I see many people posting success stories on the Forums about how they rented their properties using popular rental services like Airbnb. These people are generally house hacking or renting vacation rentals on a short-term basis. It’s a great system and an excellent way to earn a premium rental charge over a typical monthly rental.
But have they thought about a strategy to mitigate changes to their tax liability?
Probably not… and they should. If they’re not careful, they may end up subjecting the income earned from Airbnb or similar hosting services to self-employment taxes at an additional 15.3% rate. I’m going to explain how you subject yourself to this tax and ways to avoid it.
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Schedule E or Schedule C?
If you rent your house or vacation house for over 14 days per year, then you are going to be required to report rental income earned to the IRS. The question is whether you should report this income on Schedule E or Schedule C.
Generally speaking, you don’t have a choice and must report rental income on Schedule E. This is advantageous over Schedule C because reporting income on Schedule C subjects earned income to self-employment taxes. This explains why investors who flip and wholesale properties usually establish S-Corps to minimize the self-employment tax liability.
Reporting income on Schedule C will also generally disqualify that income/loss from the generous passive activity loss deduction, which can be up to $25,000 pending you meet AGI thresholds. The IRS takes the position that if you are reporting rental activity on Schedule C, it is no longer rental activity but rather a business.
Average Rental Period
If you have an average rental period of less than 7 days, the IRS will automatically assume you are running a business, and that income will be reported on Schedule C. This is significant because investors are making a killing on short-term rentals without fully understanding the tax implications of their business.
If your average rental period is over 7 days but less than 30 and you perform substantial services such as a maid service, breakfast, or cleaning, then the IRS assumes you are running a hotel or a bed and breakfast. This income will be reported on Schedule C and subjected to self-employment taxes.
The problem is that net losses from these activities are still going to be considered passive losses, and as I stated above, you may be ineligible for the passive loss offset of $25,000. So it’s really a lose-lose situation being that your earned income is subject to self-employment taxes or your losses can’t be deducted.
You may have noticed that if your average rental period is more than 7 days but less than 30 days AND you provide substantial services, your business will be classified as a hotel or a bed and breakfast. So what are substantial services?
Substantial services are primarily for your tenant’s convenience, such as regular cleaning, changing linen, maid service, cooking meals, etc. Substantial services do not include the furnishing of heat and light, cleaning of public areas and trash collection. Basically, anything a hotel would do qualifies as substantial services for the convenience of your guests.
Example of Income Reported on Schedule E vs. Schedule C
To convince you that you need to strive to avoid operating a hotel or bed and breakfast, I have laid out a short example to you to show you how taxes impact overall earnings.
Let’s assume you buy a place for $100,000 cash and utilize Airbnb and other hosting services to rent it out. For the entire year, you gross $25,000 and after all expenses, including depreciation and amortization, you have $10,000 net income.
Assuming your average rental period was greater than 7 days, less than 30, and you did NOT provide substantial services, you will report the income and expenses on Schedule E. So your net income before it’s subjected to your marginal tax rate will still be $10,000.
Now let’s assume your average rental period was greater than 7 days and less than 30, but you DID provide substantial services to your tenants. You will now report your income and expenses on Schedule C, which subjects your net income to self-employment taxes, a 15.3% tax rate. Now your net income before being subject to your marginal tax rate is only $8,470.
By reporting your income on Schedule C over Schedule E, you’ve decreased your return on investment (ROI) from 10% to 8.47%, which is substantial in terms of investor returns.
How to Mitigate Schedule C Risks
This is actually easier than it may seem. The obvious answer is to strive to have an average rental period of over 7 days in order to avoid automatic Schedule C reporting requirements. Simply making guests stay 8 days will mitigate this risk.
If you have an average rental period greater than 7 days but less than 30, don’t provide your guests with substantial services such as cleaning their rooms each day, doing their laundry, changing their linens and providing them daily meals. Additionally, you absolutely need to charge your tenants a separate cleaning fee at the end of their stay. It’s important that this fee is a separate item on the bill because if not, the IRS may take the stance that you are providing cleaning services (substantial services) as part of the rental rate.
Lastly, if you can push your average rental period to greater than 30 days, you will likely be fine and this article will be a moot point.
The key point is that income is generally better reported on Schedule E than Schedule C. Short-term and vacation rentals increase your reporting risks and can have a significant impact on your tax liability. Take necessary steps today to mitigate your reporting and tax risks.
Investors: Have any questions about taxes when it comes to Airbnb and short term rentals?
Leave them below, and let’s talk!