Sorry, You Can't Get There From Here: The Untenable Goal of Using Short-Term Rental Real Estate To Attain Real Estate Professional Status

Abstract

Is the owner of an inn or a bed and breakfast engaged primarily in the business of managing real property or primarily in the business of providing services to mainly transient customers? What about the owner of a vacation home who rents out the property on a daily or weekly basis during prime tourist season? How would you characterize Conrad Hilton, J. W. Marriott, and Jay Pritzker: as hotel entrepreneurs or as real property moguls? Does it really matter? It does in the complex world of passive activity losses.

This Article analyzes whether the law allows, and whether public policy should allow, taxpayers to count personal service hours they provide in connection with short-term rental real estate as hours of personal service they provide in association with a real property trade or business. This simple question matters because if a taxpayer has sufficient hours in real property trades or businesses, then subject to other restrictions not at issue here, the taxpayer may qualify as a real estate professional under I.R.C. § 469(c)(7). Real estate professional status is important in turn because professionals usually become eligible to deduct passive activity losses arising from their rental real estate activities. Conversely, taxpayers who are not real estate professionals must usually suspend their losses.

A 2013 case provides an example of the impact of this issue. In Hoskins v. Commissioner, a taxpayer sought to establish real estate professional status to overcome the Commissioner’s determination of $66,110 in deficiencies and penalties over two years.

In Hoskins, the taxpayer’s extensive real estate activities seemingly fit the profile of a real estate professional. The taxpayer maintained a Florida real estate sales license; worked “approximately 40 hours per week as an independent contractor assisting other individuals with selling, purchasing, and leasing homes;” “provided maintenance services for bank-owned properties [for] approximately 15 to 20 hours per week;” and owned four properties in Ohio and six properties in Florida. One of the Florida properties in 2006 and two in 2007 were vacation home rentals where the average customer stay was seven days or less. ” The rest of the properties were either not rented or were long-term rentals.

The parties and the court agreed that the short-term rentals “were not rental real estate because the average period of customer use was seven days or less during those periods.”13 The court concluded that those short-term rental real estate properties were “a trade or business or an income-producing activity.” Further, the court held that those short-term rental real estate properties were “not rental [real estate] activities for purposes of section 469(c)(2).” Consequently, the court excluded the taxpayer’s hours connected with the short-term rentals when reviewing the taxpayer’s contention that he was a real estate professional. Without those hours, the taxpayer failed to establish real estate professional status and the court sustained the Commissioner’s $66,110 deficiency determination. This example shows that the characterization of short-term rental real estate can have a significant impact on real estate professional status, which in turn can have a significant financial impact on a taxpayer.

Section II of this Article examines scholarly commentary from the tax community on this topic. Next, Section III will review the broader statutory, regulatory, and judicial framework. Section IV analyzes public policy. Finally, Section V concludes that it is clear that taxpayers may not count hours expended in short-term rental real estate as hours expended in a real property trade or business.

To preview an important part of the rationale for the conclusion, taxpayers involved in short-term rental real estate are not involved in a real property trade or business. Instead, according to Congress, they engage in a labor intensive service- oriented business. That is the distinguishing factor.

Consider ownership of a service business such as a barbershop, restaurant, car wash, golf course, or drive-in movie theater. Part of each customer’s fee is an offset of the owner’s expense of real property taxes and of maintaining the real property. In other words, to a greater or lesser extent, service businesses also manage, operate, or rent real property.

The main difference from rental real estate is the temporal length of the customer’s stay. Congress carved out a specific set of rules for hotels and other transient short-term rentals of real estate. In particular, Congress stated that these short-term rentals are service businesses, not rental real estate businesses.

The United States Department of the Treasury then set the temporal bar at seven days or less for purposes of passive activity losses. Consequently, for passive activity purposes, owners of short-term rental real estate properties are treated similarly to service business owners. In other words, they are tested on whether they are material participants in the trade or business, not whether they are real estate professionals.

In summary, the exception for a real estate professional is simply not available to owners of short-term rental real estate. Therefore, attempts to use short-term rental real estate as an activity for obtaining real estate professional status are misplaced. The statutory language of §469 supports this conclusion, as do opinions by the United States Tax Court. Moreover, this conclusion promotes good public policy.