EP 139 - How to Survive an IRS Audit Using the Short-Term Rental Loophole

We break down why the short-term rental loophole can produce massive tax savings and why the same strategy can collapse in an IRS audit if the paperwork is weak. We walk through what actually triggers scrutiny, what auditors ask for first, and how we document the rules so the losses stay usable.
• short-term rental loophole basics under IRC Section 469 and why it changes passive loss limits
• seven-day average length of stay and how to prove it with Airbnb or VRBO stay logs
• audit triggers we see most often, especially missing or mismatched 1099 income
• how the IRS tests deductions, including bank statement tie-outs and reasonable expenses
• cost segregation study scrutiny, what can get adjusted, and why it is usually not the main fight
• material participation tests that matter: 100 hours plus no one else more, 500 hours, substantially all
• why cleaners, property managers, partners, and big properties make the 100-hour test harder
• grouping elections for multiple short-term rentals and why long-term rentals cannot be grouped in
• how to prove hours, why courts punish vague estimates, and why logs win audits
• what hours count, what investor hours do not count, and where the gray areas live
• what to do if you lose, including appeals and amending to elect out of cost segregation
Go to https://www.prosperlcpa.com/apply for a free conversation and a video from me illustrating what maybe be possible and how much we can save you with advanced tax reduction strategies. 
If you want that, just type our log in the comments or just email me and I’ll send that right on over to you. 

Transcript

Why The Strategy Draws Scrutiny

SPEAKER_00 0:00

The short-term rental loophole is one of the most popular tax reduction strategies for high income earners, whether you're a high W-2 or a business owner. It can eliminate hundreds of thousands of dollars in taxes, but if you can't defend it in an audit, it will blow up your entire tax return. So pay close attention whether you're an early stage investor or veteran short-term rental investor, or maybe you're just a little overwhelmed by all the noise and oversimplification out there online. Because in this video, I am going to show you exactly what the IRS looks for when auditing this strategy, and everything you need to know to protect yourself against the scrutiny of the IRS when implementing this strategy effectively. So pay close attention here. You are going to learn what triggers the audits, what they will question when it comes to the treatment of the losses and savings on your return. And you will also learn how to defend yourself in this return and all the savings you've you've been able to earn by using the short-term rental loophole. Now, before we go into the material here, if you feel a little overwhelmed or you're curious on how the short-term rental loophole or any other potential advanced tax reduction strategy for high income earners may apply to you, go to prosperoca.com. That's prospero with an L CPA.com slash apply for a free conversation and a video from me illustrating what maybe be possible and how much we can save you with advanced tax reduction strategies. Before we get into the material, also a quick recap of what we're looking at here. In the IRC 469, a rental property is a rental prop. Sorry, let's do that whole thing again. Now before we get into the material, just to refresh your memory, if you've been following along or if you're new, under internal revenue code section 469, a rental is not treated as a rental activity if the average length of stay is seven days or less. And this is very important because normally rental losses cannot offset your ordinary income or UW2. But there are a few sections, and this is one of those exceptions. The other thing that we need to prove not only is the average length of stay seven days or less, but we also have to show material participation to show that these losses are not passive investment activity, that is an ordinary business, and those losses can offset your other sources of income, such as your high W-2s or your business income, or even stock gains, dividends, interest, any other type of income can be offset by these non-passive losses. Those two attributes exist. Now there is some sort of urban legend out there that if you create massive losses, you are going to trigger an audit. And we have never really seen that take place. Let's talk about what will trigger an audit. The most common thing that we see is a discrepancy in 1099 income. So if a client doesn't give us all their 1099s, and in particular a 1099 B showing your portfolio income, whether it's interest, dividends, or stock gains, the IRS has that information. So they know that you have income that you are not reporting on your return. So they obviously know there's a discrepancy, and that will be one of the most common red flags for the IRS to start auditing your return. Um, now some other things that we may see is if you receive a 1099 showing rental revenue from Airbnb or VRBO, and that revenue amount is less than the revenue you are reporting on your tax return, that has also been an instance that would trigger an audit. But the cost deductions themselves, those when we're accelerating accelerating depreciation from a cost segregation study, that has never triggered an audit. You created multi-million dollar losses from cost segregation and either real estate professionals or short-term rental loophole investors. And that has never triggered the audit. It's almost always because of some unique scenario where the IRS knows that you're not reporting all the income you have. Now, some other things here that you may think can trigger an audit, and they might, is if you have unusually high or low numbers. So uh we've what we've been told is if we have an exceptionally round numbers. So if you're reporting, you know,$100,000 in repair and maintenance costs, it may look abnormal and potentially trigger an audit. We have never seen that play out because we don't accept faulty numbers from our clients, but we've been told that's the case, we don't see it happening, and we don't have access to the algorithms of the IRS audit, so I can't tell you exactly what