The ongoing Covid-19 pandemic has caused many people to reassess vacation destinations and where they choose to work. As a result, individuals are increasingly turning to short-term rental packages offered by online platforms such as Airbnb, Vrbo and HomeAway that allow owners of everything from vacation homes to guest rooms to connect with a wider range of potential tenants.
To attract more tenants, many rental property owners offer additional amenities and services. However, according to IRS Chief Counsel Memorandum of Advice, CCA 202151005providing “additional” amenities and services to tenants could subject rental income to self-employment tax.
The additional cost of taxes on self-employment can be significant. Under Sections 1401(a) and (b) of the Internal Revenue Code, individuals may be subject to an additional global self-employment tax on taxable rental income of 16.2%, consisting of the following:
- 12.4% OASDI tax,
- 2.9% health insurance tax,
- and 0.9% additional Medicare tax above certain self-employment income thresholds on their net income from self-employment (NESE).
As a general rule, rent from rental contracts is not subject to self-employment tax. Section 1402(a)(1) provides an exclusion from this self-employment income for gross income that individuals other than real estate brokers derive from “rentals of real estate and personal property rented with the real estate”. Cash regulations define a real estate broker as “a person who engages in the business of selling real estate to clients for the gains and profits that may arise from such sales”. The regulations also provide that “an individual who merely holds real estate for investment or speculative purposes and derives rent therefrom is not considered a real estate broker.”
Although rental activities are generally excluded from the NESE, the exclusion of rental activities from the NESE does not apply if sufficient services are provided to the occupant. Treasury regulations provide that: “Payments for the use or occupation of rooms or other spaces where services are also rendered to the occupant, such as the use or occupation of rooms or other accommodation in hotels, boarding houses or serviced apartment buildings, or in tourist camps or tourist residences, or payments for the use or occupation of space in parking lots, warehouses or garages of storage, do not constitute rentals of real estate; therefore, these payments are included in the determination of net self-employment earnings.
Recognizing that a certain level of services is required for any rental property, Treasury regulations provide a standard under which rental income will only be NESE where the level of services exceeds “those customarily or customarily rendered in connection with the rental of rooms or other space for occupancy”, and are primarily for the convenience of the occupant.
In CCA 202151005, the IRS evaluated two general fact patterns for short-term rental arrangements to illustrate when services are usual and customary for occupancy, as opposed to primarily for the convenience of the occupant. In the first example, the owner has rented a fully furnished vacation property through an online rental marketplace. The owner has provided linens, cooking utensils and various other items to make the vacation property fully livable for the occupants. The owner also provided daily cleaning services, access to dedicated Wi-Fi, access to the beach and recreational amenities for use during the stay, and prepaid rideshare vouchers between the rental property and the shopping district. nearest business. The IRS determined that the services provided to the tenant exceeded the services required to maintain the space in a condition suitable for occupancy and were for the convenience of the tenant. Due to the substantial nature of the services, the IRS considered a significant portion of the rent to be in exchange for services. Therefore, the IRS concluded that the net rental income constituted NESE and was therefore subject to self-employment taxes.
In the second example, the landlord has rented a fully furnished bedroom and bathroom in a unit through an online rental marketplace. The owner cleaned the bedrooms and bathroom between each occupant’s stays, but provided no other amenities or services. The occupants did not have access to the common areas of the dwelling, such as the kitchen and the laundry room. Thus, the landlord generally did not provide any services other than keeping the premises in a good state of occupancy. The IRS has not considered cleaning of premises between occupants to be primarily for the convenience of the occupants or of such a substantial nature that it constitutes a significant portion of rent payments. The IRS concluded that the net rental income was not NESE because the landlord failed to provide substantial services beyond those required to maintain the space in a condition suitable for occupancy.
In its guidance, the IRS has deliberately taken into account factual patterns with varying levels of services provided to occupants by the landlord. The question of whether the services are for the convenience of the occupants or whether they are substantial enough to justify the treatment of part of the rent in exchange for the services is inherently based on the facts and circumstances of each case. Although the IRS has not classified or weighed the relative factors in the CCA, existing case law and regulatory and administrative guidance indicate that activities such as daily cleaning, recreational and cooking activities and services, and information services will likely be treated as services primarily for the convenience of the occupier and, therefore, services that cause rents to be NESE. In contrast, the cleaning of common areas, the provision of utilities, the collection of sewage and garbage, and the existence of laundromats or vending machines are probably not important enough for rental activities to be treated as NESE. Individuals who engage in rental business through online marketplaces must balance the increased attractiveness of their property that results from the provision of services against the likelihood that the IRS will view rental payments as subject. taxes on self-employment.
In addition, owners of rental properties must separately assess the characterization of their activities for other purposes of the code. In the CCA, the IRS said that the qualification of landlords’ rental activity under the passive activity rules was not determinative of its qualification for self-employment tax purposes. In both CCA examples, the average duration of use by the occupants of the rental properties was less than seven days, and the activities were therefore not considered rental activities for the purposes of Section 469. In addition, the owners of the assets were materially involved in the rental activities and therefore the activities were not considered passive.
The IRS has concluded that whether an activity is a rental activity for purposes of the passive activity rules is irrelevant to determining whether the exclusion of rental activities from self-employment income is applies. Therefore, in addition to assessing whether rents are subject to self-employment tax, owners of rental property must separately consider whether they are engaged in passive activity for the purposes of Section 469 and self-employment tax. the net investment income under Section 1411if they earn qualifying business income for the purposes of the Section 199A deduction, and if they are engaged in an active trade or business for the purpose of the depreciation of certain assets under Section 179.
With 2021 tax returns due soon, rental property owners must report the rental income they have earned and determine the various taxes owed to the IRS. Owners of short-term rental properties who incorrectly assume that rental income is only subject to income tax, or potentially tax on net investment income, may face unexpected valuation taxes on self-employment. Therefore, rental property owners need to assess the level of services they provide to their occupants and determine if the services are significant enough to cause their rental income to become NESE.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Author Information
Eric M. McLimore is a partner in the Chicago-based tax firm of Neal Gerber Eisenberg. He advises individuals, businesses and tax-exempt entities on federal income tax, state and local income tax, sales tax and residency matters, including representations in audit defense and appeals, and advises nonprofit organizations on training, operations, and compliance issues.
Eric N. Mann is an associate of Neal Gerber Eisenberg at the private, Chicago-based wealth management services firm. He provides gift, income and charitable planning strategies for high net worth individuals, both domestically and internationally, and advises on all aspects of estate and trust administration, including audits. gift and inheritance tax.
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