In Brief
The proliferation of home-sharing platforms has allowed many property owners to make some extra money by renting out their homes, or portions thereof, to vacationers. But like any other income, that money is subject to taxation, and many home sharers are unaware of all of the rules that apply. The author explains the legal requirements regarding classifying home sharing as either a rental or a business activity, and the tax treatment of each, as well as some of the more common compliance challenges.
***
The last 10 years have seen explosive growth in home sharing. Homeowners with a spare couch, guest bedroom, or vacant beach house are finding that short-term rentals are a ready source of supplemental income. Internet platforms such as Airbnb or HomeAway make it easy to list properties, screen potential guests, and receive payment electronically. Airbnb reports that its accommodation marketplace provides access to over 5 million unique places to stay in more than 81,000 cities and 191 countries (https://press.airbnb.com/about-us/). In addition to providing a bed, homeowners often make their listings more attractive by offering breakfast, kitchen privileges, use of exercise equipment, or concierge-type services.
There is, however, more than a little confusion over the tax consequences of home sharing. How is this income classified and reported for federal income tax purposes? Which expenses are deductible? Are losses deductible? What additional taxes might a host be subject to? This article discusses the tax compliance issues faced by individual property owners who rent residential space for short periods of time through an online booking platform.
Classifying the Activity
When a property owner offers a room or cottage for rent, and a guest pays for its short-term use, the owner might assume that the transaction produces rental income. But various provisions in federal tax law take into consideration the length of the average rental period and provision of services in connection with the rental in distinguishing a rental activity from a business activity. For an individual, sporadic rentals of nonresidence real-ty may not even have a demonstrable profit motive, and may be characterized as a not-for-profit activity (i.e., a hobby).
What is rental activity?
Rental activity is defined by Internal Revenue Code (IRC) section 469(j)(8) as any activity where payments are principally for the use of tangible property. Rental income is by definition passive, meaning that losses from rental activities can only be deducted against passive income. But an activity involving the use of tangible property is not a rental activity if the average period of customer use is seven days or less, or if the average period of customer use is 30 days or less and significant personal services are provided by the owner of the property.
What are “significant” services?
According to Treasury Regulations section 1.469-1T(e)(3)(iv)(B)(3), the term “significant personal services” does not include services that are commonly provided in connection with long-term rentals of high-grade commercial or residential real property, such as utilities, maintenance of common areas, repairs, trash collection, elevator service, and security. In Stover v. Comm’r [781 F2d 137 (CA-8, 1986)], the court explained that “the term ‘rents’ does not include payments for the use or occupancy of rooms or other space where significant services are also rendered to the occupant, such as for the use or occupancy of rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist homes, motor courts, or motels. Generally, services are considered rendered to the occupant if they are primarily for his convenience and are other than those customarily rendered in connection with the rental of rooms or other space for occupancy only.” By that definition, it would seem that unless guests are required to supply and launder their own sheets and towels, most home-share bookings do not qualify as rental activities.
What is a trade or business?
The most commonly used criteria for defining business activity are those laid down by the U.S. Supreme Court in Groetzinger v. Comm’r [480 U.S. 23 (1987)]: “To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” Whether a profit motive exists is to be determined on the basis of all the facts and circumstances of each case. Treasury Regulations section 1.183-2 provides a list of factors that may be considered in determining whether an activity is engaged in for profit.
What is a not-for-profit activity?
If the activity is not engaged in primarily for profit, IRC section 183 limits deductions to income from the activity. Such expenses were included in “Miscellaneous Itemized Deductions” prior to 2018; however, that entire category of itemized deductions is suspended for tax years 2018 through 2025 by IRC section 67(g). It follows that while the revenues from an individual’s hobby must be included in gross income, no expenses are deductible that would not have otherwise been deductible. Rental activity involving a dwelling unit that is subject to the IRC section 280A vacation home rental or home office rules is not subject to the hobby loss rules of IRC section 183.
