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Navigating IRS’s Guidance on Short-Term Rental Taxes

Feb. 28, 2022, 9:45 AM

The ongoing Covid-19 pandemic has caused many individuals to reevaluate vacation destinations and where they choose to work. Consequently, individuals have increasingly made use of short-term rental arrangements offered by online platforms such as Airbnb, Vrbo, and HomeAway that allow owners of everything from vacation homes to spare bedrooms to connect with a wider range of potential tenants.

To attract more tenants, many owners of rental properties are offering additional amenities and services. However, according to IRS Chief Counsel Advice Memorandum, CCA 202151005, providing “extra” amenities and services to the tenants could subject rental income to self-employment taxes.

The extra cost of self-employment taxes can be significant. Under Sections 1401(a) and (b) of the Internal Revenue Code, individuals could be subject to an extra aggregate self-employment tax on taxable rental income of 16.2%, consisting of the following:

  1. 12.4% OASDI tax,
  2. 2.9% Medicare tax,
  3. and 0.9% additional Medicare tax above certain self-employment income thresholds on their net earnings from self-employment (NESE).

Generally, rents from rental arrangements are not subject to self-employment taxes. Section 1402(a)(1) provides an exclusion from such self-employment income for gross income that individuals other than real estate dealers earn from “rentals from real estate and from personal property leased with the real estate.” The Treasury regulations define a real estate dealer as “an individual who is engaged in the business of selling real estate to customers with a view to the gains and profits that may be derived from such sales.” The regulations also provide that “an individual who merely holds real estate for investment or speculation and receives rentals therefrom is not considered a real-estate dealer.”

Although rental activities are generally excluded from NESE, the rental activities exclusion from NESE does not apply if sufficient services are provided to the occupant. The Treasury regulations provide that: “Payments for the use or occupancy of rooms or other space where services are also rendered to the occupant, such as for the use or occupancy of rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, or payments for the use or occupancy of space in parking lots, warehouses, or storage garages, do not constitute rentals from real estate; consequently, such payments are included in determining net earnings from self-employment.”

Recognizing that some level of services is required with respect to any rental property, the Treasury regulations provide a standard under which rental income will be NESE only when the level of services exceed “those usually 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 rented out a fully furnished vacation property through an online rental marketplace. The owner provided linens, kitchen utensils, and various other items to make the vacation property fully habitable for occupants. The owner also provided daily cleaning services, access to dedicated Wi-Fi, access to beach and recreational equipment for use during the stay, and prepaid ride-share vouchers between the rental property and the nearest business district. The IRS reasoned that the services provided to the tenant exceeded those services required to maintain the space in a condition suitable for occupancy and were for the convenience of the tenant. Because of the substantial nature of the services, the IRS viewed a material portion of the rent to be in exchange for services. Therefore, the IRS concluded that the net rental income constituted NESE and, thus, was subject to self-employment taxes.

In the second example, the owner rented out a fully furnished room and bathroom in a dwelling via an online rental marketplace. The owner cleaned the rooms and bathroom in between each occupant’s stay but did not provide any other amenities or services. Occupants did not have access to common areas of the dwelling, such as the kitchen and the laundry room. Thus, the owner generally did not provide any services other than keeping the premises fit for occupancy. The IRS did not view cleaning the premises in between occupants as primarily for the convenience of occupants or so substantial in nature as to constitute a material part of the rent payments. The IRS concluded that the net rental income was not NESE because the owner did not provide substantial services beyond those required to maintain the space in a condition suitable for occupancy.

In its guidance, the IRS purposefully considered fact patterns with different levels of services provided to the occupants by the owner. Whether services are for the convenience of occupants or are sufficiently substantial to warrant treating a portion of the rent as in exchange for the services is inherently based on the facts and circumstances of each case. Although the IRS did not rank or weigh the relative factors in the CCA, the existing case law and regulatory and administrative guidance indicates that activities such as daily cleaning, recreational, and cooking activities and services, and informational services will likely be treated as services primarily for the convenience of the occupant and, thus, services that cause rents to be NESE. In contrast, the cleaning of common areas, the provision of utilities, sewage, and trash pickup, and the existence of laundry facilities or vending machines are unlikely to be sufficiently substantial to cause rental activities to be treated as NESE. Individuals who are engaged in rental activities through online marketplaces must balance the increased desirability of their property that results from the provision of services, and the likelihood that the IRS may view the rental payments as subject to self-employment taxes.

In addition, owners of rental properties must separately evaluate the characterization of their activities for other purposes of the code. In the CCA, the IRS stated that the characterization of the property owners’ rental activity under the passive activity rules was not determinative of its characterization for purposes of self-employment taxes. In both examples in the CCA, the average use duration by occupants of the rental properties was less than seven days, and the activities therefore were not viewed as rental activities for purposes of Section 469. Furthermore, the properties’ owners materially participated in the rental activities, and therefore the activities were not viewed as passive.

The IRS has concluded that whether an activity is a rental activity for purposes of the passive activity rules is not relevant for determining whether the rental activities exclusion from self-employment income is applicable. Therefore, in addition to evaluating whether rents are subject to self-employment tax, owners of rental properties must separately consider whether they are engaged in a passive activity for purposes of Section 469 and the net investment income tax under Section 1411, whether they are earning qualified business income for purposes of the Section 199A deduction, and whether they are engaged in an active trade or business for purposes of depreciating certain assets under Section 179.

With 2021 tax returns soon due, owners of rental properties must report the rental income that they have earned and determine the various taxes that are owed to the IRS. Owners of short-term rental properties who mistakenly assume that rental income is only subject to income taxes, or potentially the net investment income tax, may be faced with an unexpected assessment of self-employment taxes. Consequently, owners of rental properties should evaluate the level of services they are providing to their occupants and consider whether the services are so substantial as 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 Neal Gerber Eisenberg’s taxation practice, based in Chicago. He advises individuals, businesses, and tax-exempt entities on federal income tax, state and local income tax, sales tax, and residency matters, including audit defense and appeals representations, and he advises not-for-profit organizations on formation, operations, and compliance matters.

Eric N. Mann is a partner in Neal Gerber Eisenberg’s private wealth services practice, based in Chicago. He provides gift, income and charitable planning strategies for high-net worth individuals both domestically and internationally, and he counsels on all aspects of estate and trust administration including gift and estate tax audits.

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To contact the reporter on this story: Melanie Cohen at mcohen@bloombergindustry.com

To contact the editor responsible for this story: Kelly Phillips Erb at kerb@bloombergindustry.com