Tom Talks Taxes - August 14, 2023

Another short-term rental loophole that you need to know

I’m excited to welcome back Natalie Kolodij, EA, CRETS as a Tom Talks Taxes contributor. Natalie is an Enrolled Agent focusing on tax reduction strategies for those building wealth through real estate, as well as a national tax educator and real estate tax subject matter expert. Visit www.cretaxstrategist.com/certification and @re_tax_strategist on all social media channels.

There is no way around it: §469, which contains the passive activity rules, is one of the most complex provisions in the Internal Revenue Code. §469 restricts a taxpayer’s use of passive activity losses and credits against nonpassive income.

Under §469(c)(1), a passive activity is any trade or business activity in which the taxpayer does not materially participate. However, §469(c)(2) states that all rental activities are passive, regardless of the taxpayer’s participation level.

A fundamental way to get around this passive taint is the short-term rental. Treas. Reg. §1.469-1T(e)(3)(ii)(A) excludes an activity involving the use of tangible property as a rental activity for §469 purposes if the average period of customer use is seven days or less. Thus, if a taxpayer materially participates in a short-term rental, the activity is nonpassive, and §469 does not restrict its losses, if any.

The original “short-term rental loophole” pairs a short-term rental in which the taxpayer materially participates with a cost segregation study to create a large one-time nonpassive loss that can offset other income on the tax return. This generates a one-time significant reduction in tax; the taxpayer can then invest those funds in real estate or other investment venues to generate income.

While cost segregation is merely an acceleration of depreciation deductions, the time value of money concept paired with investment returns can make this a winning strategy for the right taxpayer. Plenty of tax strategies can be used to mitigate later §1245 recapture and unrecaptured §1250 gain, such as capital loss harvesting, §1031 exchanges, and step-up of basis upon death.

The other “short-term rental loophole” is rarely considered, and once Natalie and I discussed how it worked, we realized it is an essential planning tool for those working with real estate investors.

Let’s use a common scenario to demonstrate it: a taxpayer has a passive, long-term rental activity for six years. Over those six years, they have accumulated $65,000 of passive losses they cannot use since they have no other passive income, and they cannot use the §469(i) active participation exception due to income limitations.

It’s January 1, 2023, and the property was vacated in December 2022. The taxpayer converts it to a short-term rental for tax year 2023 and has a net income of $35,000 from the short-term rental activity. For §469 purposes, the $35,000 is nonpassive because the owner materially participates in the short-term rental.

The short-term rental net income can be offset by prior suspended passive losses from the same activity; therefore, in tax year 2023, the net taxable income from the short-term rental is $0, and $30,000 of suspended passive losses from that rental activity carry forward to tax year 2024.

This is explicitly allowed under §469(f), which relates to former passive activities. A former passive activity is any activity that is not passive for the current tax year but was passive in any prior tax year. When an activity is a former passive activity, any unused deduction or credit from that activity may offset the income from that activity in the tax year(s) that it is not a passive activity. The unused loss or credit must be from the same activity.

According to Treas. Reg. §1.469-9(e)(2), the former passive activity rules also apply to rental activities that are nonpassive due to the taxpayer qualifying for real estate professional status and materially participating in those activities. They also apply to the new activity formed when all rental activities are grouped under §469(c)(7)(A) for purposes of real estate professional status. Treas. Reg. §1.469-9(e)(1) states that

Each separate rental real estate activity, or the single combined rental real estate activity if the taxpayer makes an election under paragraph (g), will be an activity of the taxpayer for all purposes of section 469, including the former passive activity rules under section 469(f) and the disposition rules under section 469(g).

Treas. Reg. §1.469-9(e)(4) provides an example of how the former passive activity rules apply to the real estate professional:

Taxpayer B owns interests in three rental buildings, U, V and W. In 1995, B has $30,000 of disallowed passive losses allocable to Building U and $10,000 of disallowed passive losses allocable to Building V under § 1.469–1(f)(4). In 1996, B has $5,000 of net income from Building U, $5,000 of net losses from Building V, and $10,000 of net income from Building W. Also in 1996, B is a qualifying taxpayer within the meaning of paragraph (c) of this section…

Effective beginning in 1996, B makes the election under paragraph (g) to treat the three buildings as a single rental real estate activity. B works full-time managing the three buildings and thus materially participates in the combined activity in 1996 (even if B conducts this management function through a separate entity, including a closely held C corporation). Accordingly, the combined activity is not a passive activity of B in 1996. Moreover, as a result of the election under paragraph (g), disallowed passive losses of $40,000 ($30,000 + $10,000) are allocated to the combined activity. B's net income from the activity for 1996 is $10,000 ($5,000−$5,000 + $10,000). This net income is nonpassive income for purposes of section 469. However, under section 469(f), the net income from a former passive activity may be offset with the disallowed passive losses from the same activity. Because Buildings U, V and W are treated as one activity for all purposes of section 469 due to the election under paragraph (g), and this activity is a former passive activity under section 469(f), B may offset the $10,000 of net income from the buildings with an equal amount of disallowed passive losses allocable to the buildings, regardless of which buildings produced the income or losses. As a result, B has $30,000 ($40,000−$10,000) of disallowed passive losses remaining from the buildings after 1996.

When a tax preparer encounters a taxpayer with suspended passive losses, they often take an “it is what it is” approach and simply continue advising the taxpayer that there is no choice other than accumulating passive losses.

When a tax planner encounters a taxpayer with suspended passive losses, they seek proactive ways to use those losses, often looking at either creating a passive income stream or disposing of the activity in a fully taxable transaction. The tax planner can now add the conversion to a short-term rental to their arsenal.

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