Short-Term Rentals Preclude Use of Losses
CPA tax practitioners who have clients involved in a real estate rental trade or business are no doubt aware of the rule allowing $25,000 of passive losses from rental real estate to be deducted against nonpassive income and the 750-hour material participation rule for qualifying as a real estate professional under the passive activity loss rules. However, practitioners might not realize that a rule that treats rentals shorter than eight days as nonrental activities may foil a taxpayer's ability to meet the 750-hour material participation threshold. Earlier this year, taxpayers learned the hard way. In 2004, Todd and Pamela Bailey owned three rental properties. Todd Bailey, a physician, did not participate in the rental property activities. His wife, Pamela Bailey, operated and managed all aspects of the properties. She performed all of the bookkeeping and banking tasks, fielded telephone calls regarding the rentals, and paid the bills. She also performed most of the necessary on-site tasks such as cleaning and arranging the units for viewing or rental. During 2004, she also invested many hours researching, negotiating and planning to acquire a fourth rental property and in researching other potential acquisitions. When the Baileys' 2004 joint income tax return was selected by the IRS for examination, Pamela Bailey provided a summary of 382 hours she spent on the two rental properties reported on Schedule E. She was further able to demonstrate that she had spent 192 hours researching potential acquisitions and 105 hours in activities related to the acquisition of the fourth property. While the two rental properties on Schedule E sought "year-to-year" tenants, the third property, which the Baileys called The Inn on Alisal Road, was furnished and offered for short-term rentals, with an average stay of only three days. Pamela Bailey established that she spent 324 hours with respect to the inn. That activity was reported on Schedule C. Including the hours expended to acquire the fourth property, Pamela Bailey reported a total of 1,003 hours spent on real estate rental activities in 2004. As a result of the examination, the IRS disallowed various losses and deductions, resulting in an asserted tax deficiency of more than $19,000. The Baileys petitioned the Tax Court (Todd and Pamela Bailey v. Commissioner, TC Summary Opinion 2011-22 (3/2/11)), where after stipulations the sole issue remaining was whether the taxpayers could deduct a net loss of $16,822 as nonpassive on their Schedule E from the two rental properties. …