenses can only reduce the rental income to zero – no losses can be taken.

 

Like I said in the very beginning:

 

it’s not as simple as just renting out that extra space, deducting the expenses and reporting it on your tax return.

 

And this entire article has proven that lol.

Hopefully this clears up a few things and offers some insight and new perspectives.

 

If you still need assistance I would suggest seeking the assistance of a Tax professional who is well versed in the area of rental properties.

 

Take care!