In recent years, advances in technology have provided multiple opportunities for taxpayers to earn additional streams of income or start a new business altogether. The “gig economy” business models (such as Uber, Airbnb, etc), haven’t solely generated opportunities for entrepreneurs but caught the attention of the Internal Revenue Service on how those sources of income should be taxed.
Short-Term Rental Model
One business model that has gone under the Uncle Sam’s radar for many years has been short rentals. Platforms like Airbnb and VRBO opens the doors to property house owners to a worldwide market of tourists and vacationers seeking short rentals and willing to pay prime rates for a luxury experience. To cater to them, property owners will go beyond the norm of offering a house or a room, but the rentals will come with cooks and daily housekeeping. However, the taxation of these additional services will make many property owners wondering if it is all worth it.
When a Short-Term Rental is No Longer a Rental Activity
The IRS and other tax authorities have been paying close attention to the developments of the short-term rental activities, and in recent guidance, concluded that the “rents” from some of the short-term rental arrangements may be subject to U.S. self-employment (“SE”) taxes.
The Tax Code imposes the self-employment tax on the net earnings from self-employment derived by an individual during any taxable year. SE taxes are mandatory on self-employment income in substitution for the Social Security and Medicare taxes imposed on wages. However, net income from rental activities is not subject to SE taxes, except when it is earned in the normal course of a trade or business as a real estate dealer. estate dealer (IRC § 1402(a)(1)).
What happens when a property owner offers substantial services to its property/unit occupants?
When substantial services are offered for the unit occupants, the activity may no longer be rental activity for tax purposes. When substantial services are being offered for the occupants, then the business activity gravitates to a hospitality business conducted by an individual which would be subject to SE tax.
IRS Chief Counsel Memorandum 202151005
In IRS Chief Counsel Memorandum 202151005, the IRS evaluated two “general” fact patterns for short-term rental arrangements.
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
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 property fully habitable for occupants. The owner also provided daily cleaning services, access to dedicated Wi-Fi, access to beach and recreational equipment, and prepaid ride-share vouchers between the rental property and the nearest business district.
The IRS concluded that the net rental income from this example constituted net earnings subject to SE tax. the IRS determined that since the owner rendered substantial services to the occupants, the net earnings from this rental activity is subject to SE tax.
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 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.
In the second example, the IRS concluded that the net rental income was not subject to SE tax, since the owner did not provide substantial services beyond those required to maintain the space in a condition suitable for occupancy. The IRS did not view cleaning the premises between occupants as substantial services for the convenience of occupants that should cause the rental income to be subject to self-employment taxes.
Short-term rentals that produce income may or may not be subject to SE taxes. The more substantial the services that are provided, the more likely the activity will trigger SE tax.
This presents tax 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 taken into consideration together with the owner’s long term tax plans and other tax issues, 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.