Rent your place, make some cash, and top it off with huge tax savings. Sounds too good to be true, doesn’t it? It just may be, because vacation rental property owners are finding out that their lofty dreams of taking their extra income and qualifying for a juicy tax deduction might be just that: a fantasy.
The qualified business income deduction — also known as Section 199A as part of the Tax Cuts and Jobs Act, which was signed into law in 2017 — has created plenty of potential landmines for tax professionals, and the close of another summer vacation season is a reminder of yet another.
In the sharing economy, vacation rental sites like Airbnb and HomeAway have become popular ways for real estate owners in desirable cities to make some extra money; in essence, a passive second business. To those property owners, it would only make sense that QBI would open up a way to take this “side hustle” and turn it into a business that qualifies for a tax deduction.
It seems logical on the surface, but like anything in the QBI world, it’s not as simple as it appears.
Safe, and strenuous, harbor
The entire idea of designating a home rental as a “business” is a new concept. Before the latest round of tax reform, most property owners didn’t want vacation rentals to be considered a formal business, because it would have subjected them to self-employment taxes, which come with a 15.3 percent tax on net income. Homeowners generally avoided the business label by not providing substantial services to guests.
But the QBI deduction changed that thinking. Under Section 199A, a business owner can realize a tax savings of up to 20 percent on business income. Additionally, half of the 15.3 percent self-employment tax can be claimed as a deduction on the owner’s income tax return. That’s a big carrot to dangle, but jumping through the hoops necessary to qualify for the QBI safe harbor is undoubtedly the stick.
Built into the QBI safe harbor are some rigorous requirements, including a mandate that vacation rental owners need to spend at least 250 hours in the calendar year providing rental services. Most do not exceed that threshold, and, even if they do, few are keeping track of their hours with time sheets and meeting minutes that prove they meet the threshold needed to qualify as a trade or business in the eyes of the IRS.
Doing the work
If property owners want to use the safe harbor, they are required to log all hours spent in the home by the various parties, as well as all services performed with respect to the rental and who performed them. In cases where vendors are hired — such as landscapers, housekeepers or maintenance companies — the property owner should file a Form 1099 for each vendor (for payments of $600 or more) if trade or business status is desired, something that is rarely done by casual vacation rental hosts.
None of these are recordkeeping tasks that can be fudged after the fact, nor should they be. The IRS can request to see those records, so it would be irresponsible for owners to simply file and hope their deduction goes unnoticed.
An owner also can’t solely rely on setting up a business entity, like an S corporation or LLC, to operate these properties, because that step alone does not automatically qualify a home rental “business” as a real business.
Uncertainty looms
It has yet to be seen how this will play out for vacation rental hosts who’ve been taking the QBI deduction without sweating the details. What we do know is that the IRS is always concerned about individuals accurately reporting their income, and if it appears that large numbers of vacation rental hosts are using the QBI deduction to game the system without the necessary requirements in place, they will start clamping down with audits.
Additionally, state-level authorities have been getting increasingly aggressive when it comes to enforcing rules around vacation rentals, taking measures to ensure they are subject to the same lodging taxes as traditional hotels and motels. It is highly likely that states that have information-sharing agreements in place with the IRS would even use QBI filing data to help enforce local tax collection requirements in their own regions.
To date, there are no tax court cases that provide a precedent on rental properties and the QBI deduction, but we do expect many of them to start appearing over the next few years.
For now, the key for property owners is recognizing that the initial Wild West phase of the sharing economy is no longer a novelty in the eyes of the IRS. If property owners aren’t hitting the 250-hour threshold, and aren’t prepared to do the work to prove the property’s business status, they may be better off looking for tax savings somewhere else.