In Sharon M. Rivera, et vir. [TC Summary Opinion 2004-81], the Tax Court ruled that a taxpayer’s rental activity was not for profit. Rivera rented out a second home (which did not qualify as her residence and thus was not subject to IRC section 280A) on a sporadic basis and attempted to deduct rental losses, which the IRS denied. The court was not convinced that there was a profit motive for the rentals, because “petitioners did not maintain businesslike books and records of rental activity, and there was not much time spent in carrying on the activity. Furthermore, it appears from the record that the property was rented for less than its fair rental value for the days it was rented.”
Income Tax Consequences of Home Sharing as a Rental Activity
The federal taxation of rental income is fairly straightforward. Under IRC section 61(a)(5), rents are included in gross income. Treasury Regulations section 1.61-8(a) defines rents as amounts “received or accrued for the occupancy of real estate or the use of personal property.” Rents received in advance and lease cancellation payments are included in income upon receipt, as are improvements or expenses paid for by a tenant in lieu of rent. Any amount of a damage deposit that is not returned at the end of the rental period is also income.
Ordinary, necessary expenses related to the production of rental income and the maintenance and preservation of rental property are deductible for adjusted gross income (AGI) under IRC sections 162 and 212. If only a portion of a property is rented, indirect expenses are allocated to the rented space using a reasonable basis, such as square feet occupied or number of rooms or occupants. Individual taxpayers report revenues and expenses from rental activities on Schedule E of Form 1040.
A significant tax advantage of rental treatment is that rental profits are not subject to self-employment taxes [Treasury Regulations section 1.1402(a)-4(c)]. In addition, for those collecting Social Security before full retirement age, rental income will not cause a reduction in benefits. Rental profits are, however, subject to IRC section 1411 net investment income tax (NIIT), but this 3.8% tax will only be a factor if the taxpayer’s modified AGI is over the threshold ($250,000 for married filing jointly, $125,000 for married filing separately, $200,000 for all others). The fact that rental income is classified as passive can be advantageous if one has passive losses from other activities that would otherwise not be deductible, but disadvantageous if the rental activity itself is producing losses. Rental losses (only reportable if the property is not a residence of the taxpayer) can only be deducted against passive income. There is, however, an exception for rental real estate losses of up to $25,000 for individuals whose AGI is less than $100,000 before deducting the rental loss [IRC section 469(i)].
The fact that rental income is classified as passive can be advantageous if one has passive losses from other activities, but disadvantageous if the rental activity itself is producing losses.
Special provisions for rental of a residence.
IRC section 280A contains special rules for rental activities involving taxpayer residences. A dwelling is classified as a residence if personal use exceeds 14 days and 10% of the rental days. Rental for 14 days or less in a year is disregarded, so a homeowner who limits rental of a residence to 14 nights per year does not have to report any rental income and can still include all of the home’s mortgage interest and property taxes as itemized deductions.
When a residence is rented for more than 14 days, expenses must be allocated to the rental activity using the ratio of rental days to total days of use; if the taxpayer rents only a portion of the residence, this rule is applied to the expenses attributable to that portion, and the ratio is the days on which that portion of the residence is rented at fair rental over the days on which that portion is used for any purpose [Proposed Regulations section 1.280A-3(c)(2)]. IRC section 280A(c)(5) limits such deductions to rental income; no deduction for loss is allowed. In meeting this limitation, homeowner expenses are deducted in a specified order—first, the allocated portion of mortgage interest and property taxes; second, allocated amounts of indirect expenses other than depreciation (but only to the extent of remaining income); and last, allowable depreciation only if there is sufficient rental revenue to prevent reporting a rental loss [Proposed Regulations section 1.280A-3(d)(3)].
IRC section 280A and associated regulations require allocation of all indirect expenses using the ratio of rental days over total days of use (days the property remains vacant, even though available for rental, do not count for allocation purposes). In Bolton v. Comm’r [77 TC 10 (1981)], the Tax Court allowed mortgage interest and property taxes to be allocated using rental days over total days in the year. This method results in smaller allocations of mortgage interest and property tax to the rental activity, allowing for a greater deduction of other rental expenses and depreciation. As the remainder of the mortgage interest and property tax is includible in itemized deductions, this method will benefit taxpayers whose itemized deductions already exceed the standard deduction. Given that standard deduction is much larger as of 2018, and that the total deduction for state and local taxes, including property taxes, is limited to $10,000, fewer taxpayers are likely to benefit from the Bolton method in the future.
