Short-term rental or vacation rental properties have increased in popularity. They are also popular investments.
This includes real estate rented on Airbnb and its competitors, such as Vrbo, Booking.com, Tripadvisor, Agoda, Expedia, TUI Villas, TravelStaytion, HomeToGo, Plum Guide, and Google.
Taxes are one reason for the increase in popularity. Short-term rentals can provide a number of tax advantages. The rules are nuanced and warrant advance tax planning given the tax implications and impact on one’s effective tax rate.
This article considers the holding in the IRS’s recent Chief Counsel Advice Memorandum 202151005. This memorandum answers the question as to whether income from short-term rentals triggers self-employment taxes.
If you are wondering whether short-term rentals are subject to self-employment taxes, this memorandum provides the answer. It also answers questions about how to report Airbnb income on your tax return.
Facts & Procedural History
The IRS memorandum addresses two fact patterns. These fact patterns both include the following facts:
- The taxpayer purchased real estate located near a beach.
- The taxpayer rented the real estate to third parties.
- The average rental of the property was less than seven days.
- The taxpayer materially participates in the rental activity.
The two fact patterns differ as follows:
- In the first fact pattern, the taxpayer provided:
- A fully furnished vacation property via an online rental marketplace (such as Airbnb);
- Linens, kitchen utensils (presumably more than just a coffee maker), and all other items to make the vacation property fully habitable for each occupant; and
- Daily maid services, including delivery of individual use toiletries and other sundries (such as fresh towels), access to dedicated Wi-Fi service for the rental property, access to beach and other recreational equipment for use during the stay, and prepaid vouchers for ride-share services between the rental property and the nearest business district (excursion options).
2. In the second fact pattern, the taxpayer:
- Provided a fully furnished room and bathroom in a dwelling via an online rental marketplace (such as Airbnb) (the memo does not say whether the property is the hosts primary residence or a vacation home);
- Allowed the occupants only to have access to the common areas of the home to enter and exit the room and bathroom and have no access to other common areas such as the kitchen and laundry room; and
- Cleans the room and bathroom in between each occupant’s stay.
We consider each fact pattern below.
Tax on Short Term Rentals & Airbnb Properties
Income from short-term rentals is subject to Federal income taxes. Most tax preparers look to the passive activity loss (“PAL”) rules in determining whether to report rental property on a Schedule E or a Schedule C filed with Form 1040.
Generally, Schedule E is for rental properties and Schedule C is for rental activities that are a business.
The PAL rules only apply when there are losses, not net income. Many short-term rental properties produce tax losses. This is particularly true when mortgage interest deductions and depreciation deductions are considered.
Most tax return preparers follow this distinction in reporting rental income too.
The PAL rules look to the average length of the tenant’s stay. Generally, short-term rentals are those with an average rental period during the year of seven days or less and/or the owner provides substantial services in addition to the property. These short-term rentals are considered to be a business, not a rental property, under the PAL rules.
The opposite is true for properties reported on Schedule E. These properties are generally treated as rentals, not businesses.
As explained below, the difference between reporting on Schedule C or Schedule E is not based on the passive activity loss rules. Rather, the reporting depends on the self-employment rules.
Most taxpayers do not question the accounting firm or CPAs that prepared their tax returns on how this reporting is done. Taxpayers simply accept the forms as given to them by their tax preparers.
About Self-Employment Taxes
Corporations pay payroll taxes on wages paid to employees. The employees also pay payroll taxes on their wages.
Those who are self-employed or partners in a partnership for which they provide services pay self-employment taxes instead of payroll taxes.
Self-employment taxes are computed and reported on the individual’s Form 1040 each year. They are added to the income taxes and collected with the income tax liability reported on Form 1040.
This self-employment tax is computed by looking at the net earnings from self-employment. The “net” refers to the idea that the tax does not apply unless the earnings are positive after subtracting allowable expenses.
The term “self-employment” can include rentals. This brings us to the question addressed in the IRS memo in this case. When does a rental rise to the level of a business (that should be reported on Schedule C so that it is subject to self-employment tax) or a rental (that is reported on Schedule E so it is not subject to self-employment tax)?
Substantial Services Trigger Self-Employment Taxes
Treas. Reg. § 1.1402(a)-4(c)(1) provides that rentals from living quarters, where no services are rendered for the occupants, are generally considered rentals from real estate.
However, Treas. Reg. § 1.1402(a)-4(c)(2) provides that:
Payments for the use or occupancy of rooms or other space where services are also rendered to the occupant . . . are included in determining net earnings from self-employment. Generally, services are considered rendered to the occupant if they are primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only.
Thus, the question is whether services are provided for the occupants and whether those services are substantial.
In the first fact pattern described in the IRS memorandum, the IRS concludes that:
The services go beyond those clearly required to maintain the space in a condition for occupancy and are of such a substantial nature that the compensation for these services can be said to constitute a material portion of the rent.
Thus, the IRS concluded that this income was subject to self-employment tax. The IRS concludes that the services in the second fact pattern were insubstantial. Thus, the income in the second scenario was not subject to self-employment tax as it is not a rental activity. It was a business.
This distinction is likely due to the maid service. The daily maid service in the first fact pattern makes the vacation rental more like a hotel, which has long been found to be a business. The personal nature of the in-home rental in the second fact pattern (i.e., that did not rent the whole house) coupled with maid service after the termination of each rental rather than daily maid service makes it more akin to a traditional rental property.
Short-term rentals that produce income may or may not be subject to self-employment taxes. The more substantial the series that are provided, the more likely the activity will trigger self-employment tax.
This presents planning opportunities, such as segregating out services and maybe even charging a separate fee for those services or outsourcing those services to third parties.
These rules have to be considered in conjunction with the owner’s long term tax plans and other tax issues, as these same factors can limit the availability of other real estate tax planning strategies, such as capital gain tax rates, accounting methods, Section 1031 exchanges, Section 179 expensing, bonus depreciation, deprecation recapture, etc.
Those who own or invest in vacation rentals should discuss these tax considerations with their tax professionals.