Short-Term Rental Management Contracts

The problem: you hire a property manager, they do everything, and now you look passive

Short-term rentals let you own real estate, skip real estate professional status, and STILL pull real tax benefits. It’s become a staple for tax strategists.

Read about the Short-Term Rental Tax Strategy.

Why Property Managers Can Create a Material Participation Problem

One problem: STRs are a ton of work and a ton of time. So what do busy people do? The smart thing: they hire out.

But the only downside to this is that now you can’t get the hours you need to materially participate in your STR.

If the property manager is taking all your booking time, your marketing time, cleaning time, maintenance time, and guest comms, what are you supposed to do?

Get new furniture every 6 months?

That’s not a practical strategy or approach. So what if you can combine both?

What if you can get a manager (manager of some tasks), and you do some of it yourself — then that is the best possible solution.

Because you’ve passed off some of your mental load and actual work, while keeping enough hours to do this.

Does this actually work in practice?

We have two tax court cases, Kline v. Commissioner (T.C. Memo. 2015-144) and Pohoski v. Commissioner (T.C. Memo. 1998-17), where both had some form of “management contract,” and were able to keep their losses.

Kline v. Commissioner (T.C. Memo. 2015-144): The Boat Charter Case

Yes, it’s a boat case. However, we can apply rules from these situations TO our real estate, as rental concepts are not just for real estate.

Kline was a boat pilot (I know that feels like captain, but I don’t really understand maritime lingo). He was also a real-life pilot. And when he wasn’t flying, he wanted to boat — which led to him wanting to purchase a yacht, and then led him to take fellow pilots out and let them rent his yacht.

Kline was relatively busy, being a pilot and all, which forced him to seek alternative help.

He interviewed a few different charter/management companies, and ultimately landed on one. He chose Horizon Charters specifically because the contract let him retain more control. Kline wanted various controls of the business, and he wanted the flexibility.

He adjusted the contract and the fee for what Horizon (the management company) would do and what he would do.

Horizon handled marketing, collecting money, and cleaning/maintaining. But Kline retained the customer experience, his own marketing to airline pilots, trip planning, and prep work.

The IRS began to audit Kline, and ultimately decided to take him to court after disagreements for the 2007 and 2008 tax years.

The IRS found that they did not believe Kline was able to materially participate in the activity, and because of this, the losses should be passive and not offset his W-2.

However, the tax court ultimately disagreed. The court found he met the §1.469-5T(a)(3) test: 100+ hours AND more than any other individual.

The key was that Horizon employees’ time was segregated by duty — no single employee exceeded Kline’s hours. Plus, Kline’s spouse’s hours were able to be counted as well, and those were missing.

Takeaway? Keep a log of the employees in the business of the management or contracting companies. By having this log, you have a much more solid defense against the IRS.

Note: the IRS says in their now-pulled IRC 469 Audit Technique Guide that the code is not “specific,” and will try to make the argument that material participation is measured by company, not by individual. We disagree with this approach.

Pohoski v. Commissioner (T.C. Memo. 1998-17): The Hawaiian Condo Case

Pohoski was working short-term rentals before Airbnb digitized the entire space. He lived in California but purchased some condos in Hawaii.

He wanted more operational control, and worked with the management company association on that front.

Pohoski modified his management agreement to retain bookings, advertising, and evictions. He did his own marketing: travel agents, website, phone calls, business cards.

And when I say he took phone calls, he took phone calls. So much so that he had to stop, because his “long distance” charges were racking up fast: 2–3 calls per day until he switched to written correspondence, which wound up saving him a lot of cash.

He also went on “working vacations” to do maintenance, and was able to show the projects he spent time on and what was accomplished each time.

Here is the kicker. He had two properties. One that cash flowed and performed pretty well. The other was a loser.

The court believed there was material participation on the profitable property, and that he fulfilled the 100-hour test. But he lost on the money-losing property because he didn’t delineate hours per property — he just did a 50/50 split.

Takeaway: track hours PER PROPERTY, not in aggregate.

But the larger takeaway? If you keep some operational control, and turn your property manager into more of a “co-host,” you might be able to STILL achieve material participation.

What Your Management Contract Should Include

Your contract should establish that the owner retains primary authority over all material operational decisions, while the PM operates in an execution and support capacity within owner-defined parameters. The owner sets pricing strategy, and the PM implements within approved ranges.

The owner approves vendors and the PM schedules and coordinates.

The owner establishes guest policies and the PM enforces them. The owner is the primary recipient of guest messages, while the PM handles routine inquiries.

All of the above creates documentable hours as a byproduct of normal operations.

Then tighten the language. Change “may be documented” to “shall be documented” — Pohoski lost because he couldn’t prove hours.

Add a contractual requirement to maintain a contemporaneous time log per property. And consider requiring the PM to provide monthly activity summaries showing tasks performed by PM staff vs. owner.

Not every property management company will make changes to their contracts, and not every STR manager should be keeping responsibilities. I’m a big believer in time over headache, personally.

A Few Tax Tips

Don’t include the fees, with an adjusted contract, in the “management fee box” on Schedule E. That is a red flag to the IRS in a real estate audit.

Now, if you actually have management fees, and they are not different from what is outlined above, then you need to report it properly.

Changing an expense because you are hiding from the IRS is a good way to lose.

Keep a log of the time your former PM (now vendor) actually spends. If you can’t reasonably estimate and provide good testimony, then you’re going to have issues.

Count your spouse’s hours. Participation by your spouse counts as your own under §469(h)(5), and it can be the difference between clearing the 100-hour test and falling short. Kline is the proof.

Mrs. Kline did roughly half the work in 2008, and the court counted it. So if your spouse is handling guest comms, turns, or bookings, log their time the same way you log yours.

If you’re using a property manager or considering hiring one, our team can help you evaluate your short-term rental structure, identify potential weaknesses, and develop a tax strategy that aligns with your goals.

Schedule a consultation with Hall CPA to review your STR strategy and material participation position.