Taxpayers should remember that any allowable depreciation, whether deducted or not, will reduce the basis of the property and may result in depreciation recapture upon subsequent sale of the residence. The passive loss rules of IRC section 469 do not apply to rental of a residence; this may seem to be a moot point, since IRC section 280A(c)(5) already precludes deducting a loss from rental of a residence, but Treasury Regulations section 1.469-2(c)(7)(vii) dictates that profit from such an activity is not passive income either, and cannot be offset by passive losses. Exhibit 1 summarizes the tax treatment of real estate rentals that do not involve the taxpayer’s principal residence.
Exhibit 1
Tax Consequences for Renting a Separate Dwelling or Vacation Home
Income Tax Consequences of Home Sharing as a Business Activity
The classification of a home-sharing activity as business rather than rental means that total revenues collected from guests should be reported on IRS Form 1040 Schedule C, and that ordinary, necessary, reasonable business expenses are deductible under IRC section 162. Detailed records must be kept to document business expenses. Business profits are subject to IRC section 1402 self-employment tax. To compute the self-employment tax, net earnings from self-employment (generally, the total of all Schedule C profits for the individual) are multiplied by 92.35%. If the amount is not over $400, the self-employment tax is disregarded. Otherwise, these earnings are subject to up to 15.3% self-employment tax, depending on whether the individual has also paid Federal Insurance Contributions Act (FICA) tax on wage compensation. One-half of the self-employment tax is deductible for AGI. Losses incurred by a trade or business in which the taxpayer “materially participates” are not subject to the passive loss limits, and profits are eligible for the 20% qualified business income (QBI) deduction under the new IRC section 199A.
Special provisions for business use of the taxpayer’s principal residence.
The property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer’s principal residence. Treasury Regulations section 1.121-1(b)(2) provides other factors to consider when the determination is not obvious. If rental of space in the taxpayer’s principal residence meets the definition of a business, either due to the short average rental period or the provision of significant services, there are stricter limits on the deductibility of household expenses [IRC section 280A(c)(1)]. Expenses for business use of the home are only deductible if the rented space is used exclusively for that purpose; any personal use of the space will disqualify it. IRC section 280A(d)(2) defines personal use to include days when the property is occupied by any member of the taxpayer’s family or is rented to anyone at less than fair market value. Thus, if one’s in-laws use the Airbnb guestroom when they visit (even if they pay fair rental value), the exclusively-for-business test is not met. Even when the exclusive-use test is met for a particular space, no expenses for the care or maintenance of common or shared areas, such as the kitchen, hallway, porch, or yard, are deductible. Furthermore, indirect expenses allocated to the rented space cannot create or increase a net loss from the home-based business activity, although mortgage interest and property taxes are still fully deductible, and disallowed expenses can be carried forward to subsequent years [IRC section 280A(c)(5)]. Finally, under IRC section 121(d)(6), the portion of any gain on the sale of a principal residence that represents depreciation recapture cannot be excluded from gross income.
The IRS provides an optional simplified method, whereby home office expenses are computed using a rate of $5 per square foot on up to 300 square feet of space used exclusively for business, for a maximum deduction of $1,500 (Revenue Procedure 2013-13). When this method is used, mortgage interest and property taxes remain fully deductible as itemized deductions, and the basis of the residence is not affected; however, any amount not deductible due to insufficient business profit cannot be carried forward. Exhibit 2 summarizes the tax consequences of renting all or part of the taxpayer’s principal residence.
