Coming to you from the procedural trenches of the tax compliance industry, today's post is about the sharing economy - tax war stories.
Most recently I had the privilege of leading a group discussion about the tax implications of this ubiquitous 'Sharing Economy' business model we are all currently experiencing with 60 or so members of the National Association of Tax Professionals.
I love my tax nerd friends and our discussion was a real barn burner! After addressing many questions and getting a fair amount of valuable input it is safe to write that we came to 5 general conclusions:
- Much like quantum entanglement, what the sharing economy 'is' originates predominately from the observer's perspective at this point. It can be one thing to you and another to me.
- Much like the grEAt wild west, this relatively untamed voyage involves the collection, organization and digital storage of what was once deemed private information... by LARGE corporations.
- This collection and analysis of our private data causes each of us to be systematically 'profiled' which can be both good and evil.
- Our individually compiled profiles in the hands of the wrong people or governments (think Enron or Nixon or Clinton) is a scary proposition, particularly in light of our history.
- Big Brother and lemming references aside, the procedural mechanics required to maintain regulatory compliance has many overt challenges for the average taxpayer and tax professional alike.
Airbnb v. UBER v. Everything Else
We spent the majority of the time discussing Airbnb and Uber but there are a wide variety of people participating in a multitude of different ways that together make up this newly recognizable aspect of our world we referred to as the 'Sharing Economy.'
Regardless of the income's source the IRS requires US companies that process payments, including Airbnb and UBER, to report gross earnings for all US taxpayers earning over $20,000 OR having 200 or more transactions in the calendar year.
If you exceed either threshold you should expect to be issued IRS Form 1099-K.
Do I Report THAT Income - even if there is no 1099-K?
The biggest question we seem to get as tax professionals is whether to report the income even if there is no 1099-K issued.
The simple answer is US taxpayers are obligated to report ALL WORLD WIDE INCOME, even if there is no 3rd party information reporting obligation of that income. The question remains on what schedule to report those rents and expenses, which is addressed below.
The average Airbnb host makes $1867/month or $22,404/year. With that it was easy for many of us to speculate that the MODAL Airbnb host makes under $20,000 per year and has fewer than 200 rental days per year and is not necessarily issued IRS Form 1099-K.
How many Airbnb hosts do not receive IRS Form 1099-K at the end of the tax year?
How many Airbnb hosts simply do not report their income simply because they did not receive IRS Form 1099-K? This IS low hanging fruit, not only for the IRS but for state and local governments to boot.
What the Sharing Economy Is (to us - so far)
The main feature of the ubiquitous term 'sharing economy' is this interesting new lifestyle choice of access over ownership. Resist the urge to blame any one particular millennial, we raised them. It is our fault.
Rather than buying an asset, it seems more people are 'renting' that same asset for the experience of using it without the hassle of owning it. Makes sense as I sit here typing away in my ivory tower.
Why is this good?
Data collection technology allows owners of that organized data to be more efficiently in position to transact with us than ever before. An application or platform usually on our handheld device brings these sellers to us ready to facilitating a transaction with the push of a button.
Who's not for efficiency?
Based on the precept of collaborative consumption, the sharing economy essentially monetizes the 'concept of sharing' subsequently allowing ordinary people to make extra money doing 'gigs' as it were by essentially sharing their time or space or asset.
How can we be opposed to more money or opportunity?
Many economist posit that the 'Sharing Economy' also increases the supply of goods and services, making those same goods and services in theory more affordable and the world economy less prone to inflation.
"The interesting thing about economists is that generally speaking only a few get it right, and those few are usually pushing up daisies prior to being acknowledged."ME!
Access over ownership candidly is little more than a branded image that, like a pendulum, is sure to swing back at some point. The benefits of 'minimalism' can be many here and now, but - face it - the real winners, generation after generation, are the asset OWNERS.
Assets still matter
- There is no better cushion to endure hardship than ownership.
- The real problem is many of us have forgotten what 'enduring hardship' really means.
- The need for other forms of wealth in times of strife remain all the more significant.
- Our resilience as a 'minimalist' society to withstand environments of recession are questionable.
- We all can't live like Jack Kerouac #LuckyDrunk
For many of us, the cost of being systematically profiled combined with laughable at best regulatory oversight is scary. Scariness aside, there are a whole slew of interesting companies using data and developing platforms to join this new sharing economy.
What is REALLY interesting
The company providing the 'platform' is rarely the actual service provider. Sacrificing our personal information to the algorithms of big data manipulation can arguably be deemed 'good' but it can also be a PITA if you are engaged as a provider and out in the weeds from a tax compliance and reporting perspective.
Airbnb is a global company and a big part of what many believe makes the 'Sharing Economy' possible. Their platform allows individuals to make money by renting property, the tax implications of which many more so have learned the hard way can be complicated.
