Avoiding Tax Traps on Short Term Rentals

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 who 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.

Conclusion

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.

 

 

 

About Brandon Hall

As founder and CEO of The Real Estate CPA, Brandon is focused on growing a CPA firm that provides real estate clients with an awesome experience. Brandon was named 40 under 40 by CPA Practice Advisor in 2018. Brandon leverages his personal real estate investing and his Big 4 Accounting experience to offer unique insights to his clients. Brandon enjoys CrossFit and Kiteboarding when he's not crunching numbers.

28 Comments

  1. Link Moser on March 2, 2017 at 5:19 pm

    I was just asking a CPA about this last week and he tried to tell me it the Schedule C vs. E was based on active vs. passive participation in the business, not the average rental period. I’m looking at doing STR for a yet to be purchased property and wanted to be sure I understood the tax consequences for this strategy. Even if I use a property management company to handle my short term rentals and I am essentially ‘hands off’ and thus not ‘actively’ involved in the business, is that still going to be Schedule C income if the average rental period is less than seven days?

    • Brandon Hall on March 9, 2017 at 3:49 pm

      Get a new CPA. It doesn’t matter if you are hands off when you own the property. You are in charge of making management decisions thus you are actively participating in your rental real estate activity. Then we look at the average rental period.

      Your CPA is confusing passive vs active participation. An example of passive participation is forking our $50k to be involved in a real estate syndication where you are not making any decisions, you just receive a quarterly check and report. You’re sharing in the equity but you don’t get to call any of the shots, and you are likely a limited partner. That’s a Sch E activity regardless of rental days. But if you own the property, it’s always active participation.

  2. Kate Sowerwine on April 11, 2017 at 6:23 pm

    Hi,
    So I make more than $150,000 but just bought a family lake home. I made it an LLC I’m doing STR and I know I have to pay the 2.9% Medicare tax but I was planning to use section 179 and write off lots of the furniture, painting, tile etc. I will have a loss this year. Can I not deduct the that carry on loss from my LLC to my personal taxes?

    Thanks!!!! I can’t seem to find a CPA that knows. Also have questions about conservation easement that I can’t find a CPA for…

    • Brandon Hall on April 20, 2017 at 2:24 pm

      Hi Kate – the loss will be non-deductible. Even though you report vacation rentals on Sch C, any losses generated are still considered “passive” and are subject to the passive loss limitations.

  3. DiceView on May 22, 2017 at 7:16 am

    I like the helpful information you provide in your articles. I will bookmark your blog and check again here regularly.

  4. konaboyz on October 7, 2017 at 10:17 am

    Thank you for this article!
    Fellow CPA/Surfer/tennis/mountain biker/off-road dirt biker!
    Honolulu, Hawaii

    Free surf or tennis lesson on me when I am not in Capaci, Sicliy!

  5. Samantha on October 25, 2017 at 1:26 pm

    What if you have a C Corp and actually want to be in the active business of BnB rental? Does renting for fewer than an average of 7 rental days mean that you will not be considered a Personal Holding Company even if it is a closely held corp with more than 60% of its income generated from the BnB? What if your C Corp leases the property from you (for Sched E on your taxes) and pays you reasonable salary based on how much actual time you work?

    With a C Corp, would this mean that you can pay yourself a salary and be taxed on whatever net income is left at the corporate tax rate? I guess that is similar to paying self-employment tax on the rental income, but it still seems like a reasonable way to go, right? And would an S Corp then be better for someone not wanting a C Corp because then is a pass-through?

  6. Pipper on October 25, 2017 at 6:25 pm

    What IRS PUBLICATION shows the 7 day or less and the list of substantial services list

    • Brandon Hall on November 19, 2017 at 3:25 pm

      We don’t rely on IRS Pubs for our research or analysis as they can not be used to substantiate a position. For the Seven Day rule, you’d look at Reg Sec 1.469-1T(e)(ii). For the substantial services list, you’d have to dig through court cases.

  7. Cece Bozetarnik on November 27, 2017 at 2:45 pm

    I am a tax professional and found this article really helpful. How often do your clients get CP2000 letters seeking SE on the schedule C? Do they go away with a simple reply?

  8. Ann Prather on January 2, 2018 at 5:20 pm

    I own and live in a 2 bedroom 1 bath condo in San Francisco. My teenager will be off to college soon, at which time my job will include a week of work travel per month. I’m pondering the idea of fixing up my son’s bedroom and renting it short term during my monthly work trips to help pay for college. Based on current rents in the area this would generate as much money as having a plain old roommate, but I would keep my privacy. I would also be under the 90 days per year limit that SF imposes on short term rentals where a landlord/primary tenant is not present. The short term renter would have access to the entire condo except for my bedroom. No substantial ‘hotel’ services would be offered other than access to my kitchen, and fresh linen/towels upon their arrival. These would not be refreshed during my absence unless they washed them in my laundry.

    What are the tax pros and cons between having a regular roommate or renting short term when I’m gone each month? Can I still take depreciation? Would it be on half of the unit since I would be only renting out 1 of the 2 bedrooms?

  9. Bob Nardo on January 29, 2018 at 6:18 pm

    Thanks for the article! I feel like I am in a trap, I have a short term rental (average rental is less than 7 days). However, I am doing this through a LLC (my wife and I are the only members with 50/50 share). According to other documentation I have read, I cannot use a Schedule C since we are a LLC in a non community property state. So how do I file since I cannot use schedule e or c?

