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Question

TurboTax is not permitting me to deduct short-term rental losses against W2 income

Forum|Forum|3 years ago
January 15, 2023
5 replies
0 views

I purchased a short-term rental property in 2022 which I self-manage. Based on the research I've completed, I believe I should be using Schedule E and any losses from last year can be used to offset my W2 income since I materially participate in the management of the property and the average guest stay was below 7 nights.

I have populated Schedule E in TurboTax however none of my losses are being applied against my other income. I see no option in TurboTax to change this within Schedule E. I have shared this issue with three different TurboTax CPA's, and no one has been able to help me. I do not believe I should be using Schedule C because I do not provide substantial services to guests, but it is a non-passive activity which should be reported on Schedule E and as a result the losses should be carried over to my 1040. Can anyone help me with this?

TurboTax Self Employed Online

Mike9241

You rent out your property to earn supplemental income, but you don’t put enough work into it for the IRS to consider you a self-employed rental property manager it goes on schedule E and if AGI is over $150,000 you are subject to the passive loss rules even with material participation and no loss is allowed.

You provide “substantial” services for your guests’ convenience during their stay (i.e., regular cleaning, linen service, or housekeeping). then you report on schedule C and there is no passive loss limitation.

EricUT03Author

What is the Short Term Rental Tax Loophole?

The short term rental loophole has saved people thousands of dollars a year in taxes because it doesn’t require you to be a real estate professional. It can be found in the tax code under Reg. Section 1.469-1T(e)(3)(ii)(A), and defines exceptions to the definition of “rental activity”.

We mentioned before that earning a real estate professional status is one way to turn losses on rental properties. However, this isn’t typically an option for highly paid professionals like doctors or lawyers, because they don’t have half of their working time to work in a real estate business. The good news is that the short term rental tax loophole can help.

The exceptions to the definition of rental activities in the tax code listed above can also turn losses non-passive if you, the short term real estate investor, meet one of seven material participation criteria. These tests will determine whether you qualify based on your use of and involvement in your short term rental property.

Here they are:

Spend more than 500 hours on the short term rental business
Do substantially everything for the STR business
Spend more than 100 hours on the activity and no one other individual spends more time than you do
Significant participation activity for more than 100 hours, and your combined activity in all significant participation activities exceeds 500 hours
Participating in the business for five of the 10 previous taxable years
Personal service activity (non income-producing) for three of the previous taxable years
Regular, continuous, provable participation in the business for more than 100 hours

The first three are the ones the majority of short term real estate investors qualify for.

Once you meet one of these tests, and your short-term rental is excluded from the definition of a rental activity, then it is considered non-passive.

Critter-3

I just had an update class with a tax attorney teaching it and he brought up this situation as a cautionary tale and said how the IRS almost always wins in an audit when folks try this non passive "loop hole". If you want to use it you must use the downloaded TT program and make an override in the FORMS mode. And prepare now for the audit with detailed contemporaneous records of the time you spent and anyone else working on the property which includes the cleaning crew, repairman and management company.

AmeliesUncle

You are correct that Material Participation in short-term rentals is non-passive, so the losses should offset W-2 income.

But TurboTax is not set up for this. If you use the CD/downloaded version, you should be able to access the worksheet to manually check the box for "other passive exceptions". But you can not do that with the online version of TurboTax.

If this is your ONLY rental, you may be able to say you are a Real Estate Professional, and I think it should do the same thing.

gmyoung

@EricUT03

I'm following this thread with great interest and (and some bemusement at the level of misplaced confidence in the responses of certain participants). I am wondering whether you've found a solution in TurboTax, as I am in a similar situation--bought and rented out a short-term rental in 2022 and am unable in TurboTax to apply my loss against my nontaxable income.

There is no question that I should be able to apply the loss against my nonpassive (i.e., W-2) income. Relevant facts from IRS Publication 527 (2022) Residential Rental Property:

The rental activity is reported on Schedule E if you rent buildings, rooms, or apartments, and provide basic services such as heat and light, trash collection and
on Schedule C if you provide "substantial services" [note: per at least one expert, cleaning between turns is not considered a substantial service, though daily cleaning may be].

If you have a loss from your rental real estate activity, two sets of rules may limit the amount of loss you can report on Schedule E: at-risk rules and passive-activity limits. "Generally, rental real estate activities are considered passive activities and losses aren’t deductible unless you have income from other passive activities to offset them. However, there are exceptions." These exceptions are outlined in IRS Publication 925 (2022), Passive Activity and At-Risk Rules:

"There are two kinds of passive activities.

Trade or business activities in which you don’t materially participate during the year.
Rental activities, even if you do materially participate in them, unless you’re a real estate professional."

"A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional."

HOWEVER...it goes on:

"Exceptions. Your activity isn’t a rental activity if any of the following apply:

The average period of customer use of the property is 7 days or less. You figure the average period of customer use by dividing the total number of days in all rental periods by the number of rentals during the tax year..."

As you know, this average length-of-stay is trivial to calculate (in fact, Airbnb does it for you).

This so-called 7-day "loophole"--or, as the IRS says less provocatively, "exception"--is straightforward and not at all aggressive. It is followed by this statement: "If you meet any of the exceptions listed above, see the Instructions for Form 8582 for information about how to report any income or loss from the activity." Form 8582 says:

"If an activity meets any of the five exceptions listed above [including the 7-day rule above], it’s not a rental activity. You must then determine:
1. Whether your rental of the property is a trade or business activity (see Trade or Business Activities,
earlier), and, if so,
2. Whether you materially participated in the activity for the tax year (see Material Participation, later)."

#1 is easily shown, but what about #2? There are seven tests (only one must be met). Arguably the easiest to meet is the third one (which is the one I meet): "You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year."

I'm skeptical of the claim that the IRS applies heavy scrutiny to this material participation criterion. The guidance on how to provide proof of participation strikes me as reasonable and easy to prove: "Proof of participation. You may prove your participation in an activity by any reasonable means. You don’t have to maintain contemporaneous daily time reports, logs, or similar documents if you can establish your participation by other reasonable means. For this purpose, reasonable means include, but are not limited to, identifying services performed over a period of time and the approximate number of hours spent performing the services during that period, based on appointment books, calendars, or narrative summaries."

Anyway, with that longwinded preamble, I'm curious to know whether you were able to successfully apply your losses against your nonpassive income. With how popular short-term rentals have become, I'm surprised TurboTax is stumbling. This doesn't strike me as an esoteric edge case.

johnbaumgartner7

ah ha... after many hours finally found answer in an old note on this site.... you must go to forms and find schedule E form or maybe it is the E worksheet on forms (took me awhile to find) and check non passive.

It works. Disappointing and surprising turbo tax software does not ask proper questions and handle this. Note I found referenced good worksheet from HR Block on airbnb treatment.

Teresa88

Where do I check non passive on Schedule E? I cannot find it.

DawnC

Employee

Look on Line 22 of Schedule E to see your deductible rental loss. @Teresa88

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PaulaM

Employee

Generally, the passive activity loss will offset other passive income. The exception with active participation is up to $25,000 for non-passive income, however this phases out with modified adjusted gross incomes between $100,000-$150,000 for married filing joint filers. After $150,000 there is no exception and the losses carry forward to future years with passive income.

IRS Pub 527

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