Painting the real estate landscape for Kentucky CPAs

By Jon Tennent, CPA

For many real estate clients – from multifamily landlords to owners of short-term rental properties – the interaction of passive activity rules, self-rental characterizations, and grouping elections under IRC §469 can materially affect taxable income and cash-flow optimization. The landscape is complicated by state and local tax regimes (including Kentucky’s transient room taxes and local short-term rental licensing), the growing prevalence of Airbnb and similar platforms, and emerging enforcement emphasis on real estate professional status and activity characterization. Understanding these nuances is essential for CPAs advising on individual and pass-through returns with real estate components.

Passive activities background

Let’s open with a bit of history for context. Among the many changes in the Tax Reform Act of 1986 was the advent of the passive activity loss limitations. Prior to this change, taxpayers were able to offset their primary earned income source with losses from investments that we now view as “passive.” Congress addressed this issue by stipulating that “passive” sources of income now had to be in their own bucket where passive income could be offset by passive losses, but nonpassive income could not be offset by passive losses until the activity was disposed. Seven tests were established to prove material participation[1] and achieve nonpassive status, and the most well-known of these tests is the 500 annual hours requirement. However, and most notably for the purposes of this article, rental activities were classified as passive by default.

Real estate professional rules

This had an unfavorable impact on people who made their living in the real estate world because rental properties were often not simply a passive investment but rather a cornerstone of their day-to-day trade or business. Therefore, in 1993 Congress unveiled the Real Estate Professional rules which allow rentals to be treated as nonpassive if the taxpayer materially participates. CPAs will be familiar with the Real Estate Professional requirements: 1) all real estate hours must be more than 50 percent of your total working hours; and 2) your real estate hours must be more than 750 per year. Real estate hours could be in construction, development, management, brokerage, or rentals – though notably not short-term rentals with significant personal services, which we’ll deal with later. Unlike the normal passive activity tests, your spouse’s hours cannot count toward these metrics. However, once real estate professional status is established, it can cover all the activities on a jointly filed tax return.

A common misperception among clients is that achieving Real Estate Professional (REP) status automatically converts rentals to nonpassive status. This is not the case; instead, it simply removes the assumption that all rentals are passive by default. After becoming a REP, the taxpayer still has to go back to the normal seven passive activity tests (such as the 500 hours test – although the first three tests are most common in the real estate world) and establish material participation in rental activity specifically, just like they would have to do with any other trade or business. One of the biggest hurdles here is the use of property managers. However, if the taxpayer materially participates, they can also avoid Net Investment Income Tax on the rental income, which would normally apply to passive investments. And at the same time, they can likely avoid self-employment tax as long as substantial services are not provided with the rental.

Grouping elections

Despite the above, real estate professionals can find it difficult to demonstrate material participation in each rental. This is where Treasury Reg. §1.469-9(g) comes in and allows rental properties (excluding short-term rentals) to be grouped into a single activity that is evaluated together for determining material participation. To make the election, the taxpayer must attach a written statement to the original return for the tax year in which the election is made. Once made, the election is binding for all future years unless revoked due to a material change in circumstances with IRS consent.

Separately, Regs. §1.469-4 allows a taxpayer to group activities (including rental and non-rental) into an “appropriate economic unit” for purposes of the material participation tests when properties are sufficiently interrelated by shared management, services, or economic interdependencies. For the grouping of a rental and an operating business, one would have to be insubstantial in comparison to the other and have the same proportionate ownership interest. The unit as a whole would then be subject to the material participation tests. These groupings are more flexible but also require a robust, defensible economic rationale in case of audit.

Self-rental rules

Self-rentals are another common factor in the equation as real estate holding companies are typically separated from the operating entity of the trade or business. If the owner of the property is renting to a trade or business in which that some owner materially participates, then we end up with a “self-rental” in which losses remain passive but income is recharacterized as nonpassive.

From a historic perspective, these recharacterization rules were established in the wake of the passive activity loss limits. They were designed to combat the onslaught of “passive income generators” that had emerged to create income offsets and allow taxpayers with large passive losses to utilize them. If self-rental income remained passive, the taxpayer could essentially generate large passive income. There is also case law (see Carlos v. Commissioner, 123 T.C. 275 (2004)) to support the idea that grouping elections can incorrectly subvert the intention of the recharacterization rules.

It’s not all bad news with self-rentals, however. Since the income is reclassified as nonpassive, taxpayers can generally avoid the Net Investment Income Tax. At the same time, they can usually avoid self-employment tax since it’s still a rental.

Short-term rentals

Another factor that often confuses our clients is the fact that short-term rentals (average stay of seven days or less, or 30 days or less with significant personal services) are not treated as rental activities under Treas. Reg. §1.469-1T(e)(3)(ii). As a result, these activities jump directly to the seven standard material participation tests and bypass the default “passive rental” rule.

They may end up passive, or they may end up nonpassive. If they end up nonpassive due to material participation, they will most likely end up on Schedule C (not Schedule E) and be subject to self-employment tax (though not NIIT) and potentially a 39-year depreciation schedule, similar to a hotel operation. Either way, they’re not “rentals” and therefore can’t benefit from the $25k “mom and pop” allowed loss, etc.

One of the most important factors to bear in mind: if your client is real estate professional and is relying on rental aggregation to achieve material participation in rentals, these short-term “rentals” will not count toward rental aggregation and may end up kicking the taxpayer out of rental material participation even if they’re a real estate professional.

Kentucky implications

Kentucky imposes a statewide 1% transient room tax on short-term accommodations (stays less than 30 days) under KRS 142.400, and since 2017, major platforms like Airbnb and VRBO now collect and remit this tax on behalf of hosts. Local jurisdictions can impose additional transient room taxes, and platforms are generally required to collect and remit these as well based on total charges, including service fees.

It is essential to discuss with your client exactly where the short-term rental is located, what the zoning is in that area, and if the property will be “hosted” (meaning the owner also lives on the property) or “un-hosted” (which in most jurisdictions equates to greater restrictions, conditional use permits, and Board of Adjustment approval). Regulations will vary widely by jurisdiction, including the mandatory distance required between short-term rental units.

In Lexington, for example, licensure and zoning requirements include obtaining a zoning compliance permit, a business license, and a special fees license (renewed annually at a rate of $200 for the first unit and $100 per additional unit), with fines up to $500/day for non-compliance. Other jurisdictions (e.g., Pikeville, Shelby County) impose occupational licenses and coordinate local transient room taxes that may differ in collection mechanics.

Conclusion

Real estate clients, from traditional landlords to short-term rental operators, present nuanced tax planning and compliance challenges. Intersecting passive activity rules, REP tests, self-rental rules, and grouping elections under IRC §469 require careful, fact-specific planning. Overlaying state and local short-term rental tax regimes (transient room taxes and licensing requirements) further complicates the landscape. CPAs who proactively integrate these federal and state considerations will be positioned to deliver sophisticated, defensible tax outcomes for their real estate clients.

[1] Note that “material participation” is not the same as “active participation,” which is a separate carve-out with a much lower threshold for certain “mom and pop” rentals. “Active participation” allows certain small landlords with modest AGI to deduct up the $25,000 of rental losses against their ordinary income without being real estate professionals or reaching the higher material participation tests.