Although rental activities are generally treated as “passive,” the following six activities are excluded from the category of rental activity and thus losses from the activities are not deductible under the $25,000 rental real estate loss allowance (10.2). The fact that these activities are not treated as rentals does not mean that the passive activity rules are inapplicable. Income or loss from these activities will still be treated as passive income or loss if you fail to meet one of the business material participation tests (10.6).
1. The average period of customer use of the property is seven days or less. Short-term rentals of vacation units, autos, videocassettes, tuxedos, and hotel and motel rooms are not considered rental activities if the average period of customer use is seven days or less. You figure the average period of customer use for the year by dividing the aggregate number of days in all rental periods that end during the tax year by the number of rentals. Each period during which a customer has a continuous or recurring right to use the property is treated as a separate rental.
A loss from a seven-day-or-less real estate rental activity is not eligible for the up-to-$25,000 loss allowance (10.2). Since it is not treated as a real estate rental activity, it may not be included in the election to aggregate rental real estate activities under the real estate professional rules (10.3).
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Planning Reminder
Short-Term Vacation Home Rentals
If you rent out a vacation unit for an average rental period of seven days or less at a loss, the loss is treated as a business (not rental) loss deductible from nonpassive income if you meet one of the material participation tests (10.6). If you do not materially participate, the loss is treated as a passive loss, deductible only from passive income. The loss does not qualify for the up-to-$25,000 rental loss allowance (10.2) because the property is not treated as rental property.
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EXAMPLE
The Toups purchased a cottage in Callaway Gardens, a vacation resort south of Atlanta, Georgia. The unit was rented for short-term periods of seven days or less during the year to resort guests. The resort’s operator was the sole managing and rental agent. Over a three-year period, they deducted net losses of $46,848. Under the seven-days-or-less rule, the activity was not a rental activity, but the IRS disallowed their losses as passive activity losses because they were passive investors who did not materially participate in the activity. The Toups argued that they materially participated, spending more than 300 hours each year preparing an annual budget and cash flow analysis and meeting with other owners to set rental fees and inspect the grounds.
The Tax Court sided with the IRS. The losses were passive because the Toups did not materially participate in the resort operation. They had nothing to do with running the resort on a day-to-day basis. Their activity was merely that of investors.
2. The average period of customer use of the property is more than seven days but is 30 days or less, and you provide significant personal services. Personal services include only services performed by individuals and do not include (a) services necessary to permit the lawful use of the property; (b) construction or repair services that extend the useful life of the property for a period substantially longer than the average period of customer use; and (c) services that are provided with long-term rentals of high-grade commercial or residential real property such as cleaning and maintenance of common areas, routine repairs, trash collection, elevator service, and security guards.
Note: For purposes of Exceptions 1 and 2, if more than one class of property is rented as part of the same activity, average period of customer use is figured separately for each class. The average period of customer use (as explained in Exception 2) is multiplied by the ratio of gross rental income from that class to the total rental income from the activity; see the Form 8582 instructions.
3. Regardless of the average period of customer use, extraordinary personal services are provided so that rental is incidental. In a rare case, it may be possible to avoid the passive loss disallowance rule by showing that “extraordinary personal services” were provided to tenants who rented the space primarily to obtain these services. IRS regulations give as examples the use by patients of a hospital’s room and board facilities, which is incidental to the medical services provided, and the use by students of school dormitories, which is incidental to the teaching services provided.
In one case, an attorney and her husband, a medical doctor, convinced the Tax Court that they met the “personal services” exception by providing legal support services to law firms who leased office space from their LLC. The attorney supervised three clerical employees in providing legal support services to the tenant firms, which included client intake, answering phones and taking messages, conducting legal research, typing briefs and memoranda, binding briefs, photocopying, taking dictation, express mailing, process serving, filing documents at the courthouse and state capital, maintaining a file room, law library, and conference facilities, and providing coffee service. Her husband provided consulting services to the attorneys, reviewing medical malpractice cases, serving as an expert medical witness, helping the attorneys prepare for accreditation reviews of health-care organizations, and providing quality assurance trainings.
Before the Tax Court, the tenant firms testified that these support services, particularly the legal research, were unique and that they would not have moved into the LLC’s building without them. The Tax Court held that the LLC’s leasing activity was not a rental activity under the extraordinary services exception, but the taxpayers still had to prove that they “materially participated” in the leasing/support activities to avoid passive loss disallowance for the rental losses. They did so by showing that at least 500 hours were spent working on the activity (10.6).
4. Rental is incidental to a nonrental activity. A rental of property is excluded from the rental activity category if the property is held mainly for investment or for use in a business. A rental is considered incidental to an investment activity if the principal purpose of holding the property is to realize gain from its appreciation and the gross rental income from the property for the year is less than 2% of the unadjusted basis or fair market value of the property, whichever is less.
A rental is incidental to a business activity if (1) you own an interest in the business during the year, (2) the rented property was predominately used in that business during the current year or during at least two of the immediately preceding five tax years, and (3) gross rental income from the property is less than 2% of the lower of the unadjusted basis of the property or its fair market value. Under test (2), a rental may qualify for the exception although it is not rented to the related business in the current year, so long as it was used in the business in two or more of the preceding five years.
EXAMPLE
Kyle Gail owns unimproved land with a fair market value of $400,000 and an unadjusted basis of $300,000. He holds it for the principal purpose of realizing gain from its appreciation. To help reduce the cost of holding the land, he leases it to a rancher for grazing purposes at an annual rental of $3,500. The gross rental income of $3,500 is less than 2% of the lower of the fair market value or the unadjusted basis of the land. The rental of the land is not a rental activity.
5. Providing property to a partnership or S corporation that is not engaged in rentals. If you own an interest in a partnership or S corporation and you contributed property to it as an owner, the contributed property is not considered a rental activity. For example, if as a partner you contribute property to a partnership, your distributive share of partnership income will not be considered as income from a rental activity. However, this exception will not apply if the partnership is engaged in a rental activity.
6. The property is generally allowed for the non-exclusive use of customers during fixed business hours, such as operating a golf course. The customers are treated as licensees, not lessees.
Where you conduct rental as well as nonrental business activities, you may not group a rental activity with a nonrental activity, unless they form an appropriate economic unit and one of the activities is considered insubstantial in relation to the other. No guidelines are provided for determining what is “substantial” or “insubstantial.”
Under an exception, a rental of property to a business may be grouped together with the business, although one activity is not insubstantial to the other, provided each business owner has the same proportionate ownership in the rental activity and the activities are an appropriate economic unit.
An activity involving the rental of realty and one involving the rental of personal property may not be treated as a single activity, unless the personal property is provided in connection with the real property or the realty is provided in connection with the personal property.
