Editor’s Note: Today’s post comes from Nicole Green, owner of Strataxtic. Strataxtic is a sponsor on the site but is not paying to have this post published. All guest posts, even those from partners, have to meet editorial guidelines to be published. We asked Nicole to tell us what we need to know about the tax implications of running an Airbnb or other short-term rental property.
There they go again, Facebook ads and YouTube videos, the places where real estate “experts” are born. These gurus claim they are making a killing running an Airbnb and investing in real estate, but are they really? As attractive as these may sound, is real estate investing worth the hype and what exactly are the tax implications?
First, let’s address some key points related to real estate rental activities and the internal revenue code.
In general, rental activities are subject to passive activity loss (PAL) rules under I.R.C. 469. A special rule allows taxpayers who “actively participate” in a rental activity to deduct up to $25,000 of loss from the activity each year, regardless of the passive activity loss rules. Essentially, this special allowance is used to offset a taxpayer’s nonpassive income. When married taxpayers file separately, the allowance is cut in half, allowing only $12,500 per taxpayer if the couple lived apart for the entire year; otherwise, the allowance is zero.
The $25,000 is reduced by 50% of the amount by which the taxpayer’s modified AGI (MAGI) exceeds $100,000 ($50,000 for married taxpayers filing separately). Accordingly, as a taxpayer’s MAGI increases from $100,000 to $150,000, the loss allowance decreases below $25,000, and this special allowance is completely phased out for taxpayers with higher adjusted gross incomes (AGIs).
In general, real estate rental income is exempt from self-employment (SE) tax unless:
1. Individuals receive the income in the course of their trade or business
In that case, it is classified as nonpassive rental activity, subject to self-employment tax. Such an activity is classified as a real estate dealer, this is someone engaged in the business of selling real estate to customers with the intent of making a profit from those sales. (This is beyond our scope here. If you’re in the real estate business, this article isn’t for you.)
2. Individuals derive other nonpassive income from performing significant personal services
You may not be exempt from SE tax if other nonpasive income is derived from the rental activity of short-term rentals such as Airbnb or vacation condo if significant personal services are performed, and the average rental period is seven days or less.
If services are rendered, this type of income is not considered passive income from real estate rental, but rather as nonpassive, subject to self-employment (SE) tax.
Services customarily rendered in connection with the rental of rooms or other space are ignored for this purpose. Additionally, permitted activities that are not considered significant personal services include cleaning public entrances and exits, stairways and lobbies, cleaning and maintenance of common areas, routine repairs and trash collection.
However, services rendered for the occupants of a short-term rental primarily for their convenience (e.g., maid service) classifies the income as nonpassive, subject to SE tax. Rev. Rul. 57-108 provides the example of a taxpayer who rents furnished beach houses. The taxpayer provided a number of services for the comfort and convenience of his guests, including many in connection with their recreational activities. In some, but not all cases, maid service was provided as well. The IRS found that these services caused the activity to produce SE income.
In many cases, activities that fall under the hotel/motel exception for the PAL rules will be subject to SE tax, because services are rendered to the occupant. Conversely, even rental arrangements that do not fall into the hotel/motel exception for the PAL rules can be subject to SE tax.
Rental activity illustrating passive and nonpassive (SE tax) activities
Elina owns an apartment building. She is not a real estate dealer. Last year she received $20,000 rent from Apartments 1 and 2, which were rented without services rendered to the occupants, and $36,000 from Apartments 3 and 4, which were rented with services rendered to the occupants. Each of the units was rented to the same tenant for the entire year. Elina’s interest and tax expense for the entire building was $30,000. In addition, she had $6,000 of expenses attributable to the services rendered to the occupants of Apartments 3 and 4. Elina’s net SE earnings included the $36,000 received from Apartments 3 and 4, less expenses of $21,000 ($6,000 direct expenses plus $30,000 × 50%). The income and expenses attributable to Apartments 1 and 2 were not included in her SE income. Thus, Elina had $15,000 ($36,000 – $21,000) of net SE earnings from the building. For PAL purposes, the apartment building is a rental activity. Elina reports the net income from Apartments 1 and 2 on Schedule E and that from Apartments 3 and 4 on Schedule C, subject to self-employment tax.
Nonrental activity where SE tax does not apply
Sharon owns a condo in Bahamas. She and her family vacation there for two weeks in the summer and also spend several long weekends there throughout the year. The rest of the time, a leasing agent attempts to rent the unit. During the current year, Sherrie and her family used the condo for personal purposes for 24 days. The unit was rented for 245 days and vacant for 96 days. The average period of customer use was seven days. No services are provided to the occupants other than utilities, trash collection, and cleaning of the public areas. The condo is not a rental activity under the PAL rules because the average use period is seven days or less. Thus, for the PAL rules, it is tested for material participation like any other trade or business.
The income, however, is exempt from SE tax because no services other than those customarily provided in connection with renting rooms or other space are provided to the occupants. Sharon reports the net income on Schedule E. If she materially participated in the activity, the income or loss is nonpassive. If she did not materially participate, the income or loss is passive.
Variation: Assume the agent provides maid and concierge service to the renters (which is often the case in vacation rentals). These services are outside the scope of what is customarily provided. Thus, any income or loss on the condo would be included in Sharon’s net SE earnings, regardless of the average period of customer use and the income or loss is reported on Schedule C.
Nonpassive rental activity is subject to self-employment tax if the length of stay is seven days or less and significant services are provided. Thus, taxpayers with Airbnb or vacation condos are penalized when an exception applies, making the activity ineligible for the special $25,000 rental real estate loss allowance.
Passive activity, on the other hand, allows up to $25,000 in PAL losses. However, the passive activity loss limitation is a trap if the taxpayer’s income is above the limit, but proper planning can help to minimize the effects of the rules.
One final point: for a high-income earner, the unallowed losses are not completely lost. They are released in a later year when the taxpayer’s income is reduced below the threshold or the activity is disposed of.
Joshua Holt is a practicing private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.