A good example of this is the vacation rental tax rules.
Vacation Rental Rules
- IRC §212(2) permits deduction for “the management, conservation, or maintenance of property held for the production of income.”
- IRC §262(a) prohibits deductions “for personal, living, or family expenses.”
- IRC §280A is essentially a hybrid basically asserting that 'vacation rentals' are NOT:
- subject to passive loss limitations
- deemed an active trade or business
- subject to self-employment tax under §1402(a) (1).
If this isn't complicated enough, vacation rental activity exceeding 14 days in the tax year is reported for income tax purposes (when there is an obligation to report) on EITHER Schedule E or Schedule C, depending on circumstances.
Schedule C vs. Schedule E - How is That Determined?
Vacation rental rules govern rental activity of a residential dwelling units which can be an apartment, condominium, mobile home, houseboat or any residence used by the tax payer for more than 14 days in the tax year or 10% of the days that the property is rented.
It is NOT a hotel, motel or inn.
What is a Dwelling Unit? The 14 Day Rule
A dwelling unit can be a residence if you use it for personal purposes more than 14 days in the tax year, or 10% of the days the unit is rented at a fair market rate, whichever is greater.
If you rent your dwelling unit for fewer than 15 days you are not required to report the rental income, but you also cannot deduct expenses attributable to the rental. Rental days don’t include days you OR your family use the dwelling unit for even part of a day.
If there is an income reporting obligation which form is used and why?
A vacation rental is properly reported on Schedule E, Supplemental Income and Loss - Part I, Income or Loss From Rental Real Estate and Royalties when substantial personal services are NOT included.
A vacation rental that also includes substantial personal services is reported on Schedule C, Profit or Loss from Business will generate SE tax, reported on Schedule SE.
What catches many people off guard?
- If you have a reporting obligation, vacation rental deductions are limited to gross rents received from the activity for the tax period.
- Expenses that exceed rents are carried forward to the next tax year, subject to the same limits even if you stop using the dwelling unit as a residence in that second year.
What are Substantial Personal Services?
This can be a whole other post but in general IRS Publication 527 references: regular cleaning, changing linen, or maid service. If you have those then report via Schedule C subject to Self Employment tax.
Substantial services however do NOT include air conditioning, lighting, cleaning of public areas, trash collection and the like. For more information, see IRS Publication 334, Tax Guide for Small Business.
When you use part of the property for personal use and part for profit you are obligated to apportion expenses.
Two Tax Court Decisions, Bolton and McKinney, presently differ from the IRS' methodology on how to apportion expenses spelled out in IRS Prop. Reg. §1.280A-3(c) & (d), 45 Fed. Reg. 52405 (August 7, 1980), and IRS Publication 527, Worksheet 5-1.
Generally speaking what I have found is that most preparation software will likely calculate apportionment of vacation rental expenses and carry forwards on Schedule E, but not Schedule C.
As a practical matter my team and I use the Schedule E worksheet for computing allocations and carry forwards, and then transferring those calculations to the Schedule C.
This one begins with a cardiac surgeon who prepared, signed and filed his own income tax forms using TurboTax ... I call this my #ArrogantDumbAssStory .
#ArrogantDumbAss 'Cardiac Surgeon' believed - probably due to a combination of hubris and poor vision - that vacation rental meant if he used the property for more than 14 days and did not rent it our for more than 14 days to any one person that ALL GROSS RENTS were not reported.
Adding to the confusion this doctor had 4 such properties that would each be used by him or his family for at least 14 days in tax year leading this poor schmuck into a heap of trouble times four.
When the file went to the Minnesota Department of Revenue audit, it took a fair amount of time to work through with this otherwise intelligent person the nuances of the vacation rental rules before he fully understood my audit response strategy of - STOP THE BLEEDING FIRST.
The problem was he thought - incorrectly so - that he could rent the property out multiple times in the tax year and as long as the rental period was under 14 days none of the gross rents were to be reported, presuming that the property was properly classified as a dwelling unit.
I had the distinguished pleasure of charging this pusillanimous reprobate a hefty PITA surcharge, in fact delineating it on the invoice as a PITA surcharge. Did Dr. DipShit learn his lesson, we'll see...
What about rental of property not subject to the vacation rental rules?
If you use Airbnb to rent out a property and don’t use the property personally as a residence, how the income and expenses from that property are reported depends on a more in-depth analysis of the rules governing rental activity. This is where the services of a tax professional are helpful.
7 Day & 30 Day Rule
Treasury Regulation §1.469-1T(e)(3)(ii), general rules (temporary), lays down two scenarios for distinguishing a rental reported on Schedule C from a conventional real estate rental reported on Schedule E. The first is duration (how many days the rental lasts). The second is whether significant personal services were provided.
