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1031 Exchange: Solution for Short-term Rental Property Owners Faced with Legislative Changes

Accruit
04/09/24
This blog article covers short-term rentals, specifically the rise of Airbnb and VRBO, and how recent and proposed legislative changes are impacting the way in which property owners are able to utilize their property. For many of these property owners, a 1031 Exchange can be utilized to defer tax as they look to sell their short-term rental and reinvest into a different property type.
1031 Exchanges are a solution for short-term rental property owners restricted by recent legislative changes

Short-term Rental Market Overview 

Over the past 15 years, short-term rentals, such as Airbnb and VRBO, have become an increasingly popular investments for property owners. In 2020, the COVID-19 pandemic led to an explosive need for short-term rentals, which led many investors to turn their sights and funds toward short-term rentals. As of 2024, Airbnb has over four million hosts, or property owners, and seven million global listings, as many hosts own more than one rental property. In recent years, the short-term rental market has exploded. The average number of short-term rentals in the US in 2022 was 1,278,254, a 20.5% increase from 2021 and 2023 saw an additional 11% increase up to 1,424,441 total rentals. In 2022, the average monthly rental income from Airbnb in Denver was $3,540, for a combined annual rental income of $42,480.  

It was reported in 2023 that 30% of vacation property owners and 32% of investment property owners have expressed interest in renting their homes as short-term rentals. While interest and inventory for short-term rentals has drastically increased over recent years, residents of high-interest areas are voicing concerns over the impact they feel short-term rentals may have on their neighborhoods. As a result, many cities and counties have begun to institute restrictions and even bans in specific high-tourism and urban areas which affect the return-on-investment potential for short-term rental property owners.  

Proposed Limits to Short-Term Rentals in Colorado 

County Specific 

Increased restrictions and bans on short-term rentals can be seen across the country, but below are some specific examples of proposed legislation that would impact Colorado short-term rental property owners.  

Park County, Colorado, which includes popular towns such as Alma and Fairplay, has experienced an increase in short-term rentals. In 2021, the county passed an ordinance that property owners must obtain an annual license. Additionally, the tourist-filled ski region is considering limiting or eliminating short-term rental properties as issues of housing scarcity, increased pricing, and neighborhood disturbance have been called into question. While Park County faces decisions regarding this industry, many towns and counties across Colorado, as well as other parts of the country, are also weighing the decision between allowing a strong rental market to continue or impose hard limits. 

Another Colorado county dealing with proposed regulations is Summit County, home to many iconic and popular ski towns such as Breckenridge, Frisco, and Keystone. In terms of Summit County’s property tax rates, it was proposed earlier this year to increase tax rates based on classifications between lodging and residential properties. If short-term rental properties are classified as lodging properties, due to being booked as a short-term rental for more than 90 days per year, then the tax would be four times the residential rate. This large discrepancy would make it difficult for these property owners to cover their operating expenses or receive any meaningful return on investment, hence reducing property being used in this way.  


Colorado Senate Bills 33 & 2: 

In Colorado, two proposed bills are set to address and revise guidelines regarding short-term rental properties. Senate Bill 33 proposes that property, as well as the land it is on, can either be categorized as residential real property or lodging property. If the unit was leased for short-term stays over 90 days in the previous tax year, then it would be classified as lodging property. Otherwise, it would be residential real property. From this assessment, property taxes could be determined, highlighting large discrepancies between the classifications with lodging properties facing a much higher tax rate.  

Senate Bill 2 proposes amendments to current law, allowing counties to offer property tax credits or rebates to promote specific uses of real property addressing local concerns to the use of real property. These concerns may include issues affecting residents' health, safety, welfare, equity, housing access, and education. The bill would allow counties and cities to give tax breaks to properties that are used for mental health, childcare, and other areas of “specific local concern.” The bill defines an "area of specific local concern" as real property use that is diminishing or unavailable or deemed necessary for residents' well-being.  

