I had just completed all 3 installments of my HGTV “You Won the Dream Home” series and was satisfied with myself. It was a witty, informative series on a timely tax topic.
And then one night I woke up and couldn’t get back to sleep because something was nagging at my mind. Specifically the Section 469 passive activity rules that apply to short-term rentals of houses. It’s the stuff of nightmares and it threw a wrench into my plan of what I would do if I won the Dream Home, which was rent it out as a vacation condo. Oh, the horror of the Internal Revenue Code! The horror!
Then further terror struck on January 26th when a website visitor mentioned that local covenants prohibit short-term rental of the home, thus completely obliterating my master plan. Read all about it in Part 4.
But what if you could rent out the Dream Home as a short-term vacation condo? What would the tax consequences be? Well, it wouldn’t be pretty. Since we know now that we can’t do a vacation condo situation with the Dream Home, the rest of the article will instead focus on a hypothetical house that we are renting out as a vacation condo.
What in the World Am I Talking About?
I wrote the first 3 parts of this series, and made my initial decision that I would rent out the Dream Home if I won it, because I thought (before my middle-of-the-night revelation) that regular rental property rules would apply.
Normally, renting out a house provides tax benefits. If your income is below certain limits, you can deduct up to $25,000 of rental losses each year. In Part 3 of this series, I estimated that the yearly losses from renting out the Dream Home would likely be at least $30,000. (Losses greater than $25,000 are carried forward to future years.)
Unfortunately, vacation condos are oftentimes not considered actual rental properties.
Enter Treasury Regulation 1.469-1T(e)(3)(ii)(A), which states that a rental activity is not a rental activity if “The average period of customer use for such property is seven days or less.” This poses a problem for vacation condos because the average customer stay is likely to be 7 days or less.
Instead of being a rental property, the house becomes a business property. This sounds good on the surface, right? There are no deduction limits on losses from businesses. Right? WRONG.
More Section 469 Nightmares
Business activities are subject to the Section 469 “passive activity” rules. Unless you “materially participate” in your business or you have net income from other passive activities, you can’t deduct business losses. The losses accumulate each year and can be deducted in full when you sell the business. But until then, you’re stuck with no loss deductions.
In the situation of renting out our hypothetical vacation condo where no local covenant restrictions apply, you would have to meet one of these four requirements in order to materially participate and therefore be able to deduct your business losses in full:
- You do all the work. Or…
- You hire a management company but also work more than 500 hours in the business yourself. Or…
- You hire a management company but also work more than 100 hours yourself AND more hours than anyone else. Or…
- You work more than 100 hours and can meet the “facts and circumstances” test (this is almost impossible to pull off).
Unless you can do one of these things, your yearly deductible loss from renting out the vacation condo would be $0.
It’s All Hypothetical
Remember, this is all hypothetical as it relates to the Dream Home, because of the covenants against short-term rental of that particular house. But this does illustrate the tax conundrums faced by people who own vacation condos.
I’ll put a wrap on this entire HGTV Dream Home series in Part 6, coming soon….