Exhibit 2
Tax Consequences of Renting Taxpayer’s Principal Residence for more than 14 Days
Compliance Challenges
A major compliance challenge for taxpayers in the home-sharing business is the confusion regarding classification of activities. Until further guidance is promulgated, many taxpayers and preparers will decide to classify their activity as “rental” or “business” based upon which choice will result in the lowest total tax liability. The federal government has failed to provide a bright-line distinction between rental income and business income, particularly where the taxpayer’s residence is involved, nor is there an objective definition of significant services. Is a home-share host who regularly and continually books guests for an average stay of less than seven nights and who cleans the rooms, launders the linens, and makes up the beds between bookings really running a business in the home? Is this activity really subject to the “used-exclusively-for-business” standard?
Another compliance challenge for home sharers is the allocation and substantiation of expenses. A host can compile a list of any number of incremental costs of having paying guests in the home. Expenditures for furniture, bedding, and décor for guest rooms, and keypad locks for entrance doors are straightforward and easy to document. Indirect costs such as utilities and supplies consumed by guests in their daily ablutions, incremental costs of cleaning products used to launder linens and towels and to clean guest rooms, and the costs of providing coffee or breakfast are much more difficult to compute or document. How does one track how many of the bagels or bananas on the grocery receipt were consumed by paying guests versus family members? In Backlund v. Wisconsin Department of Revenue (Wisconsin Tax Appeals Commission, Nos. 06-I-67 and 06-I-68, August 9, 2007), the commission held that the taxpayers’ claim that they never purchased breakfast items for themselves and that all breakfast items were either eaten by paying guests or thrown away was not credible. The Wisconsin Department of Revenue suggested an allowance of $10 per breakfast per guest, which the court found to be reasonable.
Expense allocation could be streamlined by the provision of standard rates similar to the per diems used for business travel (Revenue Procedure 2011-47), the standard meal and snack rates for family day care providers (Revenue Procedure 2003-22), and the $5 per square foot rate used for the simplified method of determining home-office expenses (Revenue Procedure 2013-13). These safe-harbor rates are helpful to both taxpayers and the IRS, and could greatly minimize compliance burdens and administrative costs. Until they are provided for home sharers, however, hosts should save receipts and be able to substantiate their calculations for an average cost per person per night for coffee or breakfast, to launder a set of sheets and towels, and other services.
Indirect costs such as utilities and supplies consumed by guests, incremental costs of cleaning products, and the costs of providing breakfast are much more difficult to compute or document.
Additional Taxes on Home-Share Transactions
Transaction taxes that apply to home or room rentals, such as sales and occupancy taxes, are the responsibility of the property owner to collect and remit. Needless to say, many hosts will fail to do so, whether out of ignorance or otherwise, and it is nearly impossible for state and local governments to detect these omissions. To stay in the good graces of local authorities, Airbnb and other booking platforms have made arrangements to collect and remit these taxes on behalf of hosts wherever possible. As stated in the terms of service on the Airbnb website, “In certain jurisdictions, Airbnb may decide in its sole discretion to facilitate collection and remittance of Occupancy Taxes from or on behalf of Guests or Hosts, in accordance with these Terms, if such jurisdiction asserts Airbnb or Hosts have an Occupancy Tax collection and remittance obligation. In any jurisdiction in which we decide to facilitate direct Collection and Remittance, you hereby instruct and authorize Airbnb (via Airbnb Payments) to collect Occupancy Taxes from Guests on the Host’s behalf at the time Listing Fees are collected, and to remit such Occupancy Taxes to the Tax Authority” (https://www.airbnb.com/terms#sec13). This service increases compliance and relieves individual property owners from the burden of filing additional tax returns.
A Complicated Endeavor
Those who offer their property for short-term rental currently must navigate a maze of federal income tax rules, all of which hinge on fuzzy definitions, to find one of 13 possible combinations of tax consequences. Home-sharing hosts who desire to file accurate tax returns and taxing authorities desiring to collect appropriate amounts of tax will all benefit from clearer guidance and objective definitions from the IRS. In the meantime, many commercial tax preparation software programs are equipped to deal with home-share transactions. Ultimately, however, the responsibility for compliance rests with the taxpayer.
