In recent years, technology has provided opportunities for taxpayers to create additional revenue streams or start new businesses altogether. The business models, marketplaces, and gig economy that have emerged have not only generated business opportunities for entrepreneurs but have inspired governments to innovate new ways to tax those incomes. Consider the 2018 U.S. Supreme Court ruling in South Dakota vs. Wayfair and the resulting state economic nexus laws that have sprung up across the country. However, one business model growing in popularity carries a tax risk that has, so far, flown under the radar: short-term rentals.
Platforms like Airbnb and VRBO provide property owners access to a worldwide market of tourists and other vacationers seeking short-term rentals and willing to pay top dollar for a luxury experience. To command high rates, owners often go above and beyond for their guests, providing services not customarily included with longer-term rentals, like cooks and daily housekeeping. Unfortunately, the tax risk associated with these additional services could leave property owners wondering whether the juice is worth the squeeze.
When a Rental Is No Longer a Rental
Self-employment taxes are imposed on self-employment income in lieu of the Social Security and Medicare taxes typically withheld from the pay of employees. Self-employment income generally refers to net income that an individual derives from a trade or business. [1] Net rental income is not considered self-employment income, and therefore not subject to the self-employment tax, unless it is received in the course of a trade or business as a real estate dealer. [2] However, it should come as no surprise that the issue is not so cut and dried. When substantial services are rendered for the occupant in connection with the rental, the activity may no longer constitute a rental activity for tax purposes. For example, when a hotel rents a room to a patron, this is not a rental activity; it is clearly a hospitality business that would constitute self-employment if conducted by an individual.
With respect to rentals of private residences—Airbnb, VRBO, etc.—Treasury Regulations draw a distinction between (1) payments for occupancy where no services are rendered for occupants and (2) payments for occupancy where services are rendered for occupants. [3] If services are rendered in connection with the occupancy, the occupants’ payments do not constitute rental income and are subject to the self-employment tax. This is somewhat of an oversimplification: the analysis requires a determination of whether the services are truly provided for the benefit of the occupant.
Treasury Regulations provide that services are only considered rendered to the occupant if they are “primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only.”[4] In making this determination, the appropriate inquiry is whether the services rendered are required to maintain the space in a condition for occupancy and for the conservation of invested capital. [5] Any service not clearly required to maintain the property in a condition for occupancy is considered work performed for the occupant.
Services rendered to the occupant do not automatically disqualify the rental of a private residence if such services are merely incidental to the realization of return on investment. The IRS and courts have read into the law a “substantiality” requirement that converts the analysis into a two-prong test: (1) “whether [the services rendered] are required to maintain the space in condition for occupancy and, (2) if not, whether [the services rendered] are substantial.”[6] Unless the services are of such substantial nature that the compensation for them could clearly be said to constitute a material part of the payments made by the tenants, the services will not transform rental income into self-employment income. For example, in Bobo v. Comm’r, the U.S. Tax Court found occupants’ payments for laundry services were not “substantial enough to classify all the tenants’ [rental] payments as received for ‘services to the occupants.’”[7] Similarly, in Hopper v. Comm’r, the Tax Court held that net rental income from storage units where the landlord also provided a soft drink machine and sold locks, packaging materials, pallets, and insurance, was excluded from the owner’s self-employment income because the services provided for the convenience of the occupants was not “substantial.”[8]
IRS Signals Scrutiny of Short-Term Rentals
The IRS has given a not-so-subtle signal that it intends to scrutinize short-term rentals in a memo issued in December 2021. In Chief Counsel Memorandum 202151005, the Service opined that rents received with respect to a fully furnished vacation property via an online rental marketplace constituted self-employment income as the owner provided linens, kitchen utensils, and all other items to make the vacation property fully habitable; daily housekeeping services, including delivery of individual use toiletries and other sundries; access to dedicated Wi-Fi service for the rental property; access to the beach and other recreational equipment for use during the stay; and prepaid vouchers for ride-share services between the rental property and the nearest business district.
The low-hanging fruit here is daily housekeeping and concierge-type services, staples of the hospitality industry, services that had been the principal offenders even before the advent of the online marketplace. For example, in Rev. Rul. 57-108 (1957), the Service ruled that rents received with respect to furnished beach houses were self-employment income where the landlord rendered services “for the comfort and convenience of his guests in connection with their recreational activities,” including housekeeping, swimming, and fishing instruction, mail delivery, furnishing of bus schedules, and information about local churches. Similarly, in Rev. Rul. 83-139 (1983), the Service ruled that rents received with respect to a trailer park were self-employment income where the owner-operated “a recreation hall, consisting of a card area, pool room, kitchen, auditorium, stage and library.”
To reduce the self-employment tax risk associated with their short-term rentals, property owners should avoid ongoing housekeeping services beyond cleaning before and after their guests’ stays. Additionally, concierge-type services, such as assisting guests with leisure activity scheduling and transportation, should be avoided as these services are not maintenance-related. Some risk is acceptable, as guests have become accustomed to certain amenities, like linens, kitchen utensils, certain toiletries, and Wi-Fi access. While these amenities are clearly for the benefit of the occupants, taxpayers have a reasonable argument that the value associated with them is not substantial in relation to the transaction as a whole.
Unfortunately for property owners, there is no clear line drawn in the sand as to what services might trigger a self-employment tax liability; the substantiality requirement creates a significant gray area to be navigated. While past cases and revenue rulings may be illustrative in testing services as to whether or not they trigger a self-employment tax liability, I suggest a simpler test: “If it walks like a duck and it quacks like a duck, you can deduce with a fair amount of certainty that it is a duck.” The more property owners try to create a hotel-like experience for their guests, the more likely the Service will treat their business like a hotel.
Reference links:
[1] IRC § 1402(a)-(b).
[2] IRC § 1402(a)(1).
[3] Treas. Reg. § 1.1402(a)-4(c).
[4] Id.
[5] See Bobo v. Comm’r, 70 T.C. 706 (1978); Johnson v. Comm’r ,60 T.C. 829, 832-33 (1973); and Delno v. Celebrezze, 347 F.2d 159, 166 (9th Cir. 1965).
[6] Bobo at 710-11.
[7] Bobo at 711.
[8] 94 T.C. 542, 548 (1990).
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