    • Brandon Hall on January 31, 2018 at 5:54 pm

      Technically you should file a Form 1065. There is a small partnership exception that allows you to not file a Form 1065 as long as your report your allocable income and expenses on your tax return. This is supported by Rev. Proc. 81-1115, McKnight v. Commissioner, Davis v. Commissioner, and Harrell v. Commissioner.

      Generally though, we still file Form 1065s for our clients as we’d prefer to be on the compliance safe side.

  10. Joseph Clemens on February 2, 2018 at 4:56 pm

    Brandon – Reading the regs and code I’ve come to the same conclusion as you on the Schedule C – E – SE issue. The problem lies with the 7 days or less, but no substantial services. Put it on C, but not SE. How do you think the best way to report that is? The instructions for a notary are clear to back it out on line 3 of the SE with a note to the left. But the instructions for rental contradict it all. Don’t include it on line 2 (and thus assume a letter on the way), or back it out on Line 3 like a notary?

    • Brandon Hall on February 3, 2018 at 5:30 pm

      You would need to back out the SE tax. You may be better off trying to qualify your facts for Sch E to avoid the hassle of backing out SE.

  11. Teresia S. on February 19, 2018 at 2:48 am

    Would the ‘substantial’ services need to be performed DURING the stay? In mine, the linen change and towel re-supply are done in between guests.

    • Brandon Hall on February 25, 2018 at 9:42 pm

      Substantial services can be broad in scope but most will be performed during the stay.

  12. Tikka on February 23, 2018 at 10:30 pm

    How do you determine the average rental period? Some of the reservations were from BnB with definitely 30 days. So, say I had 5 reservations all year — 1 for 30 days and 4 for 2 nights. Do I add up 30+2+2+2+2 and divide by # of reservations?

    • Brandon Hall on February 25, 2018 at 9:40 pm

      Yes, total days rented divided by # of tenants.

  13. PDX Gal on March 3, 2018 at 6:26 am

    Seems to me a big advantage of doing STR vs long term is the ability to deduct self-employment health insurance premiums. I’m considering ‘semi-retiring’ in the near future and living primarily off income from my rentals and savings. The upstairs of my house is a separate unit (ADU) that I’d planned to rent out long term. If instead I do STR as a Schedule C business my understanding is I can include health insurance premiums as an operating expense. That alone would offset about 30-50% of my anticipated gross STR income. After deducting other expenses I figure my *net* income from STR would be minimal, reducing both self-employment and overall taxes. Does this reasoning make sense, or am I missing something?

  14. Kim on March 12, 2018 at 1:20 am

    Over what period do you depreciate the residence used for a STR. My account Reported the income on schedule C, we check that I did not materially participate so I am subject to the passive loss rules, But I noticed that TurboTax depreciate that property over something like 37 years where is my account and use 27.5 for the residential rental property. Is it a different. For rentals on schedule C than schedule E?

    • Brandon Hall on March 18, 2018 at 8:27 pm

      Short term rentals are subject to different rules and tests. If your short term rental does not meet the transient basis test (80% of gross rents come from long term tenants), then you generally have a non-residential property and must depreciate over 39 years.

  15. Tom on March 18, 2018 at 7:20 pm

    How about this. I already have an S-Corp doing property management. How about if I lease my condo under a long term lease to my S-Corp and have it do the STR activity. I would own the condo, report my rental income received from the S-corp on Schedule E and the S-Corp would report the balance of the income on it’s return. Did I just “cleanse” the self employment element?

    • Brandon Hall on March 18, 2018 at 8:30 pm

      You could do this, though you’ll need to read up on self-rental rules.

  16. welmeres on March 25, 2018 at 8:14 pm

    I enjoyed your article and the comments… I have short term rentals that I actively manage (I spend more than 750+ hours per year) and its my primary business (I don’t do anything else). I qualify as a real estate professional and I feel that my income should be subject to SE tax.

    However, I can’t seem to find the answer on how these homes should be depreciated. The homes are residential real estate (27.5 year life) but they are used in a trade/business, so I am thinking they should be 39 year property. I read through some articles and the IRS depreciation publication but I can’t seem to find a straight answer on this.

    Can you provide Rev. Ruling or some other support for the above statement:

    “Short term rentals are subject to different rules and tests. If your short term rental does not meet the transient basis test (80% of gross rents come from long term tenants), then you generally have a non-residential property and must depreciate over 39 years.”

  17. Katie Krska on June 19, 2018 at 12:57 pm

    Hi Brandon,
    On your podcast “Episode #2 – Tax Strategies for Your AirBnB Rentals,” you mentioned that when your average rental period is under 7 days, you’ll be subject to SE tax. In this article, you state that if you don’t provide substantial services and the average rental is under 7 days, you aren’t subject to SE tax. Can you please clarify which is correct?

    Thanks so much!
    Katie

    • Brandon Hall on July 23, 2018 at 8:10 pm

      You have to provide substantial services – it’s tough to update a podcast 😛

  18. Airbnb Cleaners Sydney on July 24, 2018 at 4:59 am

    Good points though and thanks for few more resources you have shared. Thanks for sharing it.

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