Tax Treatment of Short-Term Residential Rentals Reform Proposal

CRS Report for Congress
Tax Treatment of Short Term Residential
Rentals: Reform Proposal
Pamela J. Jackson
Analyst in Public Sector Economics
Government and Finance Division
Summary
Generally, taxable income has included rental income from real property.
However, an exclusion for de minimis¹ rental income (from the rental of a taxpayer’s
residence for a period of less than 15 days per year) was enacted by the Tax Reform Act
of 1976, (P.L. 94-455). Since that time, a number of tax reform proposals have called
for inclusion of de minimis rental income as taxable income. The most recent proposal
was contained in a report prepared by the Joint Committee on Taxation at the behest of
Senators Grassley and Baucus. The proposal would cap the currently unlimited
exclusion at $2,000 and rental income greater than $2,000 would be included as taxable
income. Deductions for operating costs associated with the rental period (and
depreciation) would be allowable but would reduced in proportion to the ratio of
excludable income to total rental income from the property. The effective date would
be for taxable years beginning after the date of enactment.
The proposed changes would provide more equitable tax treatment of income than
current law, but at the cost of increased record-keeping for taxpayers and enforcement
problems for the Internal Revenue Service. It appears that no changes would be made
to present-law treatment of expenses allowable to taxpayers (e.g., mortgage interest,
property taxes, and casualty losses). The Joint Committee on Taxation has estimated
that the proposal would increase revenues by approximately $10 million each fiscal year.
This report will be updated in the event of legislative changes.

¹ In this report, de minimis refers to a small number of rental days and is not necessarily meant
to imply small dollar amounts.
Congressional Research Service ˜ The Library of Congress

Current Tax Law
Generally, taxable income has included rental income from real property. However,
present law provides an exclusion for de minimis rental income. This exclusion applies
to rental income collected for rental periods of less than 15 days per year. The exclusion
may apply to rental income from either a primary home or a second home. The law also
precludes a taxpayer from taking deductions for any operating expenses attributable to
that income. Such operating expenses would include items such as gas, electricity,
telephone/cable/internet services, or maintenance expenditures, and also depreciation.
Current law allows taxpayers to claim a deduction for qualified home mortgage interest
expenses and property taxes, which can include rental income property if the property is
either the main home or the second home of the taxpayer. The tax law does not
distinguish between personal and business use for the purpose of the interest and tax
deductions for the short term rental period.
Legislative History and Rationale
The exclusion of de minimis rental income was enacted by the Tax Reform Act of
1976, which had six stated major goals as reasons for passage. One those goals was to
improve the equity of the tax system at all income levels without impairing economic
efficiency and growth. Another of the stated goals was to simplify the tax law by
modifying individual income tax deductions and credits. Before the passage of this act,
the marketing of vacation homes frequently emphasized the tax benefits of renting the
property for part of the tax year. Congress found it difficult to distinguish rental activities
engaged in to make an economic profit from other rental activity. Accordingly, under the
1976 Act, Congress set up rules that limited deductions for rentals when the taxpayer also
used the unit for personal use.²
Both the House and Senate bills for the 1976 Act provided a de minimis exclusion.
While not specifically stated in their reports, it appears likely that Congress saw the
exclusion as a simplification measure. The Senate bill would have provided an exclusion
for short term rentals of less than one month over the course of a year. The conference
agreement followed the House bill, which provided the exclusion for rentals of less than

15 days over the course of a year.

In 1992, the House passed H.R. 2735, which would have repealed the 15 days de
minimis rule. That same year, another bill, H.R. 11, also would have repealed the broader
exclusion but provided one exception. That exception stated that when “accommodations
to visitors to an event for which commercial accommodations can provide no more than
one-half of the needed accommodations, then the current-law exclusion (and denial of
deductions) applies to the extent that the rental rate charged is not greater than the³
reasonable commercial rate.” H.R. 11 was vetoed by former President George H. W.
Bush and, thus, the provision did not become law.

² Different rules apply depending on if the home is rented for more than 14 days a year and is
used by the owner more or less than 14 days or 10% of the rental days (whichever is greater).
³ U.S. Congress, Joint Committee on Taxation, Comparison of Revenue-Related Provisions of
H.R. 11 (Revenue Act of 1992) as Passed by the House and Senate, JCS-16-92, 102^nd Cong., 2d
sess., (Washington: GPO, 1992), p. 36.

