Tom Talks Taxes - December 31, 2021

When is short-term rental income subject to self-employment tax?

I’d like to wish everyone a happy new year! 2022 is going to be great, and thank you for being a part of the Tom Talks Taxes community. -Tom

I’ve seen a lot of tax professionals apply the §469 passive loss rules to other tax law determinations to which they do not apply. It is important to note that §469 only matters for determining whether an activity is passive or nonpassive. It has no impact on other tax law provisions unless it is specifically referenced.

Here are two common misconceptions based on the above:

1. A passive activity under §469 does not qualify for the §199A deduction. Under the statute, an activity qualifies for §199A as long as it is a §162 trade or business. An activity can be both a §162 trade or business and passive to the owner under §469.

2. Nonpassive rental income is subject to self-employment tax. Whether an activity is passive under §469 has no bearing on whether an individual is liable for self-employment tax on the net income from that activity under §§1401-1402.

The IRS provided an excellent analysis as to the second situation above as it relates to short-term rentals in Chief Counsel Advice 202151005.

In a nutshell: short-term rental activities for which the average stay is seven days or less are not automatically passive “rental activities” under §469; therefore, they are only passive if the taxpayer fails the material participation tests for that rental activity. Based on this rule, most short-term rental activities, such as Airbnb and VRBO rentals, are nonpassive rental activities.

Tax professionals often get confused as to when short-term rental income is subject to self-employment tax (and thus reported on Schedule C instead of Schedule E). The general rule is that net rental income is excluded from self-employment tax; however, there is an exception if services are offered in conjunction with the rental activity. Please note that the average length of stay has no bearing on this determination.

The above Chief Counsel Advice had two main holdings:

1. Whether or not a rental activity is a passive rental activity under §469 has no bearing on whether or not there is self-employment tax liability as that is a separate determination.

2. Net rental income from the rental of living quarters is exempt from self-employment tax when no services are rendered for the occupants. However, if services are rendered for the occupants and the services rendered (1) are not clearly required to maintain the space in a condition for occupancy, and (2) are of such a substantial nature that the compensation for these services can be said to constitute a material portion of the rent, then the net rental income received is subject to self-employment tax.

The IRS also provided two useful examples that will apply to most situations seen in tax practice:

1. The taxpayer is an individual who directly and solely owns and rents, in the course of a trade or business a fully furnished vacation property via an online rental marketplace. The taxpayer provides linens, kitchen utensils, and all other items to make the vacation property fully habitable for each occupant. In addition, the taxpayer provides daily maid services, including delivery of individual use toiletries and other sundries, 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. For the year at issue, the average period of customer use of the vacation property is seven days, and the rental activity is nonpassive since the taxpayer materially participates.

2. The taxpayer is an individual who directly and solely owns and rents, in the course of a trade or business, a fully furnished room and bathroom in a dwelling via an online rental marketplace. Occupants only 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. The taxpayer cleans the room and bathroom in between each occupant’s stay. For the year at issue, the average period of customer use of the vacation property is seven days, and the rental activity is nonpassive since the taxpayer materially participates.

In scenario 1, the IRS opined the net rental income is subject to self-employment tax because the taxpayer provides substantial services beyond those required to maintain the space in a condition suitable for occupancy.

In scenario 2, the IRS opined the net rental income is not subject to self-employment tax because the taxpayer does not provide substantial services beyond those required to maintain the space in a condition suitable for occupancy.

Here are two considerations for your tax practice based on the above:

1. If you made a client’s net rental income subject to self-employment tax simply because it was a short-term rental, and no services were provided, then you should prepare and file an amended return as a claim for refund provided the refund statute of limitations remains open.

2. These rules create planning opportunities for a taxpayer, as a short-term rental activity can be either passive or nonpassive, or subject to self-employment tax or not, depending on the services provided and the involvement of the owner. For example, if a short-term rental activity is designed to generate passive income due to the owner failing the material participation tests, then the passive income can be used to offset passive losses generated from a different activity, such as a long-term rental property.

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