Short-Term Rental Loophole: Schedule C or E?

The rise of online rental platforms has created new opportunities for property owners but has also introduced complexity into tax reporting. For owners of short-term rentals, a determination is how to classify their activity for tax purposes. This classification dictates which tax forms to use and can alter the amount of tax owed. The Internal Revenue Service (IRS) provides specific criteria to distinguish between a passive rental activity and an active trade or business, with the choice of reporting method impacting self-employment taxes and how losses can be deducted.

Determining if Your Activity is a Rental or a Business

The factor determining if your short-term rental (STR) is a rental activity or a business is the level of services you provide. The IRS distinguishes between services that are customary for lodging and those that are “substantial.” If you provide substantial services, your activity is treated as a business, and you must report income and expenses on Schedule C, “Profit or Loss from Business.” If not, it is a rental activity reported on Schedule E, “Supplemental Income and Loss.”

Substantial services are offered for the guest’s convenience and are not associated with simple property occupancy, making the experience more like a hotel. Examples include providing daily cleaning, changing linens for a current occupant, offering meals, or arranging transportation and concierge-style services.

In contrast, insubstantial services do not trigger the business classification. These services are necessary for maintaining the property, such as providing utilities, collecting trash, and performing cleaning and maintenance between guest stays. The classification is based on the nature of the services guests receive, not the amount of work the owner performs.

Reporting on Schedule E Supplemental Income and Loss

When a short-term rental activity does not involve providing substantial services, it is reported on Schedule E. By default, rental activities are considered passive by the IRS. This classification invokes the Passive Activity Loss (PAL) rules, detailed in IRS Publication 925, which prevent taxpayers from deducting passive losses against non-passive income like wages. If your STR generates a net loss for the year, you cannot use that loss to reduce your other taxable income. Instead, the loss is suspended and carried forward to offset future passive income or gains from the property’s eventual sale.

An exception exists for STR owners, often called the “short-term rental loophole.” If the average guest stay is seven days or less, the activity is excluded from the definition of a “rental activity” under the PAL rules. This allows losses to be treated as non-passive if the owner can demonstrate “material participation.” Meeting one of the seven material participation tests allows an owner to deduct STR losses against all other forms of income.

These tests require careful documentation, and the most common for STR owners include:

• Participating for more than 500 hours during the year.
• Participating for more than 100 hours if that is more than any other individual.
• Your participation constitutes substantially all of the participation for the activity.

Other tests involve participation in prior years or are based on specific facts and circumstances. To meet the 100-hour test, an owner must log time spent on management, guest communication, and coordinating maintenance, and ensure no single contractor spent more time.

Reporting on Schedule C Profit or Loss from Business

If your STR operation is classified as a business due to providing substantial services, you must report the financial activity on Schedule C. The primary consequence is the application of self-employment taxes to any net profit, which is in addition to regular income tax. Self-employment tax consists of Social Security and Medicare taxes, totaling a combined rate of 15.3% on 92.35% of your net business profit. The 12.4% Social Security portion applies up to an annual income limit, while the 2.9% Medicare portion applies to all net earnings.

An advantage of Schedule C reporting appears when the property generates a loss. Losses from a Schedule C business are automatically considered non-passive, meaning you do not need to meet any material participation tests to deduct them. The loss can be used to offset other income sources on your tax return, such as wages or investment income. This automatic non-passive treatment for losses comes at the cost of higher taxes on profits.

Required Documentation and Record-Keeping

Regardless of whether you file on Schedule C or Schedule E, the burden of proof is on you to substantiate the figures on your tax return. The IRS requires accurate records to support all income, expenses, and tax positions. Maintaining organized documentation is a necessary defense in an audit.

Proving Material Participation for Schedule E

For owners claiming non-passive losses on Schedule E, the primary documentation is evidence of material participation. A contemporaneous time log is the strongest proof, detailing the date, hours spent, and a description of tasks performed. Supporting documents can include emails with guests or contractors, management calendars, and receipts that corroborate your logged hours.

Proving Substantial Services for Schedule C

If you file on Schedule C, your records must prove you provided substantial, hotel-like services. This could include contracts with cleaning companies specifying daily service, menus or receipts for meals, and records of guest communications confirming services like transportation. The goal is to demonstrate that your operation functions more like a hospitality business.

General Financial Records

All STR owners must maintain detailed financial records. This starts with a separate bank account for rental-related income and expenses to avoid commingling funds. You must keep all income statements from booking platforms, as well as receipts for every claimed expense, such as cleaning, repairs, supplies, mortgage interest, property taxes, and insurance. The IRS requires that you keep these records for at least three years after filing your return.