Tax planning for real estate activities often involves a myriad of tax
considerations. For example, if the real estate produces a loss, a
determination must be made whether the loss is limited by insufficient
basis or by the at-risk or passive activity loss rules which arise
under IRC sections 465 and 469. When income is generated, other
questions arise, including whether such income will qualify for the
IRC section 199A deduction introduced by the Tax Cuts and Jobs Act
(TCJA) of 2017, whether the income may be subject to the net
investment income tax surcharge of 3.8% under IRC section 1411, and
whether the rental income will be subject to self-employment tax. This
article discusses the intersection of rental real estate and
self-employment tax.
In a Chief Counsel Advice issued on December 23, 2021, CCA 202151005,
the IRS discussed various rules relating to the application of
self-employment tax by describing two general fact patterns. The CCA
involved limited issues but provides a good starting point for
understanding how the IRS classifies real estate rentals for
self-employment tax purposes. Both fact patterns involve the
application of IRC sections 469(c) and 1402(a)(1) to short-term
residential rentals from real estate. IRC section 469 describes the
rules related to passive activities, and IRC section 1402 discusses
net earnings from self-employment (NESE).
CCA 202151005
In the first example, the individual taxpayer provided various
services and accommodations with respect to a vacation property rented
via an online rental marketplace. The taxpayer provided the following
services: Linens, kitchen utensils, all items making the property
fully habitable, daily maid services, delivery of individual-use
toiletries and other sundries (not described), Wi-Fi service, beach
access, recreational equipment, and prepaid ride-share vouches between
the property and the nearest business district.
In the second fact pattern, the individual landlord rented a fully
furnished room and bathroom without access to most common household
areas such as the kitchen or laundry room. Cleaning was only provided
between each occupant’s stay, and the example included no discussion
of any other items furnished to the occupants.
In both examples, the individual taxpayer was not a real estate
dealer. Surprisingly, and without discussion, both examples also
stated that the rental activity occurred in the course of a trade or
business. Because average customer use was less than eight days, both
activities were not considered a rental activity for IRC section 469
purposes [Treasury Regulations section 1.469-1T(e)(3)(ii)(A)]. The
examples also included a statement that taxpayers materially
participated in the activity for purposes of the passive activity
rules, but they did not describe how the required tests were met.
The CCA concluded that the determination of whether the activity
constitutes a rental activity under the passive activity rules is not
determinative for self-employment tax purposes. In addition to income
taxes, IRC section 1401 imposes a tax of 12.4% on the self-employment
income of individuals. IRC section 1402(b) defines self-employment
income as NESE, which is described in section 1402(a) as the income
derived by individuals from any trade or business carried on by the
such individual, less the deductions allowed that are attributable to
such trade or business, plus the distributive share of partnership
income. However, IRC section 1402(a)(1) excludes net rental income
from NESE unless the amounts are received in the course of a trade or
business as a real estate dealer. In both fact patterns, the taxpayer
provided short-term residential rentals and was not a real estate
dealer. Treasury regulations provide that rentals from living quarters
are not considered NESE and are considered rentals from real estate
when no services are rendered for the occupants [Treasury Regulations
section 1.1402(a)-4(c)(1)]. The CCA discussed two examples that
addressed the level of services provided to the occupants.
With respect to the services rendered to occupants, the two fact
patterns present a stark contrast. In the first situation, net rental
income was not excluded from NESE due to the substantial services
provided; in the second, the income was excluded from NESE as
residential rental income. These were predictable outcomes: What about
situations not as blatant as the first fact pattern, but perhaps not
as starkly bare as the second? In describing services, the CCA states
that “services are considered rendered to the occupant if they are
primarily for his convenience and are other than those usually or
customarily rendered in connection with the rental of rooms or other
space for occupancy only.” For example, the IRC section 1402(a)(1)
exclusion from NESE did not apply to the rental of a vacation beach
dwelling that included services such as maid services, swimming and
fishing instruction, mail delivery, furnishing of bus schedules, and
information about local churches [Revenue Ruling 57-108, 1957-1 C.B.
273].
