The growth of the sharing economy has raised important questions about the proper tax treatment of assets divided between business and personal use. One example is the tax treatment of personal residences used as short-term rental properties, which are often advertised on new economy sharing platforms.
While traditional hotels are permitted to fully deduct business-related expenses when determining their taxable income, the rise of short-term rentals has sparked new conversations about what expenses are deductible when a personal residence is used as part of a short-term rental business. Policymakers should consider simplifying these rules for the short-term rental market’s newest participants.
Under current law, homeowners who rent out their personal residence, including those in the short-term market, are limited in their ability to deduct expenses. Internal Revenue Code (IRC) Section 280A ensures that property owners who rent out and live in the same property cannot deduct expenses that might otherwise be associated with personal use of the property. The provision limits the owner from subsidizing their personal use of the property by deducting personal expenses.
Section 280A applies when property is used personally by the owner for greater than 14 days of a year or when more than 10 percent of the days that it is rented at a fair market price the property is considered a residence, limiting the owner’s deductions. (Income from properties rented less than 14 days a year is excluded from taxable income, possibly due to the lobbying of residents of Augusta, Georgia, home of the Masters golf tournament, where luxury homes are rented out for the week of the event.)
When Section 280A is triggered, property owners are limited to deducting interest, property taxes, and casualty losses when calculating taxable income. Absent the Section 280A limitation, property owners would be able to deduct expenses associated with maintenance of a rental such as repairs of the property, insurance, management fees, and cleaning fees.
Section 280A is the result of more than 20 years of amendments. Beyond the confusing litmus tests and exemptions, Section 280A may not be well-structured for short-term rental arrangements. Modernizing this part of the code has the potential to improve tax compliance for the owners of the more than 8 million short-term listings in the United States.
An updated Section 280A should prioritize economic neutrality. The provision’s exclusion for infrequent rentals provides more benefits to high-value property owners over low-value property owners, as high-value property owners can exclude their higher rental incomes. At the same time, the exclusion offers homeowners a chance to not bear the costs of tax compliance for infrequent renting. Any change to make the provision more neutral should ensure that reporting does not become burdensome.
Section 280A highlights how new technologies and markets do not always fit squarely within the tax code. The structure of the provision may confuse homeowners calculating what portion of their expenses are deductible, especially if the homeowner is living in the property during the rental period. The growth in the sharing economy and options to list shared spaces or private rooms in homes shows that personal and business use increasingly coincide with one another.
Reimagining Section 280A’s structure is a balancing act. Homeowners should not be able to deduct non-business expenses, but the provision’s current structure is not perfect. Perhaps, for example, policymakers could reevaluate the usefulness of the 10 percent rule when compared to alternative methods.
A policy modeled on the home-office deduction, which calculates eligible deductions based on square footage as opposed to the duration of use, may be more effective at targeting the expenses of those who live on and rent out a property. The home-office deduction makes it easier for homeowners to deduct business expenses without requiring them to produce receipts for the actual expenses of the home office. Simplification will help encourage tax compliance, especially if language is authored in a way that includes more non-traditional short-term rentals.
The short-term rental market looks different than it did in 1976, the year that Section 280A was enacted. While the essence of the market remains unchanged, the way that suppliers and demanders of rental properties interact and how these players behave has evolved, largely thanks to the internet and the new economy. It is on policymakers to recognize the changes and take steps toward adjusting for them. Simplification will help encourage tax compliance, especially if language is authored in a way that includes more non-traditional short-term rentals. Updating IRC Section 280A would be one of the places to start.
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