How Does California View the Real Estate Professional Status & the Short-Term Rental Loophole?

By Thomas Castelli, CPA | February 17, 2022

If you’re a California resident, it’s probably no secret that California is a bit unique when it comes to state tax issues. 

Most states conform the federal tax code pretty closely, with relatively few deviations. However, California tends to deviate significantly from the federal tax code and it’s usually not in favor of the taxpayer.

The big question is does California recognize the real estate professional status (REPS)? What about the short-term rental (STR) loophole?

With LA winning the Superbowl this weekend, it’s only appropriate that we address these issues in this week’s article. After all, CA residents will need a way to shelter their winning sports bets from tax ;)!

Does California Recognize the Real Estate Professional Status (REPS)?

Unfortunately, one major area California deviates from the federal tax code is the real estate professional status (REPS). California does not recognize REPS.

Their position is clear and definitive. It is found under California Revenue and Taxation Code Section 17561(a):

“Section 469(c)(7) of the Internal Revenue Code, relating to special rules for taxpayers in real property business, shall not apply.”

Section 469(c)(7) is the section of the Internal Revenue Code (IRC) where you can find REPS.

In addition, California also addresses this in their instructions for Form FTB 3801, Passive Activity Loss Limitations:

Beginning in 1994, and for federal purposes only, rental real estate activities of taxpayers engaged in real property business are not automatically treated as passive activities. California did not conform to this provision. For California purposes, all rental activities are passive activities. Therefore, an election under IRC section 469(c)(7) is inapplicable for purposes of California personal income or franchise tax and taxpayers should group rental activities without regard to IRC section 469(c)(7).

This means, if you qualify for REPS, the losses from your rental properties will be non-passive and can offset your active income at the federal level – but will remain passive at the state tax level.

There is no room for interpretation here. It’s clear and definitive, California simply does not conform to this part of the federal tax code.

What About the Short-Term Rental (STR) Loophole?

When it comes to the Short-Term Rental (STR) Loophole, the answer isn’t clear and is open for interpretation.

Referencing the section above, California views all rental activities as passive activities, regardless of whether you qualify for REPS under the federal tax code. 

But the question is, are STRs rental activities under the California tax code?

At the federal level, Reg. Sec. 1.469-1T(e)(3) defines rental activities and the exceptions to that definition. Under Reg. Sec. 1.469-1T(e)(3)(ii)(A), you’ll find the exception to the definition of a rental activity which has become known as the STR Loophole, “The average period of customer use for such property is seven days or less”

While California calls out that it does not conform to Section 469(c)(7), it doesn’t appear to specifically call out that it does not conform to Reg. Sec. 1.469-1T(e)(3).  

So assuming that California does not specifically call out that it does not conform to this section, we would be left to believe that it does. And thus, STRs with an average stay of seven days or less are NOT rental activities, just like the federal tax code. 

However, that is not enough for us to confidently make that call, we would like to have something that addresses Reg. Sec. 1.469-1T(e)(3)(ii)(A) from California if possible.

Here we have, Appeal of Craig Wheeler and Dani Wheeler California State Board of Equalization, a tax court case identified by none other than the Founder of Tax Smart Investors, Brandon Hall.

In this case, one issue that the taxpayers brought to the table was the exception to the definition of a rental activity found in Treas. Regs. Sec. 1.469-1T(e)(3)(ii)(A). While its use case is related to rental of an airplane, and not real property, it’s the most relevant case we can find.

The following is a block of text from the court case. “Respondent” is California:

Respondent notes that appellants assert these activities are not rental activities because they meet exceptions listed in Treasury Regulation section 1.469-1T(e)(3). Respondent contends that appellants do not meet the exception for when the average customer rental use is seven days or less during each taxable year (i.e., Treasury Regulation section 1.469-1T(e)(3)(ii)(A)) because the rental length cannot be based on the isolated use by charter customers since Sea-Ya was not certified to conduct charter flights, and these customers were Global’s customers, not Sea-Ya’s. Instead, respondent argues, Sea-Ya’s customer was Global, who had a twelve-month lease. Respondent asserts that this analysis is in line with the finding in Frank, where the court determined that the taxpayer was leasing the plane to the flight schools, and not to the customers of the flight schools. 

Here California acknowledged Regs. Sec. 1.469-1T(e)(3)(ii)(A), and states that the appellants don’t meet that exception. While not definitive, it appears California does recognize this section, and thus STRs with an average stay of seven days or less would not be rental activities.

A Word of Caution

“The science involved in tax law is finding cases, rulings, procedures, and publications that support your position. The art form is putting your spin on the deduction. That’s all you can do when neither the law nor the regulations give clear advice” – Unknown

Having said that, I do want to add some words of caution. 

The first is, the argument presented above is not 100% bullet proof because we have nothing that explicitly indicates whether or not California actually conforms to this section –  everything we have is implicit.

Secondly, it’s possible that reporting non-passive losses from this type of activity on your California state tax return may trigger an audit. Given that the California FTB is known to be an aggressive taxing authority, and California already places a fair amount of restrictions on STRs, defending this position under audit could turn into an uphill battle. Even if this position is ultimately upheld, it could come at the cost of headaches as well as tax and legal fees to fight the case. 

The Bottom Line

Unfortunately, California makes it very clear that they do not recognize the real estate professional status (REPS). Which means even if you qualify for REPS at the federal level, that losses from rental activities are still generally passive and will not offset active income at the state level.

When it comes to the short-term rental (STR) loophole, we don’t have a clear and definitive answer. However, based on what was presented in this article, it appears that California implicitly conforms to Regs. Sec. 1.469-1T(e)(3)(ii)(A), indicating that the STR loophole should be in play in California. 

But again, because of the lack of anything explicit, taking that position is not without risk. Always consult your own tax and legal advisors before implementing any tax strategy. 

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About Thomas Castelli, CPA

Thomas is a Tax Strategist and real estate investor, who helps other real estate investors keep more of their hard-earned dollars in their pockets and out of the government's. His real-life real estate investing experience, combined with his ever-growing arsenal of hard-hitting tax strategies, allows him to see eye-to-eye with clients in ways an average CPA never could.