As long as people have owned property, they have earned income by renting it out to others, both for long-term living and for short-term stays. In the last decade and a half, however, the short-term rental market has exploded. As rental brokers like VRBO and Airbnb have gained in popularity, more people than ever are earning income by renting out their properties.
Becoming a landlord—whether for short-term stays like Airbnb or for more traditional leases—can be a great investment. The taxes, however, can be a little tricky.
Depending on the circumstances, a landlord may—or may not—owe self-employment tax on rental income. And with self-employment taxes being 15.2%, it’s worth understanding what those circumstances are.
Self-Employment Tax—What Is It? Who Pays It?
When taxpayers work for employees, they typically split the costs of social security and Medicare tax, with each paying 6.2% for Social Security and 1.45% for Medicare. Self-employed taxpayers, however, are responsible for paying those taxes in their entirety, so they pay 12.4% for Social Security and 2.9% for Medicare—15.3% altogether.
The IRS defines self-employed people as follows:
- You carry on a trade or business as a sole proprietor or an independent contractor.
- You are a member of a partnership that carries on a trade or business.
- You are otherwise in business for yourself (including a part-time business or a gig worker)
Rental Income: Passive vs. Active
Most of the time, landlords who rent out a residential property do not have to pay self-employment tax on their income. The IRS considers this “passive income,” and usually taxes it at the same rate it taxes salary received from a job.
But there are exceptions. In some cases, money made from renting out property is considered self-employment income and thus subject to self-employment tax.
Real Estate Professionals
The first exception is if the owner of the property is a real estate professional, such as a broker or agent. The IRS defines this as someone who works at least 750 hours in real estate a year and spends at least half their work time on real-estate activities. Real estate professionals who are also landlords must report their earnings as self-employment income.
Even if you’re not a real estate professional, though, you might still be on the hook for self-employment tax. Rental situations in which the landlord offers “substantial services” for the tenant’s convenience may cross the line from occupancy to hospitality and thus become “active” income. At this point, the IRS may decide that you are in business for yourself and are self-employed. An example would be a bed and breakfast that not only offers guests a place to sleep but also provides meals and possibly other services such as transportation.
Services Make a Difference
Some short-term landlords are fairly hands-off, supplying tenants with a key and not much more. However, as more people enter the short-term market and competition increases, many owners are providing more and more amenities for their guests, ranging from car service to chef service to daily housekeeping and more. Services like this may cross the line from a passive rental to an active business and thus trigger self-employment taxes.
The Internal Revenue Code makes clear that services necessary for the upkeep of the property, such as cleaning and maintenance of common areas, routine repairs, trash collection, elevator service, and security, will not trigger self-employment tax, nor will providing services, such as heat, running water, or electric lighting, that are generally expected with any residential rental.
Other services, however, are not always as clear-cut.
Properties might offer services such as laundry, vending machines, and satellite television that blur the line between active and passive and might need to be considered on a case-by-case basis. Some owners might perform more services for upgraded guests than regular-price ones. Or owners with more than one rental unit on the same property might perform different services for different units. In those cases, prorating the income might be a possibility.
Other Tax Considerations for Landlords
One silver lining to having to pay self-employment tax is that “active” income allows landlords to deduct rental losses of up to $25,000. “Passive” income, on the other hand, means that rental losses can be deducted only against rental or other passive income.
In most cases, landlords can deduct operating expenses and mortgage interest from their taxes and may also qualify for a depreciation deduction. They may also be able to defer paying capital gains on the sale of a rental property by using a 1031 exchange.
Becoming a landlord can be a smart way to build and preserve wealth, but it pays to work with a qualified CPA who can help you understand the nuances involved and ensure that you’re not paying more in taxes than necessary. Contact Tonneson today.
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