If you plan rent out a room of your home or a second home on Airbnb to earn extra income, you need to know how to determine if what are you doing qualifies as a business or hobby in order to properly prepare your taxes.
Here are the rules to help you figure out if your rental activity is a business or hobby.
How the IRS Defines a Business vs. Not-for-Profit (Hobby)
There are nine factors that the IRS considers in determining whether your rental activity is a business:
- You carry out your rental activity in a businesslike manner and you make sure to maintain complete and accurate books and records.
- You put in time and effort with the intention of making it profitable.
- You depend on your income from your rental activity in order to earn a living.
- When you incur losses, they are due to circumstances that are beyond your control.
- You change your methods of renting your property in an attempt to improve profitability.
- You have the knowledge needed to carry out your rental activity as a successful business.
- You were successful in turning a profit in similar activities in the past.
- You made a profit in previous years.
- You can expect to turn a profit in the future from the appreciation of your property or other assets that are used in your rental activity.
Internal Revenue Code (IRC) 183: The Hobby Loss Rule
The general rule is that if you did not earn a profit in at least three of the prior five years, the IRS will consider your business as a hobby. IRC Section 183 (Activities Not Engaged in for Profit), sometimes referred to as the “hobby loss rule,” limits deductions that can be claimed when an activity is not engaged in for profit. The consequence of having your business considered as a hobby by the IRS is that you won’t be allowed to use losses to lower your tax bill. In practice, this allows the IRS to adjust your prior tax returns if deductions were taken and make you pay back any taxes you would owe after disallowing those deduction. These kinds of changes often result in big tax adjustments, interest, and penalties.
In the event that the hobby rule is applied, a taxpayer can still claim certain personal expenses, such as a home mortgage deduction, advertising, insurance premiums, depreciation, amortization, and wages. However, you must have earned more from your hobby than the total amount of all of these expenses in order to claim them (you cannot claim a loss).
McKinney v. Commissioner
However, don’t be quick to rely on the hobby loss rule alone as there are exceptions. A rental activity with multiple years of losses can still qualify as a business.
Recent cases have shown that your rental activity may still qualify as a business even if you do not turn a profit over a multiple year period. That is because many people who want to earn profits from real estate rentals have negative cash flows despite having earned a profit at some point during the business.
This occurred in the case of McKinney v. Commissioner where an Oklahoma couple who owned a vacation condo in Hawaii were found to be running a profit-motivated business by the tax court even though they had substantial losses. This ruling was made despite the fact that the couple rented out their property on a part-time basis and they had lost money on their rental activities for 11 of 13 years.
The tax court was persuaded by the fact that the McKinneys had earned a profit for the prior two years and that the couple made improvements to the property in hopes of charging higher rents. The couple had spent a significant amount of time to remodel the property which subsequently increased their gross rental income. This is a critical case, which highlights the importance of changes in gross earnings over net income or loss, which is typically the focus of the IRS.
Despite exception, you should be aware that running your rental activities with large losses year over year can trigger an IRS audit if you do not properly classify your rental activity on your taxes. That is one reason we recommend rolling your business into a new LLC with a distinct taxpayer ID, which some argue resets the time period.
How to Document Your Rental Business
To take deductions confidently, you need to be confident that you’re able to demonstrate to the IRS that your Airbnb is in fact a business and that there is no question around your profit motivation. Keeping proper records and receipts can help you to successfully prove your profit motives to the IRS in the event of an audit.
Make sure to maintain complete financial records and open a separate bank account for your rental activity. You should also keep records of your online listing on Airbnb and document the dates your property was available for rent as well as the dates that it was actually rented out (which is available as a transaction history export from Airbnb).
In addition, keep track of any improvements that you make to your property separately and the associated expenses incurred. These should be recorded separately for depreciation purposes.
Finally, obtaining a business license from your city or county will add substance to support your business’ paper trail. We have seen cases where the IRS has tried to disallow deductibility on the grounds that no business license was present. And while we feel that is a weak argument since it ignores profit motivation, it does highlight how a business license can help a taxpayer against the hobby rule. However, obtaining a license should be done with a thorough understanding of local ordinances. In recent years, obtaining city permits for short-term rentals has triggered audits by city finance and tax offices particularly in San Diego, Los Angeles, and San Francisco as taxing authorities look for past violations and tax revenues.