You’re a savvy investor. You’ve just turned one of your rental units and are ready to place a new tenant. A friend of yours mentions how well they have done with short term rentals so you figure you’ll turn to a popular platform and give it a try. AirBnB, VRBO, and Homeaway make it extremely easy to market your listings and after only a few days on market you have multiple hits. Soon enough, you’re a pro with a 5-star rating and it’s smooth sailing from here on out. But have you considered how taxes on these short term rentals will significantly lower the return you thought you were receiving?
I generally don’t let tax considerations weigh heavily on my investment decisions even though I’m a CPA. While tax impacts are certainly important to consider, in most cases, they shouldn’t be the basis for decision making. The investment offering the highest Internal Rate of Return doesn’t necessarily result in the lowest tax liability.
However, tax implications must absolutely be considered when renting property through one of the three platforms mentioned above. Ignoring the tax issues will ensure that you receive a large tax bill come April 15th. You may even be subjecting yourself to IRS penalties.
In today’s post, I’m going to tell you why taxes on BnB rentals are different than regular rentals. I’m then going to explain why it’s relatively hard to find advice regarding short-term rentals. I’ll conclude with solid advice to plan your BnB rentals in a manner that can save you thousands of tax dollars.
For the rest of this article, I’m going to refer to short term rentals as “BnB” properties.
Why Taxes on BnB and Short-Term Rentals Are Different than a Regular Rental Property (Don’t Fall for The Trap!)
You likely already know that there are tax benefits to owning rental real estate. Tax strategies regarding rental property are numerous and sometimes exotic. Rental income is often reduced to $0 ultimately eliminating your tax liability caused by that rental income. This of course lowers your effective tax rate (since you are receiving tax-free income) which means you are keeping more of your dollars. That’s the goal right?
When rental income is not reduced to $0, it will be taxed at your marginal tax rate. Even in the event your rental income causes a tax liability, you’ve likely already sheltered much of it from taxes which also lowers your effective tax rate.
This is where taxes on BnB and short term rentals varies.
First, short-term rentals often allow you to generate a higher amount of rental income per month compared to a tenant on a 12 month lease. This fact makes short-term rentals attractive to landlords. The problem with earning more income is that you’ll have more to shelter from taxes. Because short-term rentals require a higher level of involvement, the additional income you earn may not be worth your time post-taxes.
The second major difference with short-term rentals is that they may be considered active businesses, much like hotel operations. Should this classification occur, you could be subject to self-employment taxes similar to any other person whom owns and operates a business. Each dollar of net profit is subject to self-employment taxes at an additional 15.3% rate. The 15.3% rate comes from the employee half (7.65%) and the employer half (7.65%) of Social Security and Medicare taxes. When you’re self-employed, you have the pleasure of contributing to these wonderful government programs not once, but twice! Aren’t you lucky?
Assuming you are subject to self-employment taxes, here’s an example of how BnB rentals can crush your tax bill and your returns:
I pulled these numbers out of thin air so cut me some slack. What I want to demonstrate is that certain short-term rental income incurs an additional 15.3% tax on the net income.
If the short-term rental was not subject to the 15.3% tax and the landlord is able to save the $578 and the return on investment increases to 9.45%. The self-employment taxes of 15.3% cost the landlord two percentage points of overall returns. That’s HUGE people.
The question landlords need to ask themselves is whether or not the additional return on investment is worth the hassles inherent with short-term rental properties. As I stated earlier, short-term rentals require a more hands on management approach.
And if taxes on short term rentals aren’t bad enough, landlords must also consider hotel regulations depending on where the rental is located. For instance, NYC and San Francisco are making it as difficult as they can for landlords leasing their units through sites like AirBnB.
Why Few People Understand Taxes on BnB Property
The sharing economy is relatively new and because of this, the information available online is scarce. Even if you find information regarding the taxation of short-term rentals online, it may not be correct. I’ve seen so much hogwash regarding taxes, in general, online. Throw in the complications of short-term rentals and you’re bound to read error prone content. Even big brand name tax prep firms don’t have their data right. Trust, but verify.
Related: Hiring a CPA is Key to Your Success
One major problem is that CPAs who don’t specialize in real estate feel comfortable providing advice on short-term rentals. They do so in blogs, interviews, and podcasts. And because small landlords presume they can’t afford the cost of a CPA, they try to prepare their taxes themselves while harnessing the advice they’ve received from a blog post.
