The Tax-Free Way to Rent Out Your Home

This Week's Quote:

"Alone, we can do so little.  Together we can do so much."
                        - Helen Keller

One of the best freebies in the tax code has gotten better—for people who don’t abuse it. The shift springs from a recent Tax Court decision. 

The freebie is tax code section 280A(g), often called the Masters’ exemption, which is worth reviewing on its own. It’s a longstanding provision allowing people to rent out their homes for two weeks or less and pocket the rental income free of federal taxes. 

This benefit is often called the Masters’ exemption because residents of Augusta, Ga., use it to rent their homes to players and fans tax-free during the famed golf tournament. During the tournament, large, lavish homes can rent for thousands, and sometimes tens of thousands, of dollars a night.

The exemption is useful far beyond Augusta. “People living near events like the Super Bowl, a rock concert, or a presidential inauguration can use this provision, and so can owners of vacation homes,” says Ed Zollars, a Phoenix-based CPA who teaches tax professionals about new tax developments. 
  
For many homeowners, that’s benefit enough. However, a recent Tax Court decision in the case of Sinopoli v. Commissioner permitted a twist on this strategy: It allowed three business owners to rent their homes to their business for meetings, deduct the rent, and receive the rent tax-free under the Masters exemption. But owners must follow all the rules—and they didn’t.  

Here are key facts, according to the opinion. Two anesthesiologists and an orthopedic salesman based on the Mississippi Gulf Coast had nearly equal shares in a Planet Fitness franchise that owned outlets in Louisiana from mid-2013 to mid-2017. The business was organized as an S Corporation, an entity that passes income, credits, deductions and losses through to the personal return of the owner or owners. 

The owners said that, for convenience, they decided to hold business meetings in their homes during 2015, 2016 and 2017. For that, the business paid each one about $3,000 a month in rent and deducted total rent of $290,900 over that period, reducing the firm’s taxable earnings. Each owner then claimed the rental income he received from the business was tax-free under the Masters’ exemption.

Not so fast, said the Internal Revenue Service. Its agent and lawyers pointed out that the going rate in the area was $500 for a full or half-day rental of much larger spaces. They also said the owners didn’t keep good records—or sometimes any records—of the meetings. 

The judge agreed with the IRS and allowed a total rent deduction of $16,500, saying the owners likely “adopted a tax-savings scheme.” 

An attorney for the taxpayers in the case said they declined to comment on it. 

Tax schemes using the Masters exemption do happen, says Troy Lewis, a CPA who teaches at Brigham Young University. “They’re a tax dodge and the pitch is, ‘Here’s a way to make business income disappear. You’re a chump if you don’t.’” 

This ploy can be tempting, he adds, because it’s hard for the IRS to detect. The deduction is often one of many for the company, and the taxpayer can leave Masters’ exemption rental income off their own returns.

Still, it’s notable that the judge allowed some deductions rather than none, says Zollars. While the opinion can’t be cited as precedent, it helps validate the strategy. 

To be sure, many taxpayers will reap more tax-free income by renting an entire home to someone else than by renting their living room to their business. For everyone interested in the Masters’ exemption, here’s more to know. 

The basics

The income from a short-term rental of one or more personal residences can be free of both federal income and payroll taxes, although state or local taxes may be due. There’s no limit to the amount of income that qualifies. So if the Super Bowl is coming to town or you have a showplace beach compound, even a six-figure rent could be tax-exempt.   
 
Time limits

By law, the rental period must be fewer than 15 days. This rule comes with a cliff: If the rental is longer, none of the income is tax-exempt, and it must be treated like other rental income. See IRS Publication 527 for more information. 

However, the days can be discontinuous, such as one week in June, two days in July, and five days in September. If someone owns more than one residence, says Zollars, each may qualify for a separate 14-day exemption—but it could be hard to make this work in practice.

Eligible properties

The property must be a dwelling unit with eating, sleeping and toilet facilities, so the exemption could apply to the rental of a boat or RV as well as a house. The property must also be used as a residence during the year, although it doesn’t have to be your principal residence.

Income treatment

On page three of Publication 527, the IRS tells taxpayers not to report the income they earn from these rentals on their tax returns. 

If a business pays the rental income, however, it may be required to send the owner and the IRS a 1099 form reporting it. In that case, says Lewis, the owner can claim the income on the return, subtract it, and attach an explanation. This may attract IRS attention.      

Unlike with other rental income, no expenses (such as for food, supplies or utilities) are deductible from this rental income. However, filers who itemize on Schedule A don’t have to dock their deductions for mortgage interest and property taxes.

Renting a home to one’s business

Taxpayers who go this route must be scrupulous in obeying the rules. 

Be sure to avoid the mistakes made in the Sinopoli case: Value the rented space properly, and keep good records—such as about the time of meetings and the issues discussed—to show the expenses were necessary.
                                                                                                  
Credit goes to Laura Saunders, published October 5, 2023 in The Wall Street Journal
 
Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.
 
This Week’s Author, Belinda Stickle

-until next week