Having receipts and great records doesn’t mean that an IRS audit will go well. IRS auditors are masters of invoking provisions in the Tax Code that often make receipts and records useless.
The tax rules are especially complex when renting a property for a few days at a time, such as renting-out a family cabin when you’re not using it. The following is an example of what can go wrong during an IRS audit of a cabin vacation rental.
Facts: You rent-out a family cabin in the mountains when you’re not using it to supplement the expenses of owning it. It provides excellent rental income for each night of stay, since it’s near a great skiing area.
You contract with a rental property management company (PM) to rent the cabin. PM has the exclusive right to rent the cabin and receives a commission of 35% on all rents collected.
Under the arrangement, you’re responsible for maintaining the property, paying the utilities and property taxes. PM is responsible for finding renters, collecting rents, providing clean linens, beddings and light housekeeping during the stay. After the tenants leave, PM is to wash and restock linens, beddings, deep-clean facility and forward the rents (after expenses) to you.
PM rented the cabin three times during the year when you weren’t using it for a total of 12 days and nine nights. You and your family visited the cabin eight times for 27 days and 19 nights. You claimed these were maintenance trips.
IRS Audit. The IRS audited your cabin rental and based on the preceding facts, it disallowed your $20,232 rental loss, even though you had receipts and records to prove all expenses. What went wrong?
Problem: the IRS reclassified the rental as a “hotel”. The IRS used the nine over-night stays to calculate the average rental period for each renter. The cabin was rented three times with renters staying overnight for a total of nine nights. The average rental period was three days for each renter, which caused the cabin rental to be deemed a hotel for tax purposes.
Reclassified as a hotel, the normal passive rental rules no longer applied. Hotels are not residential rentals, therefore the IRS disallowed the $20,232 loss claimed, because passive-loss rules don’t apply to hotels. Instead, it’s a rental business.
To deduct losses for rental businesses, you must be able to prove material participation, which requires that you participate in substantially ALL the activities in managing the hotel OR that you participated 100 hours or more during the year and NOT LESS than anyone else.
Problem: failing to prove material participation. Since PM was responsible for advertising, showing, renting and cleaning the property, you failed to prove that you were substantially the only manager or that you logged 100 hours or more managing the property during the year AND more hours than PM.
A little bit of good news: The IRS treated the cabin as a residence. Since the cabin was rented less than 15 days, the rents were deemed non-taxable. You still lost out on the $20,232 loss, but didn’t have to claim the income. However, if you had rented it more than 14 days, the outcome would have been much worse.
When renting vacation homes, cabins, condos, or other properties for short-term stays, some planning must be done to insure deductibility of expenses. You should plan how your time is spent at the property and document your time, the time of related persons, days available for rent and days (nights) actually rented.
After-the-fact tax planning for vacation rentals is not wise. Discuss your situation with a knowledgeable tax advisor before making decisions. Real estate taxation is complex and what is generally believed by lay persons is usually wrong.