This is a great way to get in trouble with the IRS, but especially when it comes to short-term rentals. For instance, in some cases short-term rentals will be reported on Schedule C rather than Schedule E. Yet many of my new clients who own BnB rentals, even those whom have had their taxes prepared by CPAs, are incorrectly reporting their BnB rentals on Schedule E.
Side note: Schedule E is where you report passive rental real estate. Schedule C is where you report business activity, such as an BnB operation.
Why is everyone and their CPA making this mistake? Simple: they don’t know the rules or they are intentionally breaking them and hoping that they simply don’t get caught. For instance, I had a new client tell me they’d prefer to report the BnB on Schedule E to avoid an additional 15.3% tax on their profits. Indeed. Unfortunately, tax prep is based on the facts and circumstances. There’s not much we can do after the fact (which is why you should hire a CPA and engage in tax planning).
Renting for Less than Seven Days
When your average rental period is less than seven days, the IRS deems the activity to not be a rental activity. Rental real estate activities are reported on Schedule E, but if your average rental period is less than seven days, and if the activity does not qualify as a rental activity, the income would ordinarily be reported on Schedule C.
However, just because we report on Schedule C doesn’t necessarily make the income subject to self-employment taxes. To be subject to self-employment taxes, substantial services must be rendered above and beyond regular rental real estate services to long-term tenants. Such substantial services may include:
- Changing linens;
- Providing fresh towels;
- Cleaning the rooms during a guest’s stay;
- Providing hotel-like conveniences such as a coffee maker and coffee; and
- Providing vehicles, bikes, or excursion options.
Section 1402 defines net income subject to self-employment tax. There is an exception for rental real estate, meaning rental income is not subject to self-employment tax. However, Section 1402(a)-4(c)(2) provides that when payments for use or occupancy of rooms where services are rendered to the occupants primarily for their convenience and outside the norm of what you would normally provide for occupancy only, your earnings will be subject to self-employment tax.
So as you can see, while the seven day rule may affect reporting requirements, your earnings will not be subject to self-employment taxes unless you also provide substantial (hotel-like) services.
Now the great thing about rental property is that your net income is never equal to your taxable income thanks to depreciation and amortization. Once we factor in these “phantom” expenses, the potential additional self-employment tax becomes less of a burden relative to our overall rental earnings.
Another factor to consider is that if you have a W2 job and earn more than $118,500, your self-employment taxes on your BnB earnings drop from 15.3% to 2.9%. The reason being that the Social Security portion of your FICA taxes drops off completely after you exceed the $118,500 threshold. Instead, you’re left with the 2.9% Medicare portion which is taxed indefinitely.
Renting for More Than Seven Days and Less Than Thirty
I suppose at this point I should pause and explain what I mean by “average rental period.”
Your “average rental days” per property is calculated by adding up the total number of days your property was rented and dividing that by the number of guests. So if you had 52 weeks of weekly rentals during a year (0% vacancy, impressive!) then you figure your average rental days by the following formula: (7 days x 52 weeks) / 52 guests. The answer here is obviously an average rental period of seven days.
But now let’s say that you rent one room out to a tenant who has a 12 month lease with you and you rent the other spare room out on a weekly basis. We’re still going to assume you are an operation god and achieve 0% vacancy. Our average rental period is calculated like so: [(12 months x 30 days) + (7 days x 52 weeks)] / (1 guest + 52 guests). Doing the math, we have [(360 days + 364 days) / 53 guests] = 13.66.
So 13.66 days is our average rental period for that particular BnB rental.
This is important from a planning perspective. We really want our average rental period to be above seven days. If our average rental period falls between seven and thirty days, and as long as we don’t provide substantial services to our guests, we get to report the property on Schedule E.
To avoid all of this completely, you can push your average rental period above thirty days. At that point, there will be no question that the property should be reported on Schedule E and is not subject to the pesky hotel rules. However, many BnB landlords are in it for the short turnovers as that’s what generates the greatest return.
BnB rentals are an excellent way to generate substantial capital and crush the gains you would otherwise see with long-term rentals. BnB rentals certainly have their place, just make sure you are proactively working with an advisor so that you understand all of the pitfalls and loopholes regarding the short term rental arena.