No one ever said: “The tax code is limited and easy to understand”. Even a topic such as filing your vacation property taxes on your tax return has many considerations and tests to determine how you should file. In this article we break down all the different options. This will provide you the ability to make the right determination about your rental activity.
Where The Confusion Starts
The first decision you need to make before you file or bring your paperwork to your CPA is your rental activity status. If you are unsure, this information will offer you the ability to know what questions to ask. With this information, a CPA will be able to help you make the correct determination.
The difficulty in making this determination is that over time the tax code has gotten more complicated. When more pages are added, these new configurations are often not understood in how they work with the existing tax code.
The most recent example of this is the recently passed Tax Reform Act (the TCJA) which provided an income deduction. This 20% income deduction applies to so called pass through entities. There was some confusion on this about how it applies to vacation rental activity. The IRS provided clarification by providing a safe harbor exemption. If you are running your rental activity as a business and earn a profit, then it is probable that you can claim this income deduction.
Safe harbor exemptions are used in many places. The exemption essentially says the following to the IRS: “I don’t really qualify for this activity, but because I am acting in manner that qualifies, let me qualify”. There are safe harbor exemptions for capital improvements and also supplies that your purchase for your rental activity.
In Plain English: Filing Options
There are four main filing option statuses that you can choose from. In the table below is a very high level summary of what they are.
| Filing Status # | Schedule to File | Rental Property Status | Description | Does It Apply to You? |
|---|---|---|---|---|
| 1 | Schedule E | Active Participation | You manage vacation property rentals, of which you are at least a 10% owner | Very Likely |
| 2 | Schedule E | Material Participation | You manage vacation property rental as a business (Do not pay anyone else management fees) | Not Likely |
| 3 | Schedule C/Schedule E | Qualified Joint Venture, Material Participation | You manage vacation property rental with a spouse as a business and want to split it by interest portion | Not Likely |
| 4 | Schedule C | Material Participation, LLC/Company | You manage vacation property rental as a business (Do not pay anyone else management fees). | Not Likely |
Schedule E – Active Participation
The most common filing option is so-called Active Participation. What this means is that you own real estate property and have some role in managing it (hiring contractors, hiring property managers, agents). It very well could be that you contract out the entire rental workflow to a third party. You would still qualify.
The key distinction here is that you own the individual properties (at least 10%) and at least direct the management of the property.
Where you wouldn’t be an active participant is when you are a part of a partnership or real estate investment trust (REIT). In these structures, you are merely a passive owner and have no say in day-to-day operations. Then, you wouldn’t be able to claim active participation, your activity would go to Schedule C. This activity would be treated similar to investment income from stocks/bonds.
Schedule E – Material Participation
Under material participation, you are running your rental activity as a business. You may not actually have a C/S corporation registration. Also, you may not even be a registered real estate professional. The tests come down to how much time and effort you put into the activity. If you are spending substantial time managing your rentals and pay no one else management commissions, you may qualify.
Look at this from a common sense point of view before considering the details of the tax law. Would you consider yourself a business based upon your activity and hours put in? Do you spend more than 10 hours on the rental activity each week? If so, then you may consider yourself as materially participating in the rental activity.
Schedule C – Qualified Joint Venture
For the purposes of claiming this status, both you and your spouse must be material participates in the rental activity as well.
Under a qualified joint venture, you and your spouse each have their own separate interest in the rental activity. If you file your tax return as married taxpayers, the default configuration is a partnership which does not necessarily confer ownership in the rental real estate by each spouse. Under the QJV, the interest of each party is made clear.
Also, each party would file their own tax forms for their part in the rental activity. The interest of each party would split up the income, expenses and other non-cash charges such as depreciation.
Schedule C – Material Participation
Under material participation, you are running your rental activity as a business. This is very similar to the filing status above under Schedule E. There are two main differences though:
- The rental activity is owned and managed under an LLC/company.
- The business entity may offer major services/products, whereby the rental activity is not the main activity.
The tests for this filing status are the same as above. You must participate in the rental activity 10 hours/week and manage the activity yourself. (e.g., you do not pay management fees to anyone else).
If you offer other services which make the rental activity subservient, the IRA suggests that you use Schedule C. However, note that this is not required as a condition for this filing status.
Conclusion
If you are unsure about your rental activity, consult a CPA. It is most likely that you are an active participant in your rental activity. If you buy additional real estate and your management and time commitments become more substantial, then consider changing/upgrading your tax status.
All documents courtesy of H&R Block.
