Taxes in Your Practice: IRS Chief Counsel advice finds substantial services subject rental income to self-employment tax
Scott E. Vincent
Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.
Vol. 78, No. 1 / Jan. - Feb. 2022
The Internal Revenue Service recently issued Letter Ruling 202151005 providing IRS Chief Counsel Advice on the application of self-employment tax to certain rental income. The chief counsel first finds that whether an activity is a “rental activity” under Internal Revenue Code § 469 does not determine whether the activity is “rentals from real estate” excluded from net earnings from self-employment under Code §1402 for self-employment tax purposes. In situations that do not involve real estate dealers, the chief counsel further finds that if sufficiently substantial services are provided to occupants, the net rental income may be subject to self-employment tax. The taxpayer requested advice on two general fact patterns that highlight the circumstances when self-employment tax may apply to net rental income.
Fact situation 1
An individual taxpayer directly owns and rents, in a trade or business, a fully furnished vacation property via an online rental marketplace. The taxpayer is not a real estate dealer and does materially participate, so the activity is not a passive activity. The taxpayer provides linens, kitchen utensils, and all other items to make the vacation property fully habitable for each occupant. The taxpayer also provides daily maid services, including delivery of individual-use toiletries and other sundries; access to dedicated Wi-Fi service for the rental property; access to beach and other recreational equipment for occupant use; and prepaid vouchers for ride-share services between the rental property and the nearest business district.
Fact situation 2
An individual taxpayer directly owns and rents, in a trade or business, a fully furnished room and bathroom in a dwelling via an online rental marketplace. The taxpayer is not a real estate dealer and does materially participate, so the activity is not a passive activity. Occupants only have access to common areas of the home to enter and exit the room and bathroom and have no access to other common areas such as the kitchen and laundry room. The taxpayer cleans the room and bathroom in between each occupant’s stay.
The Chief Counsel Advice outlines several relevant Internal Revenue Code, treasury regulations, IRS rulings, and court cases, including the following:
Code § 469(c) provides that a passive activity is generally any trade or business activity in which the taxpayer does not materially participate or any rental activity. Regulations under § 469 provide that an activity involving the use of tangible property is not a rental activity for the taxable year if the average period of customer use for the property is seven days or less. Under § 469(h), a taxpayer materially participates in a trade or business activity only if “the taxpayer is involved in the operations of the activity” on a regular, continuous, and substantial basis. In the case of individuals, the regulations provide seven tests for material participation. Regulations § 1.469-5T(a)(1) provides that an individual will generally be treated as materially participating in an activity for a taxable year if the individual participates in the activity for more than 500 hours during such year.
Regulations § 1.469-1T(d)(1) provides that the characterization of items of income or deduction as passive does not affect the treatment of such items under provisions of the code other than § 469. Therefore, whether amounts are passive activity income or loss under the § 469 regulations is not determinative of whether those amounts are rentals from real estate under § 1402(a)(1) and related regulations.
Section 1401 imposes tax on the self-employment income of individuals. Section 1402(b) defines self-employment income as net earnings from self-employment, with certain modifications. Section 1402(a) provides that the term “net earnings from self-employment” (NESE) means gross income derived from any trade or business less the deductions that are attributable to such trade or business. However, under § 1402(a)(1), rental income from real estate reduced by proper deductions attributable to that rental income (net rental income) is excluded from NESE, unless received in the course of a trade or business as a real estate dealer.
Regulations § 1.1402(a)-4(c)(1) provides that rentals from living quarters, where no services are rendered for the occupants, are generally considered rentals from real estate under § 1402(a)(1), except in the case of real estate dealers. However, regulations § 1.1402(a)-4(c)(2) provides:
“Payments for the use or occupancy of rooms or other space where services are also rendered to the occupant . . . are included in determining net earnings from self-employment. Generally, 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.”
Regulations § 1.1402(a)-4(c)(2) lists examples of situations where services are rendered for the convenience of occupants, such as hotels, boarding homes, warehouses, and storage garages.
In revenue ruling 57-108 (1957-1 C.B. 273), the IRS ruled that a landlord who rented furnished vacation beach dwellings and rendered services “for the comfort and convenience of his guests in connection with their recreational activities” – including maid services, swimming and fishing instruction, mail delivery, furnishing of bus schedules, and information about local churches – rendered these services primarily for the occupants’ convenience. Consequently, the net rental income from the vacation beach dwellings was included in the landlord’s NESE because the § 1402(a)(1) exclusion did not apply.
In Bobo v. Commissioner of Internal Revenue, the tax court considered a mobile home park that provided leased trailer park units with utility hookups, sewage facilities, and laundry facilities.2 The court held that the net rental income from the rental of the trailer park units was excluded from the owners’ NESE under § 1402(a)(1), setting the standard for when services are considered not rendered for the occupant. The court noted Section 1402(a)(1): “should be applied to exclude only payments for use of space, and, by implication, such services as are required to maintain the space in condition for occupancy. If the owner performs additional services of such substantial nature that compensation for them can be said to constitute a material part of the payment made by the tenant, the ‘rent’ received then consists in part of income attributable to the performance of labor which is not incidental to the realization of return from passive investment.”3
Ultimately, the Bobo court determined that even though the trailer park furnished laundry services that were “clearly rendered for the convenience of the tenant and not to maintain the property in condition for occupancy,” the tenants’ payments for the laundry services were not “substantial enough to classify all the tenants’ (rental) payments as received for ‘services to the occupants.’”4 Accordingly, the court held the payments at issue were rental from real estate excluded from NESE.
Chief counsel analysis – fact situation 1
In Letter Ruling 202151005, the chief counsel concluded the net rental income in fact situation 1 is not excluded from NESE under code §1402(a)(1). The chief counsel finds that determining whether services are rendered for an occupant is based on the facts and circumstances in each case. In this fact situation, the chief counsel finds that the services are for the convenience of the occupants, are beyond what is clearly required to maintain the space for occupancy, and are “of such a substantial nature that the compensation for these services can be said to constitute a material portion of the rent.” Based on these fact findings, the chief counsel determines that the net rental income is included in NESE. The chief counsel also concludes that characterization of the activity as “not a passive activity” under code § 469(c) does not affect whether it is excluded from NESE code § 1402(a)(1).
Chief counsel analysis – fact situation 2
In contrast, the Chief Counsel Advice concludes that the net rental income in fact situation 2 is excluded from NESE under code §1402(a)(1). In this fact situation, the services provided to clean and maintain the property so it is suitable for occupancy were described as “not furnished primarily for the convenience of the property’s occupants” and described as not so substantial to constitute a material part of the payments made by the occupants. Based on these facts, the chief counsel determines that the net rental income is excluded from NESE. It is again noted that this NESE determination is not impacted by characterization of the activity as “not a passive activity.”
The Chief Counsel Advice highlights a potentially unexpected tax on net rental income for certain taxpayers renting property via online rental marketplaces. When substantial services are provided with a rental, the taxpayer will need to consider the fact situations in this guidance and determine whether the net rental income from the activity may be subject to self-employment tax. Presumably, the IRS will pursue this issue, and failure to pay self-employment tax consistent with this advice could be an IRS audit flag. It’s unknown whether taxpayers will further pursue this issue in litigation to challenge the IRS chief counsel position.
1 Scott E. Vincent is the founding member of Vincent Law, LLC, in Kansas City.
2 70 T.C. 706 (1978).
3 Id at 709.
4 Id at 711.