Other efforts to repeal the de minimis exclusion have been made. Repeal efforts
were included in the House version of the Balanced Budget Act of 1995 and the House
version of the Taxpayer Relief Act of 1997. In both of these cases, the provisions for
repeal were dropped while the bill was in Conference. The proposal again surfaced in
1997 and was introduced as a revenue offset to H.R. 2621 known as the Reciprocal Trade
Agreement Authorities Act of 1997. This bill, reported by the House Ways and Means
Committee, failed passage on a vote in the full House. The most recent proposal for
change prior to the 109^th Congress was made by President Clinton, who called for repeal
of the de minimis exclusion as part of the FY2000 budget request made to Congress.
Under President Clinton’s proposal, the prohibition denying deductions associated with
the costs incurred for the rental would also have been repealed.⁴
Proposal for Change
On January 27, 2005, the Joint Committee on Taxation unveiled a new report
entitled Options to Improve Tax Compliance and Reform Tax Expenditures,⁵ which
included a proposal to limit the exclusion for rental of a residence rented for fewer than
15 days. The proposal provided that the first $2,000 of rental income would be excluded
from the taxpayer’s income. For those taxpayers whose rental income exceeds the $2,000
amount, the proposal would allow for deductions attributable to the rental property (such
as depreciation). However, these deductions would be reduced in proportion to the ratio
of excludable rental income to total rental income. The Joint Committee on Taxation
provided the following example of how this would work:
Taxpayer A rents his residence for fewer than 15 days during the taxable year. The
taxpayer receives $5,000 in rent and has $2,000 of otherwise applicable deductions
arising from such rental use. Under present law, none of the $2,000 is deductible and
none of the $5,000 of rental income is included in gross income. Under the proposal,
the allowable amount of the deduction is reduced by the ratio of excludable gross
rental income to total gross rental income (i.e., $2,000/$5,000). This reduces the
otherwise applicable deductions arising from such rental use by 40 percent from
$2,000 to $1,200. After reducing the gross rental income of $5,000 by the amount of
the allowable deductions the taxpayer’s net rental income is $3,800. Of this amount,
$2,000 is excludable so the taxpayer has $1,800 of taxable income from the rental of⁶
the residence.
Current law prohibits deductions associated with the costs incurred with the de
minimis rental income. Under the proposal made by the Joint Committee on Taxation this
prohibition would be repealed. As such, taxpayers would be permitted to offset rental
income by any expenses such as fees charged by rental agents, electricity, gas, house
cleaner services, etc. when the rental income exceeds $2,000. The proposal does not
indicate whether the $2,000 amount is to be adjusted for inflation in future tax years.

⁴ Taxpayers would have been permitted to offset rental income by an expenses such as fees
charged by rental agents as fees, electricity, gas, house cleaner service, etc.
⁵ U.S. Congress, Joint Committee on Taxation, Options to Improve Tax Compliance and Reform
Tax Expenditures, committee print, JCS-02-05, 109^th Cong., 1^st sess. (Washington: GPO, 2005),
pp. 57-58.
⁶ Ibid.

While noting that the $2,000 dollar limitation, or any amount, is arbitrary, the Joint
Committee on Taxation explained that the current unlimited exemption amount is not
justified using a de minimis rationale. Further, the Committee noted that “a dollar
limitation would allow Congress to target the de minimis exception to taxpayers with
relatively small amounts of rental income, which is more consistent with the de minimis
rationale.”⁷
In the current proposal, taxpayers who have rental income greater than the $2,000
de minimis amount would be required to take depreciation deductions for the rental
period, though no specific legislative language was included in the proposal. Some past
proposals, such as that suggested in the 105^th Congress in H.R. 2621, the Reciprocal
Trade Agreement Authorities Act of 1997,⁸ would have provided a special rule which
would have applied to those taxpayers who rent their homes for less than 15 days. The
intent of that rule was to provide those taxpayers who had a short term rental the option
to claim a depreciation deduction on the home. Current tax law provides that, for those
taxpayers claiming depreciation for residential rental property, the straight line method
based on a 27 ½ year period should be used. If no depreciation deduction was claimed,
then the taxpayer would not need to adjust the basis of the house upon later sale.⁹
Assessment
Economists believe that under a theoretically pure income tax, income should be
defined as broadly as possible. Since current law excludes rental income for stays less
than 15 days it understates income and, thus, does not tax income properly — at least
according to a theoretically pure income tax. In contrast, proposals that include rental
income in gross income and allow appropriate expenses provide for purer tax treatment.
If the proposal included a provision allowing the taxpayer the option of claiming a
depreciation deduction, then economists would find that those taxpayers who forgo the
depreciation deduction associated with the rental income would be overtaxed on that
income by the amount attributable to depreciation and not deducted.
If the rule is included as was suggested by the Joint Committee on Taxation, those
taxpayers required to take the allowable depreciation deduction would likely have
extensive recordkeeping relative to the small deduction allowed, resulting in both high
administrative expenses and increased tax code complexity. To claim depreciation,