their decision means, but we can speak from experience that we the most often scenario here is a discrepancy in 1099 income and occasionally potentially K1 income. Now, when the IRS sees that there is any discrepancy, even if it's not related to your rental portfolio, once they start that audit, they're gonna scrutinize every item on that tax return. And when they see you have a massive deduction because you have a short-term rental loophole, uh short-term rental investment with cost segregation studies and six figures of deductions, they're obviously gonna dive in and make sure that those losses are legitimate. So, in doing so, they are going to question the legitimacy of the deductions, they're gonna challenge the results of the cost segregation study. And the most important thing that we're gonna really dive into is the material participation. That's gonna be the most important thing that you want to defend. Because if you can't show material participation, you're not gonna be able to use any of those losses. And this is gonna be one of the trickiest things as we dive into the material here. But first, let's start with the simpler topic here of legitimizing your tax deductions. So, obviously, they're gonna want to look at your income statement and they're gonna wanna see that these expenses you have are reasonable, ordinary, and necessary for the type of business you're doing. In this instance, it would be a short-term rental. And they will also want to trace that these deductions from your income statement are tied to your bank statement. So if you have an Excel document showing your write-offs, they're likely going to want to see bank statements and they will tie those transactions to what shows up in your bank statements. They also may request access to your books and records if you're using a bookkeeping system. They're also, in some instances, they could question the purpose of your write-offs to make sure that they were aligned with the business and you're not just padding in write-offs to create more tax savings. Now, the cost segregation studies, because they are so impactful on the return, are also going to be examined. What we have found is the auditors usually don't put tremendous amount of time into this, but if an amount looks abnormal, they will question it and propose an adjustment. So we had one instance where an engineer maybe had a transposition error on their study and the fence valuation was far too high, and that amount was adjusted in the return. At the end of the day, though, even if you see an adjustment on the cost segregation study, I wouldn't stress out too much here because you're still in a winning position as long as you can use your losses. Because the cost segregation study is a legitimate uh common practice for real estate investors. Yeah, the auditors know it, they see it all the time. And even if an amount gets adjusted, you're still likely going to create significant savings with the cost segregation study. So I wouldn't be losing too much sleep over that. Now, the other thing they're gonna show, we know we want to, so we've legitimized our write-offs and we've legitimized the values of the cost, and we have all these write-offs. But the most important thing in the audit here is to make sure that we're actually allowed to use these losses to offset your ordinary income, though, so that we can create hundreds of thousands of dollars to create tax savings and maybe get back the taxes that came out of your paychecks, or make sure you don't owe a ton of taxes from your business profits. So the easier attributes of these is the seven days or less attribute. If we can show the average length of stay is seven days or less, we're good to go. And all you really need to do is produce a log of your stays from Airbnb and VRBO. Now, if you're just starting off with a short-term rental, most likely we will see that the average length of stay is seven days or less. We've looked at thousands of properties, and this is almost always the case. However, there is a possibility that a guest could stay longer for a few months and they could potentially offset that number, and then the average length of the stay is more than seven days. If you're planning to use a cost segregation study and using those losses, be very careful of how long your guests stay. And some of your strategy could be to price it in a manner that will be less likely to attract the longer stay guests. So maybe you don't give a discount for the longer stays. For instance, you're not gonna give a 50% discount for a monthly stay. You're gonna keep it in a in a in a price point that profits on the shorter stays. Now, no, so now that we've overcome that hurdle, let's dive into the big topic. And this is one where we're gonna spend the majority of our efforts, and that is going to be material participation. This is gonna be the most complex topic with the most ambiguity and most impact on your tax return. So we need to say that you've materially participated in this business to offset your income. And there are the three most common attributes to show this is one uh that you've spent 100 hours and no other individual spent more time than you, or we could say that you put a total of 500 hours, or we could say that you did substantially all the work in this short-term rental, and you can combine your hours with your spouse to achieve these attributes. So let's talk about uh some of these elements here and how you can protect yourself in showing that these take place. So, for the 100 hours test, not only do we have to show the 100 hours, but no one spent more time than you. And I will say a lot of these gurus in their short reels are oversimplifying how easy it is to say that you've materially participated because they're not paying attention. There is a possibility that someone is putting more time in than you, and you also have to document and find a way to prove that no one else has put more time in than you, and a lot of people will just assume you put in 100 hours and you're good to go. Well, that's not the case. Think about this. If you have a larger property, so let's say you buy a three-story vacation home and you are looking to write off this cost egg. Think about this. You were trying to say we put more