By now you’ve probably heard of the “sharing economy”. If not, maybe you’ve heard of AirBnb, Lyft, or one of countless companies that help you rent a room, car, or any number of other goods or services from private individuals. For the customers of these companies, they can often get cheaper access to one of these items than going through traditional companies. For the people offering goods and services, it’s often a way to make some extra cash from a spare room, unused item, or just spare time.
These arrangements are often a win-win for everybody involved. However, one thing that the individuals providing items through these sites often don’t consider is the tax implications. And with good reason, depending on what’s being offered for rent, the tax implications can be quite complex.
Over the next few weeks, I’ll provide some tips for providers of different types of goods an services. I’ll start by talking about the consequences of renting out space in your home for overnight visitors through a service like AirBnb. So here it is…
The definitive tax guide to renting your home out short-term
AirBnb has seen enormous growth in just the last few years. Literally millions of stays are now booked through this service that didn’t even exist until quite recently. A lot of people are finding this a great way to make extra cash from an unused bedroom, or even second home. Just recently, I had a client tell me he’s considering purchasing a second home in a desirable area that he could rent out through AirBnb and use occasionally as a vacation home when he has time to get away.
But right about now (February) a lot of AirBnb “hosts” (the people who offer space for rent) are getting tax statements from AirBnb that report to the IRS how much income they earned. For some this may be an unpleasant (and confusing!) surprise. AirBnb does provide some very basic and general tax advice at their site, but it only applies in some cases, and can be misleading if you’re not one of those cases.
So let’s start with the basics…first of all, yes, you do have to report any income you receive from renting out a room — with one notable exception. If you try out one of these services, rent out a room in your home a few times, and decide it’s more trouble than it’s worth, then you may not have to report this income at all! Thanks to special provision in the tax code*, if you rent out a room in your home for less than 15 days during the tax year, you don’t report any income from the activity. (Although you also can’t take any deductions from the activity…but that just kinda makes sense.) This exception, and the “vacation home” rules that I discuss next, are all in IRS Publication 527.
OK, but let’s say you rent it out for 15 days or more, so now there’s no getting around the fact you’ve got to report this income. Do you have to pay tax on the full amount you’ve received, or is there a way to reduce the total? The good news is you can usually reduce the taxable income from this activity. First of all, any expenses directly related to the activity are generally deductible…so costs to list a property, to repair damage done by a guest (unless reimbursed by insurance), or to clean a space in between guests, for example, would all typically be deductible against the income.
[See Note 1 at the end about renting out property without a profit motive.]
But the big deduction typically comes from what you’re paying for the space that you’re renting out. You’re probably paying either rent or a mortgage & property taxes for the property that includes the space you’re renting out, plus a lot of other things like utilities and insurance that are a requirement of maintaining the space in livable condition. You probably can’t deduct that entire total, but you can generally deduct a portion of the total.
[See Note 2 at the end about renting out property that you in turn rent from somebody else.]
The portion you can deduct is generally determined by dividing the square footage of the rented room — or whatever designated space you’re renting out — by the total square footage of the home. (This can be tricky if you’re just renting a couch…the deductible portion could be quite small!) So if you’re renting out a 150 square foot bedroom in a 1500 square foot house, you’d be able to deduct 10% of the costs incurred in owning/renting and maintaining the property. So if you pay $20,000/yr in rent, and another $2,000/yr in utilities, you’d be able to deduct up to $2,200 (10% of $22,000). Of course, if you’re renting out the entire home, then all the costs are potentially deductible. But this potential amount is based on using a space only to rent out to others at fair market rates.
However, if you’re renting out a space that’s not used only as a rental (i.e. you sometimes allow personal guests to stay there free of charge, or use it for other personal uses that preclude paying customers from staying there), then there’s a second ratio you have to apply. That ratio is the number of days the space is rented out divided by the total number of days the space is used for any purpose. So if there’s 183 days during the year that the room is used only for rental purposes and on the other 183 days (leap year to make the math easy…) the room is used as your kids’ play room, then 50% of the expenses allocated to that room are deductible. So following the example of the previous paragraph, now we’re down to $1,100 that’s deductible for the use of that room. Or in the second home example, if you rent out the entire home, then $11,000 would be deductible if you use it yourself exactly half the year.
But what if you don’t use that space for anything when guests aren’t staying in it? Do those still count as personal days and reduce your rental expenses. Actually, no…but there’s good news and bad news here. Having fewer personal days allows you to allocate more of your expenses as deductions against the rental income. However, if your personal use gets too low, the treatment of the property for tax purposes may actually change significantly.
Up until now, I’ve been discussing the situation where you rent out space in your home for at least 15 days, but you also use that same space in your home for personal use for at least 15 days or (if larger) 10% of the number of days the space is rented a fair market rate during the year. This situation is known as having a “vacation home”…it applies when you use a house (or condo, apartment, RV, etc…basically anything you can live out of) for personal use** at least 15 days (or 10% of the number of days rented, if that number is larger) but you also rent the unit out at least 15 days. A “vacation home” gets reported as a rental activity on Schedule E, with the important note that unlike a typical rental real estate activity you’re not allowed to apply up to $25,000 of net losses to reduce other income.