⁷ Ibid. p. 58.
⁸ H.R. 2621 was reported out of the House Ways and Means Committee but failed passage in the
House.
⁹ This special rule was contained in §301(e) of H.R. 2621. As drafted the bill stated that “If a
dwelling unit is used during the taxable year by the taxpayer as a residence and such dwelling
unit is actually rented for less than 15 days during the taxable year, the reduction under
subsection (a)(2) by reason of such rental use in any taxable year beginning after December 31,
1997, shall not exceed the depreciation deduction allowed for such rental use... “ The courts have
traditionally held that, while a taxpayer may choose not to avail themselves of a depreciation
deduction, if that deduction is allowable, then the property’s basis must reflect the allowable
depreciation when sold. Technical changes were discussed with an agreement that the word
taken for allowed would make the provision less ambiguous.

taxpayers must remove the value of land (not a depreciable amount) from the property’s
basis. The deduction is likely to be small because of the short rental period (up to 14 days
out of a 365-day year) and the long depreciable period (27 ½ years). Further, those
taxpayers taking the depreciation deduction would need to recapture and pay tax on any
previously claimed depreciated amounts upon sale of the property. The administrative
costs would be high not only for the individual taxpayer but also for the Internal Revenue
Service. Considering the small dollar amounts involved, the tax provision is not likely
to be cost effective. Thus, theoretically correct tax treatment would greatly increase
complexity for taxpayers.¹⁰
Requiring the computation of depreciation could result in taxpayers deciding that the
rental income was not sufficiently high to offset the accounting and tax preparation costs.
However, if the proposal were to allow taxpayers to choose whether to take a deduction
for depreciation and not require taxpayers to make a reduction in the basis of the property,
then it would not increase tax complexity. It would, however, be counter to a pure
income tax model.
Several arguments are made against exclusions in general. For example, some may
argue that all income should be included in the tax base because it is the best measure of
an individual’s ability to pay taxes. Other arguments suggest that upper-income taxpayers
receive a greater subsidy from exclusions than lower-income taxpayers because of the
higher tax rate upper-income households face.
It appears unlikely that lower-income persons are more prone to rent their homes for
a two-week period than those with higher-income. Because of the nature of special events
or areas with limited accommodations where demand is high, it can be expected that the
costs of accommodations will rise and likely be expensive. Again, news reports suggest
that higher-income households are those seeking such accommodations and that their
demands are for more luxurious accommodations more likely to be owned by higher
income individuals.
It is unclear who benefits from the current tax law’s exclusion of income from short
term rentals. While unsubstantiated, news reports typically associate the provision’s use
with special events or locations. For example, homeowners in the Washington, DC area
are reported to have rented their homes during President Bush’s inauguration while
homeowners in New Orleans’ historic French Quarter have rental opportunities during the
annual Mardi Gras period. Besides special events, the provision may benefit those living
in areas with a tight supply of hotel rooms. Such areas are frequently in large cities with
tourist sites. As an example, it is frequently difficult to find accommodations in New
York City where hotels are often booked weeks in advance. News stories suggest that
homeowners frequently use this tax-free rental income to pay for vacations in other areas
while their own homes are being rented out.
Some may argue that owner occupied housing receives excessive benefits from tax
provisions under current law. Besides having income tax deductions for interest expense

¹⁰ The Joint Committee on Taxation stated that “The burden of this additional basis calculation,
however, is relatively small when weighed against the more accurate measurement of economic
income for such taxpayers achieved by the proposal,” p. 58.

and property taxes, economists argue that homeowners also have a tax exemption for the
imputed rental value of their home. All of these tax incentives provide significant
benefits for homeowners that are not available to renters. Of course, some might argue
that home ownership is a worthwhile social goal that should be tax-favored.
In addition to the tax benefits previously mentioned, there is also an exclusion from
capital gains taxation for principal residence home sales of up to $250,000 for single
taxpayers and $500,000 for married couples. The favorable capital gains treatment of
residences encourages investment in real estate as opposed to financial assets, which
experience less favorable tax treatment. This preferential treatment of home ownership
diverts capital away from other uses, including business investment.
Alternatively, it may be argued that the benefit of current law’s exclusion for de
minimis rental income may flow through to those renting accommodations in the form of
lower rents.
Some may question whether taxpayers would report their short term residential rental
income. To the extent that such payments are made in cash, it would be difficult for the
Internal Revenue Service to monitor rental payments. The proposal does not mention if
it includes income reporting requirements by rental agents.
Revenue Effects
The Joint Committee on Taxation has estimated that if their proposal were to become
law there would be an increase in federal income tax revenue, by approximately $10
million each fiscal year.¹¹

¹¹ U.S. Congress, Joint Committee on Taxation, Options to Improve Tax Compliance and Reform
Tax Expenditures, 109^th Cong., 1^st sess. (Washington: GPO, 2005), p. 425.