time than anyone else. Think about how much time it would take to clean this property. And if you have a very small cleaning staff, you may find that a cleaner is coming in every few days and putting in five, 10 hours or 20 hours a week just into cleaning and maintaining this property. Now, how do we show that we are actually putting more time than in than the cleaners? Do you have an hour log of the cleaners? Is the property manager? Well, we don't use property managers, we'll talk about that in a little bit. But is the cleaning company able to produce some sort of record of how many people and how much hours they're all putting into your property? That's gonna be really hard to prove. Now, another challenge you're gonna find here is when you get audited, what's the way that we can do it? So, what we found, and we've actually passed this audit by showing this, is we had uh we got a list of all the cleaners that were working on the property, and then the auditor allowed us to look at the costs that we spent on the cleaner, estimate what they would have spent per hour on the cleaners, divided it by the number of cleaners, and that actually allowed us to show that it was highly improfitable, that improbable that any single cleaner put more time in that property than our client because we had a team of nine cleaners coming in and out during uh and rotating in and out on the property, and because of that, and we could be spent X dollars, so they likely spent no more than this number of hours between them. It's unlikely that our client spent less hours than any single cleaner. Now, be careful here because let's say you use a smaller cleaning company or you have one cleaner that does all the cleaning, and the cleaning work is intensive on short-term murals, they don't just have to mop the floors. Remember, they gotta clip change all the sheets, they have to inspect the place, they gotta put in new towels, they gotta put the travel shampoo and the toothpaste. They do a ton of work here. If you have only one person going in and out between all the guests, there's a good chance they're putting more time in than you. So be mindful of how many people are working to clean this property and just start thinking about what you could do to find some sort of reasonable estimate of the hours put in by each cleaner to show that you put more time in. Now, one thing that's gonna help you here is if it's your first year with this rental property, and we most often find that early stage investors, when they're just getting started and they have their first rental, they're gonna put a lot of time into the setup of this property. So even though the cleaners are gonna come in and put a lot of work in, the time that you spend doing due diligence on the product, on the properties, setting up the property, creating the listing, all those activities are gonna allow you to get lots and lots of hours in. So you're at a head start, you've already racked in a good amount of time before the cleaners really start working on the property. Now, there's another test that we can pass here for material participation where we don't have to worry about the cleaner's hours, and that is the 500-hour test. So if we can say that you or you and your spouse combine for 500 hours, we don't have to worry about the time spent by any cleaner. You might even have property managers on your portfolio. And if we put in those 500 hours, we're probably good to go here. And this is going to be the easiest to achieve if you've been in the game for a while, you have multiple properties. Let's say you bought a rental property in December, you're unlikely to get the full hundred hours in for that one property. But if you can group it with your other properties and we can do a grouping election to treat all of our portfolio as one, then we can likely say that for this collection of rentals, we put in 500 hours, and that property you bought on December 15th is in that collection. So the 500 hours test will apply to that as well. Um now, this is again, it's gonna be very hard to achieve the 500 hours test in year one. However, like I said earlier, in year one, you're putting so much time into setting up this property in the due diligence, and you probably need more time than usual because you're just getting started and learning how to set things up. So you're likely gonna rely on the 100-hour test when you're just getting started. Now, there's another attribute that is less used, and that is the substantially all test. And if we can say that you did substantially all the work on this rental property, then you have materially participated. The challenge with this is the IRS has never really defined what substantially all means. It's really our last resort if we want to use these losses and say we've materially participated. And based on what I've seen in court cases, we have found that if you can say that you've put in 80% or more of the total hours of this rental property, then you have done substantially all of the work. So this may be possible if you want to buy. Remember that earlier example, if you buy a rental property in the middle of December, you're not gonna be able to get the 100 hours in. However, we may be able to say that you've done substantially all the work in that rental property in the first year because you had to do all the negotiations, all the setup, creating the listing, getting everything in place, and maybe you've only had one or two guests before the end of the year. So the clearers have put in minimal time compared to all that startup initiative you put in to the rental property. Even then, it's not black and white. It's really, it really makes a lot of advisors uneasy when they try to take that stance. We've done it on occasion, but we always advise our clients really make sure you're put you have a lot that you can substantiate that you've done a lot in this property, and there's been minimal cleaning hours in comparison to your work to say substantially all, because that is going to be a more challenging stance to defend. Now, as you grow your portfolio, grouping, as we discussed earlier, may be a very helpful way that you can combine the hours from all of your short-term rentals to say that we materially participate. We cannot group