The definitional point
The passive activity rules treat rental activity as passive per se. The regulations then define what a rental activity is, and provide exceptions. Among them: an activity is not a rental activity where the average period of customer use is seven days or less.
The consequence is structural rather than concessionary. If the activity is not a rental activity, the per se passive rule does not reach it. It is tested as an ordinary trade or business, and it is passive or non-passive according to whether the taxpayer materially participates.
It is an average, and it is per activity
The test is the average period of customer use across the year, computed for the activity, not the shortest stay or the typical one.
A property with predominantly weekend stays and one tenant over the winter can average above seven days and fail. The figure is arithmetic, it is produced by the booking records, and it should be monitored during the year rather than discovered when the return is prepared. A property tracking towards an average above the threshold can sometimes be corrected while the year is still running and cannot be corrected afterwards.
Material participation is still required
This is the half that is left out most often. Clearing the definitional exception establishes only that the activity is not automatically passive. It does not make it non-passive. The taxpayer must materially participate under the ordinary tests.
Two of those tests do most of the work here. Participation for more than five hundred hours in the year. Or participation that constitutes substantially all of the participation by all individuals in the activity, including non-owners.
| Arrangement | Effect on material participation |
|---|---|
| Owner handles bookings, guest communication, turnovers, maintenance | The strongest case. Hours accumulate and the owner is plainly the principal participant |
| Full-service property manager engaged | Substantial difficulty. The manager's hours may exceed the owner's, which defeats the substantially-all test and makes the hours test harder |
| Cleaners and contractors engaged, owner directs everything else | Workable, and fact-dependent. Third-party hours count against the substantially-all test |
| Owner lives remotely and visits rarely | Weak. The hours are difficult to accumulate and difficult to evidence |
The records requirement is the same as everywhere else in this area, and the failures are the same. Contemporaneous logs of date, hours, property and task. Not a reconstruction, not round numbers, not totals.
The limitations that remain
A loss that is non-passive is not therefore deductible. The order of operations continues past this point.
- 01At-risk. The loss is limited to the amount genuinely at risk, which turns on the financing and on any guarantees.
- 02Excess business loss. The aggregate of business losses that can offset non-business income is capped annually, with the excess becoming a carryforward that offsets only a portion of later income.
- 03Self-employment tax. Where the activity crosses from letting property into providing substantial services to occupants, the income can become subject to self-employment tax. This cuts against the taxpayer in profitable years and is rarely modeled by people who adopted the position for the loss years.
- 04State conformity. Several states approach passive losses and depreciation differently, and a federal result is not a state result.
General information only. This article describes law and practice as we understand them at the time of writing. It is not tax, legal, accounting, or investment advice, it does not consider your circumstances, and it does not create an advisor-client or attorney-client relationship. Odyssey Strategic Advisors LLC is not a law firm and is not a CPA firm. Confirm any position with your own tax professional before acting on it. See our disclosures.