Rental Income and Self-Employment Tax – Do I Have To Pay?
As a seasoned tax professional in the real estate rental space, I often run into this question:
“Do I owe self-employment tax on Airbnb rental income?”
This is a good question that involves a disproportionally lengthy explanation. In other words, grab a cup o’ joe and settle in. Ready? Ok, here we go…
The IRS made its position on this question clear in Chief Counsel Advice (CCA) 202151005. But just because the IRS takes a position doesn’t make it the law of the land. The issue still needs to be hammered out in Tax Court. Why? Because a CCA memorandum cannot be cited as precedent or authority by others (such as you or your tax professional). Instead, we need a judge to decide.
Even so, we tax professionals always consider what the CCA says, because it essentially tips the IRS’ hands and shows us what they’ll argue if it ever came down to an audit, etc. Put simply, when the IRS provides a heads-up as to the stance they’ll take, we should watch and listen.
The Exact Question
To be specific, the CCA asks whether net income (or income after expenses) from renting out living quarters is excluded from (not considered as) self-employment income when you’re not classified as a real estate dealer.
This is perhaps one of the few times in life we want to be excluded from something!
If the income is excluded, you don’t owe self-employment tax on your net rental income. This is a win, and it’s what all real estate investors should want. The flip side is extra tax owed to the IRS – a result we all want to (legally) avoid.
The taxpayer addressed in this CCA was an individual who owned and rented out a furnished beachfront vacation property via an online rental marketplace (such as Airbnb or VRBO). The taxpayer provided kitchen items, linens, daily maid service, Wi-Fi, access to the beach, recreational equipment, and prepaid vouchers for ride-share services between the rental property and a nearby business district.
The CCA’s Conclusions
According to the CCA, when you’re not a real estate dealer, net rental income from renting out living quarters is considered rental from real estate and therefore is excluded from self-employment income – as long as you don’t provide services to rental occupants. In other words, providing services to renters can potentially cause you to lose the exclusion from self-employment income. (Losing the exclusion = paying self-employment tax.)
The IRS attorney who wrote the CCA decided that the IRS will argue that you must pay self-employment tax on net rental income if you provide services to renters and the services:
- are not clearly required to maintain the living quarters in a condition for occupancy and
- are so substantial that compensation for the services constitutes a material portion of the rent.
So, according to the CCA, the question is:
Will providing services to renters trigger exposure the self-employment tax?
Two factors come into play, when answering this question:
- What is Customary?
- What is Substantial?
The “Customarily” Issue
According to IRS regulations, services are generally considered above and beyond the norm only if they exceed the services that are customarily provided to renters of living quarters.
So, how do you decide whether the services provided to renters are above and beyond what’s customary? Well, circumstances matter.
In the real world of vacation rentals in expensive resort areas, renters customarily expect and receive lots of services that might be considered above and beyond in other circumstances.
For instance, in resort areas, renters customarily expect and receive cable service; Wi-Fi access; periodic housekeeping services, including changing bedding and towels; repair of failed appliances; replacement of burned-out lightbulbs; replacement of dead smoke alarm batteries; access to recreational equipment such as bicycles, kayaks, beach chairs, umbrellas, and coolers; and so forth and so on. That’s a lot of services!
Why are lots of services provided in expensive resort areas? Because rental charges in expensive resort areas are expensive! The cost may be $2,000 or more per week or $5,000 or more per month, or even higher during peak periods—maybe much higher! So, the portion of the rent that could be attributed to these services would almost always be a small fraction of the overall rental charges.
In the context of expensive resort area vacation rentals, it’s hard to imagine which services would be so above and beyond the norm that the property owner’s net rental income would be exposed to the self-employment tax.
It shouldn’t matter if the services are provided directly by the owner of the property (unlikely) or indirectly by a rental management agency and included as part of the fee paid by the owner of the property (likely).
The “Substantiality” Issue
In assessing whether services provided to renters are above and beyond the norm, substantiality also matters.
A Tax Court decision addressed a situation where the taxpayer rented out trailer park spaces and furnished laundry services to tenants. The laundry services were clearly provided for the convenience of the tenants (not to maintain the trailer park spaces in a condition for rental occupancy). Tenants were not separately billed for the laundry services, and they were not separately paid for – they were part of the rent.
However, the Tax Court still concluded that the trailer park owner’s net rental income was excluded from self-employment income. Why? Because they did not deem the portion of the rental payments that was attributable to the laundry services was substantial enough to trigger exposure to the self-employment tax.
In the context of the rental of vacation properties, focus on two things:
- What is customary for similar rentals?
- Is any service included in the rent charges substantial enough to trigger the self-employment tax?
To the extent any portion of rental charges could (1) be attributed to the provision of services that are not customary for similar rentals, or (2) result in substantial increases in the cost of the overall rental charges, you should change your approach. If you don’t, open your wallet and prepare for a self-employment tax hit.