your long-term rentals with your short-term rentals. And there are a few instances where the grouping may not help you out so much when if you're starting to use property managers and the property manager is actually putting in more time than you, because then you can't pass that 100-hour test on individual properties. And so if you're looking to centralize management and be hands-off, you want to make sure you, if you're grouping, that you can at least pass that 500-hour test. Uh, and on the topic of property managers, if you're just starting out and you have a property manager in place, it's gonna be really hard, nearly impossible for you to materially participate in those rental properties because they're taking away your hours, and the property manager is also there's a good chance that they're putting in more time than you in the oversight of those properties. While it is possible, just look at the rules and see how you can pass one of the attributes, it's gonna be very tricky if you're using a property manager from day one. Now, another challenge in getting you to materially participate is if you have partners. Because remember, we need to say if we want to pass that 100-hour test and no one else put in more time than you. So if you're gonna try to pass that attribute, then what about the other partners? You're not all gonna be able to say that you put in 100 hours and no one put in more time than you. It would be highly unrealistic that you all put in the ex exactly 101 hours into this project. So, usually, if you're all starting out and you're in a partnership, only one person or party is gonna be able to use those losses unless you can also pass the 500-hour rule. So one of those three attributes has to be in place, and now let's talk about how we can validate that we put in amount the amount of time. How do we show these hours and what hours can count? And this is where we're gonna be navigating a certain amount of grayness in the tax law because there have been contradictions in what the the tax law says and what the court cases decide. So let me give you a little bit of illustration here. And what we're doing here is just seeing what the law says, but all based also based on what the court cases say, to come up with the best approach to protect you and logging those hours and showing we we put in the right amount of hours to pass material participation. So if you read IRS Publication 925, it says that you can use any reasonable method to prove participation in an activity for the year. You don't have to keep contemporary records or daily uh time reports, logs, or similar documents. If you can establish material participation. In some other way. For example, services performed in the approximate number of hours spent in appointments books, an appointment book calendar or narrative summary. So that's what they say in the publication. But then when you look at court cases, you see complete a completely different outcome. So most of the times when taxpayers try to challenge or defend their material participation in their hours, they will fail. And the court cases often will emphasize the importance of keeping logs. So some of the cases I pulled up in my research, Sorrel versus Commissioner, a pilot tried to pass the real estate professional tax status, but he couldn't show 750 hours. And the court emphasized the importance of keeping logs. Linden versus commissioner is another case where uh taxpayer provided a ballpark estimate and failed. Gross versus commissioner, the court cases found that the taxpayer did not materially participate in activities because he did not document the time spent. And then even in the case uh regarding farming losses, Stanley versus US, uh, they failed due to lack of detailed records in participation. So even though the publication says you don't need contemporaneous records, you really should keep content contemporaneous records, or let's just say have an hour log to validate your time spent so we can say you materially participated. So we have, and by the way, if you're listening, uh just type our log in the comments. We do have an hour log that we have created based on the recommended guidance of the IRS to show your hours, and it's past every single IRS audit. So we've defended it against an audit. And if you want that, just type our log in the comments or just email me and I'll send that right on over to you. Now, some of the things you would think about here as far as what type of hours count. Uh, the IRS wants to see at a high level would a reasonable person do this to save money on expenses or to make more money. The IRS has defined the hours as uh as activity that is regular, continuous, and integral to the business. And we have also found that hours spent preparing your startup activity could count towards material participation. Organizing the startup business plans, negotiating with contractors, and performing other preparatory work could count as well. So we want to track our hours before we even get started with the rental property. All that setup and the searching for the property, etc. etc., may count towards material participation. However, there are some hours that do not count. Now, the IRS, or sorry, specifically the RSC, the Internal Revenue Code would say that those hours that are not typically done by a business owner of that type of activity may not count. Or if you're just logging hours to avoid the disallowances of any losses or credits. So if you're just looking for an excuse to do something to say you materially participated, and that something doesn't really provide any value for the rental portfolio or the growth of your business, it may be disallowed. And then there's another uh type of hours that may not be allowed, and these are investor hours. So if you are spending time reviewing financial statements or reports, compiling summaries or analysis of finances and operations of the activity for your own use. Other things that the IRS calls out that will not count is monitoring, monitoring finances of operations of the activity in a non-managerial capacity, preparing tax returns, and what they call investor level analysis. So look at this. So there's a little ambiguity again, um, the due diligence work and the potential acquisition