Providing Substantial Services Turns Rental Income into Self-Employment Income

(Parker Tax Publishing January 2022)

The Office of Chief Counsel advised that the characterization of an activity as a rental activity under the Code Sec. 469(c)(2) passive activity rules does not determine whether the activity constitutes "rentals from real estate" such that the income therefrom is excluded from net earnings from self-employment (NESE) under Code Sec. 1402(a)(1). The Chief Counsel's Office also advised that, in situations not involving a real estate dealer, net rental income from the rental of living quarters is considered "rentals from real estate" excludible from NESE when no services are rendered for the occupants; but if services are rendered, whether the rental income is excluded from NESE depends on the type of services rendered and whether or not those services are so substantial that they constitute a material portion of the rental income. CCM 202151005.

Background

Code Sec. 469 generally disallows deductions for passive activity losses. Under Code Sec. 469(c), a passive activity is usually (1) any trade or business activity in which the taxpayer does not materially participate, or (2) any rental activity. Under Reg. Sec. 1.469-1T(e)(3)(ii)(A), an activity involving the use of tangible property is not a rental activity for a tax year if, for the tax year, the average period of customer use for the property is seven days or less. Code Sec. 469(h) states that 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, Reg. Sec. 1.469-5T provides seven tests for material participation. In particular, Reg. Sec. 1.469-5T(a)(1) provides that an individual is generally treated as materially participating in an activity for a tax year if the individual participates in the activity for more than 500 hours during such year. Reg. Sec. 1.469-1T(d)(1) provides that the characterization of items of income or deduction as passive activity gross income or passive activity deductions does not affect the treatment of items of income or deduction under provisions of the Code other than Code Sec. 469.

Code Sec. 1401 imposes tax on the self-employment income of individuals and Code Sec. 1402(b) defines self-employment income by reference to net earnings from self-employment, with certain modifications. Code Sec. 1402(a) provides that the term "net earnings from self-employment" (NESE) means the gross income derived by individuals from any trade or business they carry on, less the deductions that are attributable to such trade or business. However, under Code Sec. 1402(a)(1), rentals from real estate, together with deductions properly deductible and attributable to the rentals from real estate (i.e., net rental income), are excluded from NESE, unless these amounts are received in the course of a trade or business as a real estate dealer.

Reg. Sec. 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 Code Sec. 1402(a)(1), except in the case of real estate dealers. However, under Reg. Sec. 1.1402(a)-4(c)(2), payments for the use or occupancy of rooms or other space where services are also rendered to the occupant are included in determining NESE. Generally, services are considered rendered to the occupant if they are primarily for his or her convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only.

Income and Self-Employment Tax Consequences of Renting Property

In CCM 202151005, the Office of Chief Counsel was asked for its opinion on the income and self-employment tax consequences of two scenarios involving rental property.

In Scenario 1, an individual taxpayer who directly and solely owns and rents, in the course of a trade or business, a fully furnished vacation property via an online rental marketplace. The taxpayer is not a real estate dealer within the meaning of Reg. Sec. 1.1402(a)-4(a). The taxpayer provides linens, kitchen utensils, and all other items to make the vacation property fully habitable for each occupant. In addition, the taxpayer 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. For the year at issue, the average period of customer use of the vacation property is seven days, and therefore the activity is not considered a rental activity for purposes of Code Sec. 469 pursuant to Reg. Sec. 1.469-1T(e)(3)(ii)(A). In addition, the taxpayer materially participates in the activity within the meaning of Code Sec. 469(h)(1) and Reg. Sec. 1.469-5T and, therefore, the activity is not a passive activity within the meaning of Code Sec. 469(c).

In Scenario 2, an individual taxpayer who directly and solely owns and rents, in the course of her 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. Occupants only have access to the 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. For the year at issue, the average period of customer use of the vacation property is seven days, and therefore the activity is not considered a rental activity for purposes of Code Sec. 469 pursuant to Reg. Sec. 1.469-1T(e)(3)(ii)(A). In addition, the taxpayer materially participates in the activity within the meaning of Code Sec. 469(h)(1) and Reg. Sec. 1.469-5T, and, therefore, the activity is not a passive activity within the meaning of Code Sec. 469(c).

The Office of Chief Counsel was asked (1) whether the characterization of an activity as a "rental activity" under Code Sec. 469(c)(2) determines whether the activity is "rentals from real estate" excluded from net NESE under Code Sec. 1402(a)(1) for self-employment tax purposes; and (2) when, in situations not involving a real estate dealer, rentals of living quarters are considered "rentals from real estate" excluded from NESE under Code Sec. 1402(a)(1).

Analysis

The Office of Chief Counsel advised that the net rental income in Scenario 1 is not excluded from NESE under Code Sec. 1402(a)(1) because the taxpayer is providing substantial services beyond those required to maintain the space in a condition suitable for occupancy. The Chief Counsel's Office cited the Tax Court's decision in Bobo v. Comm'r, 70 T.C. 706 (1978), which involved a mobile home park that provided leased trailer park units with utility hookups, sewage facilities, and laundry facilities. The Tax Court held that the net rental income from the rental of the trailer park units was excluded from the owners' NESE under Code Sec. 1402(a)(1). The Tax Court relied on the Ninth Circuit's decision in Delno v. Celebrezze, 347 F.2d 159 (9th Cir. 1965), in setting the standard for when services are considered not rendered for the occupant. In that decision, the Ninth Circuit determined that Code Sec. 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 Ninth Circuit said, the "rent" received consists in part of income attributable to the performance of labor which is not incidental to the realization of a return from a taxpayer's passive investment.

With respect to Scenario 2, the Chief Counsel's Office concluded that the net rental income was excludible from NESE under Code Sec. 1402(a)(1) because the taxpayer is not providing substantial services beyond those required to maintain the space in a condition suitable for occupancy. Services the taxpayer provides to clean and maintain the property to bring it to a suitable condition for occupancy, the Chief Counsel's Office said, are not relevant in applying Reg. Sec. 1.1402(a)-4(c)(2) because such services are not furnished primarily for the convenience of the property's occupants. According to the Chief Counsel's Office, in order to be includible in NESE, the services provided for the convenience of the occupants must be of such a substantial nature that compensation for them can be said to constitute a material part of the payments made by the occupants. The Chief Counsel's Office found that no such services are being provided in Scenario 2 and the characterization of this activity as not a passive activity within the meaning of Code Sec. 469(c) does not affect whether the activity is excluded from NESE under Code Sec. 1402(a)(1).

For a discussion of the tax treatment of rental real estate and the passive activity loss rules of Code Sec. 469(c)(2), see Parker Tax ¶247,120. For a discussion of items excluded from net earnings from self-employment, see Parker Tax ¶13,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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