August 1st 2024.
Let's take a moment to discuss Section 183 and how it relates to your short-term rental property during this summer season. You've probably been utilizing your property for rentals and may have even visited it yourself. This is a good opportunity to address the potential risks that come with connecting your short-term rental to Section 183.
For those who may not be familiar, Section 183 is a part of the tax law that prohibits deducting expenses from activities that are not pursued for profit. You may know this as the hobby loss limitation rule. However, it also applies to short-term rentals if you consistently lose money or have a string of losses in the early years.
In essence, Section 183 adds another hurdle to the already complex tax rules surrounding short-term rentals. It falls under the same umbrella as the Section 469 "passive loss limitation" rules and Section 280A "rental of vacation homes" rules. But the good news is that the risk of Section 183 falls entirely within your control. All you need to do is ensure that your short-term rental activity is pursued for profit.
But let's delve into the details because it's important to understand the specifics. The Section 183 Treasury regulations outline nine factors that are used to determine if an activity is engaged in for profit. I'll list these factors and urge you to consider each one carefully.
1. Manner in which a taxpayer carries on the activity: Is your rental activity conducted in a businesslike manner, similar to other profit-oriented activities?
2. Expertise of the taxpayer or his/her advisors: Do you rely on experts or have expertise in the rental business?
3. Time and effort expended: Do you devote significant time and effort to your rental activity, especially if it lacks personal or recreational aspects?
4. Expectation of appreciation in the value of assets used in the activity: Even if your rental doesn't produce an operating profit, will it result in a profit upon liquidation?
5. Success of the taxpayer in carrying on other activities: Are you someone who has a track record of success in other entrepreneurial ventures?
6. History of income and losses with respect to the activity: While initial losses may not be a problem, sustained losses over the years could be.
7. Amount of occasional profits earned: Occasional small profits may indicate a lack of profit motive, while occasional large profits or the possibility of a windfall profit may suggest otherwise.
8. Financial status of the taxpayer: If you have limited income or financial resources, it may be difficult to justify losing money in a rental activity.
9. Elements of personal pleasure or recreation: Deducting expenses from an activity that is considered a hobby by others could be problematic.
In the event of an audit, it's important to be able to point to several of these factors and confidently state, "See that? And that? And that? That's evidence of my profit motive." Because the challenge with Section 183 and short-term rentals is convincing the IRS that your rental activity was pursued for profit.
The Section 183 regulations provide examples of activities that are likely to qualify and those that are not. It's important for tax professionals to be aware of these examples when working with clients who may be at risk of losing their deductions. But I'll highlight a few situations that could either strengthen or weaken your argument for pursuing profits.
In situations that weaken your profit motive argument, you may only rent the property infrequently or for short periods of time compared to other rentals in the area. Perhaps you consistently operate at a loss or only have one rental property. Your property may have sentimental value as a family legacy, or it may be filled with personal items and photos. Or, if you convert your rental to personal use after a year or two, this could also be problematic.
On the other hand, situations that strengthen your profit motive argument include expecting or already experiencing significant gains from the sale of the property, utilizing cost-segregation studies for deductions and losses, having comparable rental numbers to other properties in the area, or owning multiple short-term rentals that you cannot personally use or enjoy.
In conclusion, if you're investing in short-term rentals as a way to grow your wealth and save pre-tax money, similar to investing in 401ks or IRAs, then you are clearly pursuing profits and should be safe from Section 183 limitations. However, it's important to have proper documentation to support this. But if your goal is to simply afford a second home for personal use, unfortunately, Section 183 will likely limit your deductions.
If you're interested in learning more about short-term rentals, I recommend checking out some of our other articles on the topic, such as Vacation Home Rental Traps, Surviving Short-term Rental Audits, and The Vacation Rental Tax Strategy. These can provide further insight and guidance on how to navigate the complex tax rules surrounding short-term rentals.
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