There is a lot of confusion on this topic, and even many CPAs and tax professionals handle rental income incorrectly, especially when it comes to short-term rentals.
The determining factor in whether you have to pay self-employment tax on your rental income depends on whether you are providing what is called “substantial services” (see IRS Tax Topic No. 414). Substantial services are services provided to guests that are above and beyond just providing cleaning between tenants. You are providing substantial services if you provide services to guests during their stay, such as a daily cleaning service, meals, or entertainment. In that case, you are considered to be not just running a rental property, but an actual hotel-like business.
If you provide substantial services, then your income for the property must be reported on Schedule C and you must pay self-employment tax on the income. Otherwise, you should report the income on Schedule E and you don’t have to pay self-employment tax on the income.
Is the average stay for short term rentals a factor?
You may come across some information online that says having an average stay is 7 days or less is a determining factor for what schedule the income goes on and whether you pay self-employment tax. There was some confusion on this topic in the past, but IRS Memorandum 202151005 clarified that the average stay is not a factor, and only substantial services should be considered as the determining factor in which schedule in the income is reported on (and therefore whether you pay self-employment tax on the income). But the 7-day average stay is a factor in determining whether the rental is a passive activity, which is a separate determination.
Should you avoid providing substantial services to avoid paying self-employment tax?
The current self-employment tax rate is 15.3%, so that can take a big chunk out of your rental income profits. So most people will want to avoid trying to qualify to pay that tax.
There are a couple reasons some people may want to provide substantial services and pay the self-employment tax. A portion of the self-employment taxes you pay go towards your future social security payments, so there is at least some potential future benefit to paying this tax if you haven’t already had enough years of earned income to qualify. A more common reason people may want to make their rental income count as earned income is if they have no other earned income, and they want to be able to qualify to contribute money to an IRA or other retirement account.
It’s important to realize that you only pay this tax on your net taxable rental income. Your net rental income calculation for tax purposes might be negative even if you are making a profit. This is because you get to deduct depreciation (a portion of the cost of the real estate) from your rental income each year. So check your past year tax return, or your current year calculations, to determine if you are actually generating a taxable profit or not.
If your net taxable rental income is negative, you might want to instead see if you can qualify to use that negative income to offset your other income.
Still confused? If you have other tax questions, or if you’re looking for a tax professional with real estate expertise to prepare your tax return, please contact us.
