Vacation Home Rental—What’s Best for You: Schedule C or E?Tax Planning
Do you have a beach or mountain home that you rent out?
If so, you likely have a choice—either
- claim the income and expenses on Schedule C, or
- claim the income and expenses on Schedule E.
When Is Schedule C a Good Choice?
If you show a tax loss on your rental property, Schedule C is a great choice because it allows you to deduct your rental losses against all other income (assuming you materially participate in the rental property, as discussed later).
If you show taxable income on the rental property, Schedule C is not good because it causes you to pay self employment taxes.
When Is Schedule E a Good Choice?
If you show taxable income on the transient rental, Schedule E is best because you don’t pay any self-employment taxes on Schedule E income.
If you show a loss on your transient rental and you materially participate, you can deduct your losses against all other income, but those Schedule E losses do not reduce self-employment income.
Okay, now you know how to play the game.
IRS Reg. Section 1402(a)-4(c)(2) states:
Services rendered for occupants. Payments for the use or occupancy of rooms or other space where 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 camps or tourist homes, or payments for the use or occupancy of space in parking lots, warehouses, or storage garages, do not constitute rentals from real estate; consequently, such payments 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.
The supplying of maid service, for example, constitutes such service; whereas the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, the collection of trash, and so forth, are not considered as services rendered to the occupant.
IRS in Summary Mode
In recent advice, the IRS stated that rentals of living quarters are not subject to self-employment tax when no services are rendered for the occupants.
But if services are rendered for the occupants, and the services rendered
- are not clearly required to maintain the space in a condition 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,
then the net rental income received is subject to the self-employment tax.
John owns and rents a fully furnished vacation property via an online rental marketplace.
John provides linens, kitchen utensils, and all other items to make the vacation property fully habitable.
John 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 use during the stay; and prepaid vouchers for ride-share services between the rental property and the nearest business district.
During the year, the average period of customer use of the vacation property is seven days, which means it is not a rental property for purposes of the passive loss rules.
John also materially participates in the property, which means it is an activity not subject to the passive loss rules.
Per the IRS, John’s facts are such that his rental activity is subject to the self-employment tax.
John’s rental activity is commercial because he is renting to transients. This means he must use 39-year depreciation as explained in Depreciating Residential Rental and Commercial Real Property: Avoid Surprises.
The good news is, John gets the breaks you find in Big Tax Break: Qualified Improvement Property. The big break is immediate deductions for qualified improvements.
The definition of services that trigger the self-employment tax is different from the definition of services that allow properties to escape “real estate professional” status (as defined by the tax law) under the passive loss rules.
For more on services rules, see Secrets to Pocketing Cash by Renting a Bedroom in Your Home.
If your rentals produce tax losses, you want to deduct those losses on Schedule C, where they reduce your income from all sources. The trick to getting the losses on Schedule C is to rent to transients, materially participate, and provide services.
If your rental shows income, the last place you want to report that rental is on Schedule C, where it triggers the self employment tax. You can avoid the Schedule C classification by limiting the services you provide.