While these bills are in review, the property owners of short-term rentals are pushing back on what feels like an inaccurate characterization. Al Furlone is the manager of Winter Park Lodging Company and Steamboat Lodging Company, and a founding member of the Colorado Lodging and Resort Alliance. He claims to have conducted a survey of thousands of Colorado vacation rental homeowners and found that 89% of them only own one property. This survey conflicts with a popularized narrative that many of the short-term rental properties are controlled and managed by a few large corporations. Furlone wants policymakers to understand that this bill will be targeting and effecting individual property owners, not large business conglomerates attempting to utilize a lower tax rate by claiming vacation homes and hotels as residences.  

Trends Between City Bans & Restrictions 

The three most common policies affecting short-term rental regulations are registration and licensing requirements, occupancy limits, and taxation.  

Registration & Licenses 

For many cities and counties, registering properties as short-term rentals and obtaining appropriate permits and licenses are required. In this process, fees may be applicable, and rentals must meet criteria such as safety inspections or proof of insurance.  

Also, cities are instituting caps on short-term rentals through neighborhood-specific licenses. For example, the Mission Beach neighborhood in San Diego, California, has imposed regulations that no more than 30% of the available housing units can be short-term rentals. These limits are imposed and monitored by requiring residents to apply for a license to operate in the short-term rental market. Once the 20% limit has been reached, no additional short-term rental properties would be permitted.  

Occupancy Limits 

Another common policy is occupancy limits. Some cities like Austin, Texas and Honolulu, Hawaii only allow a small number of guests, no large groups (typically a 6–10-person limit). This is often done to address concerns about noise, parking, and neighborhood disruption.  

Taxation 

Lastly, taxation is implemented across the board for rental properties. Short-term rental owners are often subjected to various taxes, including sales, occupancy, local tourism, and property taxes. Proposed legislation is focused on increasing tax rates for short-term rentals to make them a less desirable investment, as well as potentially increasing reporting requirements or collection mechanisms for these taxes.  

Overall, new legislation and regulations affecting short-term rental properties aim to balance the interests of property owners, residents, and local communities. While these regulations may impose additional requirements and costs on property owners, they are intended to address concerns related to housing affordability, neighborhood quality of life, and the overall impact of short-term rentals on local housing markets.  

These are just a few examples of proposed legislative changes that will impact short-term rentals. It is important to note that regulations can vary significantly from one town or state to another. It's essential for hosts and travelers to research and comply with the specific regulations in their area to avoid potential legal issues. Additionally, the landscape of short-term rental regulations is continually evolving, so it's essential to stay informed about any updates or changes in local laws.  

Utilizing a 1031 Exchange to Exit Short-term Rentals and 1031 Exchanges 

With looming regulations on short-term rentals, many property owners and investors may be looking for an exit. A 1031 Exchange would allow property owners to exit properties they are no longer able to use as intended, prior to new or pending legislation, while deferring tax on the real estate transaction. These property owners can redeploy the proceeds from the sale of the property into a different property type or one unaffected by short-term rental regulations. 

According to the Internal Revenue Code (IRC) §1031, real estate assets that are held for productive use in a trade or business, or for investment are eligible for a 1031 Exchange . By that definition, short-term rentals meet the qualifications for a 1031 Exchange . With that, a safe harbor definition has been created by the Internal Revenue Service (IRS). If a property is used as a personal vacation or second home as well as a short-term rental for any amount of time during the year, the following safe harbors must be met in order to qualify for a 1031 Exchange : 

Transitioning from a short-term rental to a different kind of investment property through a 1031 Exchange offers investors an avenue to optimize their real estate portfolio and achieve a greater return on investment than new regulations are allowing. By utilizing an exchange, investors can shift from what can become a low-income producing property to something that will yield higher returns, whether that be a single-family rental home, oil & gas, office building, Delaware Statutory Trust (DST), or one of the many other qualifying Replacement Properties. A 1031 Exchange not only provides tax benefits but also allows investors to diversify their rental portfolios and potentially enhance long-term financial stability. 

In conclusion, while the short-term rental market has experienced significant growth, increased regulations and proposed legislation raise challenges for property owners. With ongoing discussions in places like Park County, Colorado, and legislative efforts across the country, property owners are encouraged to explore a 1031 Exchange as an opportunity to defer tax while transitioning into a different real estate investment that can accomplish their current and future investment goals.  

 

 

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.