Discussion
The Treasury Regulations provide some bright line tests which indicate
that the following do not constitute rentals from real estate: Rentals
in hotels, boarding houses, tourist camps or tourist homes, parking
lots, warehouses, or storage garages [Treasury Regulations section
1.1402(a)-4(c)(2)]. The regulation describes tainted services as those
rendered to the occupant for the occupant’s convenience other than
those “usually or customarily rendered in connection with the rental
of rooms or other space for occupancy only.” For example, the
furnishing of heat and light, cleaning of public areas, and the
collection of trash are not considered as services rendered to the
occupant; the supplying of maid services, however, is. In cases where
multiple rentals are involved and some include services for the
convenience of the tenants and others do not, the regulations clarify
that the rentals must be viewed independently for calculation of the
portion attributable in determining NESE.
Unfortunately, there is no bright-line test, and all facts of any
particular case must be carefully evaluated. A fundamental question
relates to services that maintain the property in condition for
occupancy; such services are not considered rendered for the tenant.
If services are rendered for the tenant, the next inquiry is whether
the tenant’s services are substantial.
In BoBo v. Commissioner [70 T.C. 706 (1978), acq.], the taxpayers
owned a 46-unit mobile home park in California. Because the park
grounds were paved, no landscaping or maintenance was required. The
taxpayer’s resident manager periodically cleaned leaves and other
debris. Each home space was furnished with gas, water, a sewer, and a
separately metered electrical connection. Tenants’ garbage was
collected by a local company. An independent concession provided two
coin-operated washers and dryers at the premises with connected water,
electricity, and sewer. Machine repair was the responsibility of the
concessionaire who also collected the deposited money. The taxpayer
received a commission from the operator. No recreational facilities
were provided. Rent was collected and general operations were
performed by the resident manager.
The central issue was whether the mobile park earnings were subject to
self-employment tax. Because the IRS asserted that self-employment tax
applied and relied on the fact that the mobile park rendered services
to its tenants, the earnings were not excludable earnings and did not
constitute “rentals from real estate” under the statute and
regulations. The court noted that because the taxpayer provided
cleaning, ground maintenance, sewage and electrical connections,
laundry, bath, and toilet facilities, and roadway maintenance, he
provided services other than those “usually or customarily provided in
connection with the rental of space only for occupancy.” The ruling
clarified that many of the provided services, such as furnishing of
heat, and light, the cleaning of public areas, collection of trash,
and others, are not considered as services rendered to the occupant
under Treasury Regulations section 1.1402(a)-4(c)(2). The court viewed
most of the provided services as those required to maintain the
premises for occupancy. Although providing laundry services does not
meet that exception, such services were provided by the concessionaire
and the court found that this service was not sufficiently substantial
and did not constitute a material part of the rental payments made by
the tenant. The court viewed the laundry as an incidental or minor
service to the occupant who “pays rent primarily for his space and the
services necessary to maintain it.” The court stressed that the
determination is based upon all facts and circumstances, including the
materiality of the nonexempt services, and that each situation needs
to be carefully evaluated before a position is maintained.
Commercial Rentals
A common question arises as to whether 1) a rental real estate trade
or business, or 2) a taxpayer that qualifies as a real estate
professional is required to pay self-employment tax on net rental
income. CCA 202151005 stated that the rental in the second example
occurred in the course of a trade or business and was excluded from
NESE, but the activity seemed quite limited. In Blythe, et ux. v.
Commissioner (TCM 1999-11), the taxpayer owned 10 parcels of
residential real property. One of the central issues in the case was
whether self-employment tax was required to be paid on the net rental
income. Because the taxpayers claimed that they were not real estate
dealers, the net rental earnings were not earnings from
self-employment. The IRS maintained that the rentals constituted a
trade or business; therefore, the income was required to be included
in NESE. The court found that the taxpayer acquired the parcels for
the purpose of producing rental income and was not holding the title
for the purpose of selling real estate to customers. The taxpayers did
not offer any of the parcels for sale during the year under audit or
at any other time. The court found that because the taxpayers were not
real estate dealers, the net rental income was not subject to
self-employment tax.
Limited Guidance
Net earnings from self-employment are subject to self-employment tax.
There is a statutory exclusion for rentals from real estate and
personal property leased with the real estate. CCA 202151005 helps to
guide taxpayers with respect to the structure of residential rentals.
In some situations, the services provided will resemble either one of
the two fact patterns in the memorandum, but the analysis will often
be more difficult. Tax preparers will have to review and assess the
significance and materiality of all services provided to residential
tenants.