Four Reasons Hawaii’s Department of Taxation Is Auditing Vacation Rentals Not In Compliance With Tax Filing Obligations.

Insight Published on 09 Dec 2020

Prospective clients frequently ask me why the Department of Taxation is so interested in auditing and pursuing transient accommodation (“TA”) taxes. 

There are several answers to this question, including:

  • The Department is responding to local political developments;
  • Its easy to assess TA tax;
  • Its likely that assessed TA tax can ultimately be collected; and,
  • Assessing TA tax may lead to greater income tax compliance and ultimate revenues.

Hawaii applies a special tax to rental properties leased for less than 180 days.  Called the Transient Accommodations Tax (“TA”), this special tax is in addition to Hawaii’s General Excise Tax (“GE.”)

Political Importance Of “The Tax Gap” For Vacation Rental Properties, Especially Vacation Rental Properties Outside Resort Districts.

In Hawaii, there is a perception that vacation rental property owners outside the resort districts are deliberately avoiding paying GE and TA taxes. 

Local media headlines regularly link “illegal” vacation rentals with unpaid taxes.  The Department of Taxation is responding to these pressures with increased audits for potential vacation rental properties.

Its Relatively Easy to Assess Transient Accommodations Tax. 

For unfiled returns, TA audits can be extremely efficient once the property is identified as a vacation rental.  In many cases, the taxpayer’s federal 1040 Schedule E will provide a minimum gross revenue starting point (some adjustments may be required.)

Absent additional information from an audit target, TA and GE can be assessed upon the reported gross receipts, with little more than applying the percentages.   And, as presented below, those percentages are relatively high.

Vacation rentals are highly unlikely to qualify for exemptions or deductions from the gross receipts.

In these cases, with a relative minimum amount of effort, an examiner will be able to effectively generate assessments and put the burden on the taxpayer to demonstrate their federal tax returns were, in fact, inaccurate, or to prove that the rentals were not “transient accommodations.” 

For examinations without a federal tax return starting point, the “bank deposits method” can be effective especially for third party transfers (credit card processors, Airbnb, etc.)  Examiners will also have interest to third-party information, meaning 1099s filed with the Internal Revenue Service.

In the fall of 2019, AirBNB agreed, as part of a settlement of a subpoena request issued by the Department of Taxation, to provide fairly comprehensive information relating to its hosts for years 2016, 2017, and 2018. 

A 2018 $50,000 gross, at 10.25% for TA plus 4.5% GE (Honolulu), results in a tax owed of $7,125.  With penalty of up to 50% ($3,562.50), plus interest at 8% per year from the due date, the expenditure of relatively little time can produce a substantial tax assessment.  (penalty computation slightly simplified)

Its Likely That the Department Will Collect On Most TA Assessments, In Many Cases Without Undertaking Enforced Collections.

In general, persons liable to a TA/GE assessment are real property owners.  Many vacation rentals are well-maintained properties in desirable locales.  As such, a state tax lien can readily secure the Department’s interest in the property.   From assessment, the Department has (at least) fifteen years to collect the tax, during which time, as prior obligations including existing mortgages are paid down, and property value increases, the Department’s “equity cushion” may actually increase.   

Once a tax lien is filed, the Department obtains leverage over the sale of the property.  For properties with equity, the Department’s leverage can be considerable. 

Hawaii requires withholding by escrow for sale proceeds due to non-resident property owners.  Called HARPTA, Hawaii escrows will withhold 7.5% of the “amount realized” (usually contract or sales price) for non-resident sellers. Hawaii will generally not exempt or refund this amount pending review of full compliance with GE, TA, and income tax laws.  This can be a nasty surprise for non-compliant sellers, and its entirely possible that the amount owed will exceed the HARPTA withholding.

A Positive Side Effect Of A TA Tax Audit Is To Secure Income Tax Returns (And Perhaps Income Taxes.)

Non-resident vacation rental owners frequently express surprise that they are required to file Hawaii income tax returns (non-resident returns.) 

My observation is, in usual situations, whole unit vacation rentals do not produce an income tax “profit” right away, meaning, income tax may not be owed.   By “whole unit,” I am referring to the rental of an entire residence or condominium unit.  Room rentals may produce an income tax profit “immediately.”

Whether or not income tax is due to Hawaii, the non-resident income tax returns are still required and the expense and time involved in preparing and filing “back” state income returns can be significant.

Longer-held vacation rental properties may produce actual profits resulting in State income tax obligations.

There Are Many Good Reasons To Proactively Resolve Situation Prior To Receipt of An Examination Or Criminal Investigation Letter.

In the current (December 2020) situation where Oahu’s vacation rental market is undergoing increasing changes and is in considerable turmoil, there has never been a more important time to assess overall tax compliance.

Resolving unfiled or under-reported rental proceeds prior to contact by state or local enforcement can make a significant different to the ultimate outcome.

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