Understanding Passive vs. Non-Passive Real Estate Activities: A Focus on Airbnb and the 7-Day Rule

In the complex world of real estate taxation, especially for Airbnb rentals, distinguishing between passive and non-passive income is crucial. This distinction is made often-times before it is too late, because many tax professionals are issuing guidance to prospects and clients, that just brush upon the tax law as written. They do not take the time to analyze clients particular facts and circumstances, and integrate them with the tax laws as written. The Internal Revenue Code (IRC) Sections 469 and 1402 play pivotal roles in the determination of how rental income is taxed and reported. This article delves into these distinctions, highlighting the unique considerations for Airbnb properties and the implications of the 7-day rule.

What you’ll find here, is that there is no black and white answer, and everyone’s situation can have a very different outcome. This is worth a read if you have any rental or business activity – you will learn something you didn’t know and likely your accountant or tax professional has never touched on with you before. The topics here, present a critical understanding of the tax code, and if you do not understand you are going to be missing out.

Passive vs. Non-Passive Income: IRC Section 469

1. Defining Passive and Non-Passive Activities: IRC Section 469 categorizes income-generating activities into passive or non-passive. Passive activities are typically those in which the taxpayer does not materially participate, and the losses incurred can only offset passive income. Non-passive losses, however, can offset various types of income, including wages and investment income.
2. Form 8582 and Passive Activity Losses: Form 8582 is used to aggregate passive activities, determining the net passive income or loss. This form is pivotal in understanding the overall impact of passive activities on a taxpayer’s obligations.
3. Rental Activities and the 7-Day Rule: According to 1.469-1T(e)(1)(ii), a rental activity is generally passive unless one of the specific exceptions applies (Real Estate Professional, or self-rental status applies, any other material participation tests do not matter). However, an activity is not considered a rental activity if the average customer use is 7 days or less. This means that Airbnb properties with an average stay of under 7 days do not automatically qualify as rental activities, and thus do not automatically qualify as passive activities under IRC section 469.
   • Example 1: Tim owns an Airbnb in Iowa City, Iowa, his stay’s are typically 3 days or less throughout the year. Because the stays are less than 3 days throughout the year, Tim’s Airbnb does not qualify as a rental activity under section 469 which would have qualified it to be treated as a passive activity under IRC Section 469, and thus Tim’s Airbnb activity is considered non-passive. If he experiences any losses running his Airbnb he can offset those losses against various types of income on his tax return.
   • Example 2: John owns an Airbnb in Iowa City, Iowa. John’s stay’s are typically 14 days or more throughout the year. Because his stays are more than 7 days throughout the year, John’s Airbnb does qualify as a Rental Activity under Section 469, which means it is treated as a passive activity under IRC Section 469.
4. Material Participation Tests: If an Airbnb property meets the definition of a passive rental activity under Section 469, the material participation tests (Real Estate Professional Status, or Self-Rental Rules) should be looked at to determine if it could be considered non-passive.
   • Example 2 Above: John’s Airbnb automatically qualifies as a rental activity based on the 7 day rule, because his average stays are 14 days or more. This means that the Airbnb is considered a rental activity, and thus will be treated as a passive activity.
     • BUT WAIT– This is not the outcome John would like to see, because generally passive losses may only offset passive income. Non-passive losses can offset ALL TYPES of income – passive, investment, W2 wages, etc…
     • Exception to the rule: we can look to the material participation tests to determine if it is passive or non-passive.
       • Test 1- Real Estate Professional
         • If the taxpayer is a REP, the taxpayers real estate activity escapes the per se rule otherwise applicable to rental activity.
         • A taxpayer will be considered a real estate professional if (1) more than one-half of the total personal services the taxpayer performs in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. Ideally, taxpayers should prepare contemporaneous time logs that detail the services rendered.
         • For purposes of determining whether a taxpayer is a real estate professional, the taxpayer’s material participation is determined separately for each rental property, unless the taxpayer makes an election to treat all interests in rental real estate as a single rental real estate activity.
       • Test 2- Self-Rental
         • If John were to rent this Airbnb for the whole year, to a business entity he owns, Section 469 also covers the treatment of the self-rental transaction- it essentially treats the income as non-passive because the owner materially participates in the operating lessee entity. This rule allows Businesses to have a separate entity hold their Real Estate, but ultimately allows them to treat the the transaction as though they retained the real estate in the same entity as the business operations. Since the income (or loss) of the business operations would be non-passive, the income form the siphoned off RE activity should also be non-passive.
         • One thing to note about this provision, it does not cover any loss that may arise from the rental activity. Under the self-rental rule, the rental losses are still considered to be PASSIVE losses deductible only to the extent of PASSIVE income, while the income is treated as “active income”- Noted in (Carlos, 123 TC 275 (2004))
     • Let’s say John has a lot of Airbnb’s like the one listed in Example 2- So much so that if John elects to treat all interests in the Airbnb’s as a single activity, and that activity totals more than 750 hours of service during the tax year, John’s portfolio of Airbnb’s are considered non-passive, and any losses can offset other income!
5. Reporting Non-Passive Rentals: Non-passive rental activities are not reported on Form 8582 and can be listed on Schedule E.

Self-Employment Tax and Schedule C Reporting

1. Separation from Passive Activity Determination: The question of whether Airbnb activities are subject to self-employment tax is independent of the passive vs. non-passive determination. This is where the substantial services test comes into play.
2. IRC Section 1402 and Rental Income: Generally, rentals from real estate are exempt from self-employment tax. Exceptions exist for rentals where significant services are provided to the occupant, which are not customary in typical real estate rentals. If you provide a maid service to your Airbnb guests, or other significant services- you have an activity that is subject to SE Tax.
3. No Specific Time Requirement: There is no time requirement here, under 7 days and under 30 days doesn’t matter. You could have long-term tenants and if you provide significant services you have a rental activity that is subject to SE tax!
   • An example of this would be if you are an attorney, and you have space you rent out to other attorney’s while offering to support their back office, the rental income you receive from them is subject to S/E tax, because you are providing significant services in conjunction with the rental activity.

The 199A Deduction and Airbnb

1. Qualifying for the 199A Deduction: Determining whether a rental or Airbnb activity qualifies for the 199A deduction under the Tax Cuts and Jobs Act (TCJA) is a separate consideration. It requires the activity to be regular, ongoing, and profit-motivated. Material participation and payment of self-employment tax are not prerequisites for this deduction.
2. Various Scenarios for Airbnb Properties:
   • An Airbnb with average stays over 7 days without significant services may be passive, reported on Schedule E, and might qualify for the 199A deduction.
   • Airbnb with shorter stays under 7 days, no significant services, and owner participation could be non-passive, also on Schedule E, with potential 199A eligibility.
   • Airbnb with short stays and significant services, involving owner participation, are likely non-passive, reported on Schedule C with self-employment tax, and may qualify for the 199A deduction.

Understanding the nuances of passive vs. non-passive income, especially in the context of Airbnb rentals, is essential for accurate tax reporting and optimization. The 7-day rule under Section 469 and the considerations for self-employment tax under Section 1402 provide a framework for property owners to navigate these complexities. As always, consulting with a tax professional is advisable to ensure compliance and strategic tax planning.  Content is for education and information only. This is not advice of any kind. Please consult an Attorney or Certified Public Accountant.