Each year, anyone who makes money in the U.S. does so in one (or more) of three IRS categories: active, passive and portfolio. But how do you know when your vacation rental income is passive versus active? If you’re a property manager maintaining a client property, though, you’re looking at either passive or active income and knowing your vacation rental income tax code can make a difference.
As it stands now, all rental real estate activities are categorized as passive activities, so many property managers assume that funds from vacation rental properties will also fall into the passive income categorization.
It’s not that simple, though.
It all comes down to how much time the vacation property was used by renters versus how much time the owner spent in the space. These factors influence taxes owed on rental income and deductions.
Is Your Vacation Rental Property Active or Passive?
Here’s the general rule:
If the vacation property is rented an average of 7 (or fewer) days per rental agreement, the IRS may assume it is full-scale, which should be filed under the Schedule C, or active tax code. This applies to hotels and bed-and-breakfast joints alike.
If you’re running small-scale vacation rental properties, though, they’ll be classified as passive income by tax code Schedule E, which states that those rental activities are passive activities by Internal Revenue Service standards. Schedule E income is not subject to the self-employment tax law.
The IRS’s definition of passive income is “net rental income and the income earned by a business in which any involved taxpayers do not materially participate.”
Here’s what that means: If the vacation property is used by the owner for 14 days or less out of every year, or 10 percent or less of the time it is available to rent, the property is viewed as an investment. As such, most vacation rentals fall into the “passive” category.
The Financial Implications of Passive versus Active Income
The passive activity tax codes mean that passive losses can only be used to offset passive income, but cannot include ordinary income, such as wages paid or earned.
Some passive tax filings will be different, as the majority of renters rent for less than two weeks, which is the cut-off point for IRS taxation.
What if space at the rental property is used to run a business? This will define the income as active. All properties used for self-employment or to run a business are Schedule C or active income.
As with most things in life, property management is all about the details, and when filing taxes for the properties you manage, it is pertinent to know the mysteries of IRS tax code. Luckily, this information and more is easily available at the IRS Small Business/Self-Employed Topics Page.
Can you believe that we are talking year-end stuff already? Where did the year go? Leave a comment and tell us, what other year-end stuff are you already preparing for?