William Shakespeare’s Juliet thought that a name was arbitrary or irrelevant. Apparently, IRS Chief Counsel agrees, at least when it comes to determining if the definition of rental activity under the Passive Activity Loss rules controls whether income from such activity is exempt from self-employment tax.
One of the consistently vexing questions faced by tax professionals is exactly what is included in net earnings from self-employment (”NESE”). You would think it’s easy – I have a business, I work for myself, I make money, that income is subject to tax as NESE. Depending on what version you look at, the code section defining NESE is about 7 pages long. Leading it off, the first item excluded from NESE is “rentals from real estate and from personal property leased with the real estate…together with the deductions attributable thereto, unless such rentals are received in the course of a trade or business as a real estate dealer.” Hence the dilemma; what counts as rentals from real estate.
In most cases the answer is self-evident but the proliferation of short term rentals – rooms in people’s homes via services like AirBnB, longer term rentals of vacation homes through VRBO, etc. – have led to new questions as to how to classify such income. It becomes particularly important for taxpayers who have self-employment income from other trades or businesses but net losses from their rental activity since the tax is on net earnings from self-employment.
The Chief Counsel's Advice (“CCA”) looked at two different scenarios involving a taxpayer who was not a real estate dealer:
1. The taxpayer directly rents a fully furnished vacation property via an online rental marketplace. The taxpayer provides:
a. Linens, kitchen utensils, and all other items to make the vacation property fully habitable for each occupant
b. Daily maid services, including delivery of individual use toiletries and other sundries
c. Access to dedicated Wi-Fi service for the rental property
d. Access to beach and other recreational equipment for use during the stay
e. Prepaid vouchers for ride-share services between the rental property and the nearest business district
2. The taxpayer directly rents a fully furnished room and bathroom in a dwelling via an online rental marketplace.
a. Occupants only have access to the common areas of the home to enter and exit the room and bathroom
b. Occupants have no access to other common areas such as the kitchen and laundry room
c. The taxpayer cleans the room and bathroom in between each occupant's stay
In both cases, the taxpayer materially participates in the activity and the average customer use of the property is 7 days meaning that it is not considered a rental activity under the passive activity loss rules.
The CCA concludes that because the services provided in the first scenario go well beyond those required to maintain the habitable condition of the property and, in fact, are for the convenience of the occupants, this income is not eligible for exclusion from NESE under the rental income exclusion. The facts of the second scenario – the only service provided is to clean between occupants – leads to the conclusion that this net rental income is excludable from NESE.
Planning Point – If your net short-term rental activity results in taxable losses, and you want to use those losses to offset other NESE, make sure you provide enough services to meet the facts of Scenario 1. If, on the other hand, your rentals are profitable, consider charging separately for some services or having them provided by a third party.
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Your Friedman LLP advisor can help you plan your rental activity and assess how it affects your overall tax planning. Contact us now with any questions.