However, if you don’t personally use the rental space enough days (or if there’s no personal use at all), this is no longer considered a “vacation home”.*** This is where things can get strange. Because this property is no longer considered a “vacation home”, a new set of rules relating to whether this is a “passive activity” or an activity with “material participation” come into play. These rules are very complex and best handled by a qualified professional. But I’ll give you two rules of thumb:
1) If you (and your spouse, if married) perform substantially all of the management and work related to booking guests, greeting guests, being available during their stay, cleaning up between stays, etc., then you are probably “materially participating” in a business…a hotel business, basically. (Hiring the occasional contractor for specialized work like plumbing, electrical work, etc. will generally not prevent you from being a “material participant”.) We’ll get to the significance of this in a moment.
2) If you hire a manager and somebody else handles most of the details of overseeing the rental (as with my client who would rent the second home on AirBnb and have a property manager handle the details), then you are most likely not a “material participant”. And you now own a “passive activity”, which happens to be a hotel.
As you may have noticed, if you don’t have enough personal use of the rental space for it to qualify as a “vacation home”, then congratulations! You own a hotel (for all practical tax purposes, anyway). Well, at least assuming the average rental period is 7 days or less****…which is generally the case with AirBnb and similar sites. And if you’re the one running the show (i.e. you’re “materially participating”), then you’re conducting a business that’s subject to self-employment tax.
Under the “vacation home” rules, you still had a rental that’s reported on Schedule E and not subject to self-employment tax. However, once your personal use drops low enough, you may no longer meet the vacation home exception and, if you materially participate, you’re now treated as operating a business that’s reported on Schedule C and subject to the self-employment tax. This isn’t necessarily a bad thing…the fact that this is now considered “earned income” instead of passive income may help you qualify for certain credits. Plus by not having any personal use, you don’t have to reduce the expenses related to the rental space using the ratio of rental to overall use. But usually people try to avoid the self-employment tax, because it’s typically a ~15% tax on top of your regular income tax you would pay on the net rental income.
So…if you want to avoid the self-employment tax, then be sure to get plenty of personal use of your rental space…at least 15 days. However, be aware that the personal use cuts down on the amount of expenses that can be allocated to the rental space. And really, first and foremost, be sure to get professional assistance from somebody who’s very familiar with rental activities, vacation home rules, and passive activity rules. These are complex areas and, depending on your specific situation, there may be very good reasons that you would want to treat an activity as one type of activity or another.
And one last tip…everything discussed here relates only to payments you receive specifically for renting a place to stay. If you offer your guests additional services like airport pickup, tours of the area, or anything else that’s in addition to what they’re paying for the place to stay, then that is a separate activity…and almost certainly self-employment.
Good luck! And if you’ve got a great space to rent, and you need to build up some personal use days to avoid self-employment tax, you may want to consider offering it to me free of charge!
[NOTE 1: If you are renting out space without a profit motive, then you pretty much just report the income with no deductions...but really, unless you're charging WAY below the going rate just because you want to meet cool travelers, chances are you wouldn't be inviting strangers to stay in your home for money unless you hoped to profit from doing so. Right?]
[NOTE 2: It is entirely possible to rent out a room that you do not own...it's called sub-letting. (Of course, the property owner might prohibit this in the lease. But that's another issue entirely, so throughout this article I assume the lease you have permits this activity.) It can be a little confusing because Schedule E, and most tax software, refer to the "owner" in some instances. But as the primary leaseholder, you are in essence the "owner" of a contract that grants you the right to use a property. If you in turn rent that right out to somebody else, then you're renting out property just as if you held title on the property.]
* IRC 280A(g) specifically
** ”Personal use” includes allowing friends and family to stay in it for free or below-market rent.
*** For the tax geeks, we’ve now left the world of IRC 280A(c)(5) and — under IRC 469(j)(10) — we have to take into account all the passive activity rules of IRC 469…let the fun begin. Interestingly, one of the rules of IRC 469 (as clarified in Treasury Regulation 1.469-1T), is that when property is rented for an average period of 7 days or less, then it’s no longer considered a “rental activity”. As best I can tell, this is the reason that “vacation home” activities (which are considered rental activities under IRC 280A) are never subject to self-employment tax regardless of how short the average rental period is, while renting out property that is not used for personal purposes (and therefore governed by IRC 469) IS subject to self-employment tax when the average rental period is 7 days or less. IRC 1402 (self-employment tax) states that rental activity isn’t subject to self-employment tax, so the difference in definitions between 280A and 469 results in self-employment tax being assessed in one situation, but (with as a little as one day more of personal use) no self-employment tax being assessed in an almost identical situation.
**** Treasury Regulation 1.469-1T(e)(3)