of properties. So this leads me to believe based on the contradictions and ambiguity where investor level analysis doesn't count, but you can count some of this initial due diligence, is we don't want to rely on all those initial startup activities and speculation to pass material participation just in case you come across an hire an auditor that really wants to stick it to you. Now, um, another area that has some ambiguity is uh travel time. So some travel could be disallowed if it resembles commuting to and from an office. Here are the hours that will count. So we talked about some ambiguity and some of that investor level work or items that really just don't seem to be necessary for running the company. But trust me, when you're running a short-term mill, and I've done it personally, so I can speak from experience, there's a lot of stuff you have to do. And here are things that will clearly count towards your hours, and these activities likely will give you a significant amount of hours. Communication with the cleaners, guest communication, pricing strategy, purchasing furniture, property setup, managing listings, coordinating repairs, and supervising contractors. These are all items that will clearly count towards your material participation. Now, let's say we lose the audit, right? And hopefully we don't. So we know what hours count. We have a we have a clear detailed hour log. We know the time, we we we know that the attributes have to be in place, we know the average length of stay is seven days or less, and we know that we uh have materially participated. And usually if you're starting out, you're going for that hundred-hour role. So let's say that's all in place, and the deductions are clear and dry, they're coming right out of our bank account statement. We know we'd use that, and we have a well we we've used an experienced, uh, well-established cost segregation firm to document the cost ex study. So let's say this is all in place and you're good to go, then you could probably feel confident that you could protect yourself against the scrutiny of the IRS. But let's say some of these hours are disallowed, or let's say you may find that the average length of stay is under is over seven days and you lose the audit. And we have seen instances where even if we showed material participation, there were some other adjustments, or the client just couldn't show their write-offs. So the next step, let's say you fail the audit, or the the audit just determines that you owe some money. If it's significant enough, you can actually contest the results, you can appeal the audit. And if you appeal the audit, you can oftentimes negotiate the amount of taxes due. In fact, here's an interesting story. Uh, we had a client who did not give the 1099 Bs to us, and they um they clearly were gonna owe a lot of money because they didn't report their cap gains. And they also had every expense item, every cost segregation study scrutinized. And at the end of this, we found that the client owed$200,000 as a result of the audit. And so I told the client, all right, let's let's go and appeal this decision. And I said, Hey, you know, if you did everything right and gave us everything, you would have owed$120,000. That's it. We were in compliance. And these guys are really going after you here. They're trying to take all these aggressive stances that I've never seen anyone take. And they're saying and they believe that you owe$200,000. So let's lowball them a little bit. Let's say that we let's offer to pay$90,000 on this audit. And the auditor, uh, sorry, the the rep, the IRS rep thought about it and he agreed. And we actually brought the liability from$200,000 down to$90,000. And the tax liability was actually less than had he done everything in compliance from day one. So he didn't give us his records, the the audit, so they owed a lot of money, but actually, the end result after the appeal was actually he wound up paying less than he would have had he given us all the proper documentation. Now he lost a lot of sleep, and this guy was really nervous. You could hear, you could feel his sweat over the phone, but things worked out all right because we really followed through and handled the audit and the follow-through procedures. And I also leveraged some of my network when it comes to tax resolution. Uh, so what's really important here though, when you're navigating the structural rental loophole, is you understand the law, you know what you have to do, you're keeping the records and you're being proactive. Now, if you fail the audit, another thing to consider let's say you lose that material participation test, let's say that you don't materially participate. What we can do is we can actually amend the return and elect out of the cost segregation study because we know that the losses are non-passive. The losses are only gonna be valuable if they're non-passive. So if the losses are passive, there's no value to the cost set. So we can elect out of it and wait until you actually do materially participate. Maybe in the following year, you'll pass a material participation test, you'll have more time with the rental property, we're more proactive, and we just move the cost segregation study to another year, and maybe we time some income events in that year so we get the best bang for the buck from that cost site. So, in worst case scenario, there's usually a way that we can adjust things and plan and be proactive to make sure that things work out all right. Now, the short-term rental loophole, as I said earlier, is one of the most powerful tax strategies available. But this strategy isn't just the property, the strategy is the documentation and the planning behind it. If you're trying to use the rental the rental real estate to offset W-2 income and business income, we help clients design tax strategies that have survived the IRS scrutiny time and time again. And if you'd like us to review your situation again, I strongly urge you to apply for a free consultation at prosperoca.com slash apply. Prosper with an lcpa.com slash apply. I really hope that this conversation gave you some clarity and how you can protect yourself against the scrutiny of the IRS and audit, and I hope to hear from you soon. Have a great day.