If you rent property for 7 days or less you are deemed to be in the business of renting assets and that rental income goes on IRS Form 1040 Schedule C subject to Self Employment Tax. The rationale for the “seven-day rule” is that a customer’s use of property for seven days or less generally will require the person furnishing the property to provide services significant enough to justify the conclusion that the person is engaged in a service business rather than a rental activity.
This is NOT to be confused with the 'Vacation Rental' rules.
If you, on average, rent property more than 7 days but less than 30 days AND significant personal services are provided you are not engaged in a rental activity. So if you do not provide extra amenities during this period the income and expenses are reported on page 1 of IRS Form 1040 Schedule E, but if you do provide extra services the income and expenses are reported on IRS Form 1040 Schedule C.
Regardless of time frame, a rental is never a conventional real estate rental if significant personal services are provided.
Treasury Regulation §1.469-1 refers to the “average period of customer use” for the taxable year. The calculation adds all the days customers used the property during the year, and divides it by the number of “periods of customer use.” Defined as “each period during which a customer has a continuous or recurring right to use the property.”
The calculation isn’t affected by whether a renter actually used the property during the period of use, so long as the renter had the right to use it. And a continuous or recurring use may occur pursuant to a single agreement, or renewals thereof.
More important than determining average period of use, we need to also address whether significant personal services were provided as this is a distinguishing factor in determining a rental reported on Schedule C from a real estate rental reported on Schedule E.
So, what are “significant personal services”?
The regulation declines to specify, saying only that any definition should take “all of the relevant facts and circumstances into account.
Relevant facts and circumstances include the frequency with which such services are provided, the type and amount of labor required to perform such services, and the value of such services relative to the amount charged for the use of the property.”
IRS Publication 527, Residential Rental Property, is more specific, describing significant, or “substantial” services as those offered primarily for the renter’s convenience, like regular cleaning, changing linen, or maid service.
Substantial services do not include services similar to those customarily performed in high-end commercial or residential rental property, like cleaning and maintenance of common areas, routine repairs, trash collection, elevator service, and security at entrances or perimeters.
The regulation also lists the value of the services “relative to the amount charged for the use of the property” as a factor for evaluating whether the services are substantial.Value is measured by the cost to the taxpayer of employees performing such services.
The only threshold provided for figuring when value is too small to be significant is when maid and linen services provided to renters cost less than 10% of the amount charged for rent. On that basis, these services are not significant enough to remove a rental from the category of “real estate rental.”
If an entire structure is devoted to rental activity, deduction of expenses is straightforward. But if only part of the structure is devoted to rental activity, then expenses will have to be allocated. We’ve already discussed that process for vacation rentals.
But recall that any part of a property “used exclusively as a hotel, motel, inn, or similar establishment” is not a dwelling unit under the vacation rental rules.
So, a family who rents out one room in their home on Airbnb, for example, and never uses that room otherwise, does not apportion expenses under the vacation rental rules. Instead, the family divides expenses for the whole house, like the mortgage, real estate taxes, water, heat, exterior painting and landscaping, and so forth, between rental and personal use using “any reasonable method.”
Dividing based on the number of rooms, square footage of the home, or even the number of people (for water usage, for example), are all reasonable methods.
Expenses exclusively attributable to the rental, like wallpaper for the room or premiums for liability insurance necessitated by the rental, are not apportioned, since they have no personal use.
Short-term Rentals and the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act gives a taxpayer doing business as a pass-through entity a possible 20% deduction from taxable income. Pass-through entities include sole proprietors, partnerships, limited liability companies, and S corporations.
For 2019, the deduction is available to a taxpayer filing jointly with $321,400 or less of taxable income, and a single taxpayer with $160,700 or less of taxable income.
A taxpayer earning above those amounts is subject to various limitations, including a phaseout, and disqualification of a specified service trade or business (SSTB).
Whether and how a pass-through entity in the trade or business of real estate rentals qualifies for the 20% deduction is a facts and circumstances based test and must adhere to the trade or business thresholds of IRC 162 that essentially dictate the precepts of regular, consistent pursuit of profit motive.
IRC 6041 requires businesses to report payments of more than $600 to individuals. To avoid backup withholding, which is now 24%, hosts should submit Form W-9, Request for Taxpayer Identification Number and Certification, to the companies collecting the rent.
- Sales Tax
- With the US Supreme Court ruling on the Wayfair Decision sales tax has become a real nightmare for many taxpayers.
- Wayfair established very clear definitions of nexus for sales tax purposes. Where the consume takes delivery of the item subject to sales tax is where the transaction is taxed.
- In Colorado alone with all their home rule cities this can present a nightmare scenario for people selling small items in Colorado hoe rule jurisdictions.
- For more about this contact me.
- Occupancy Taxes
- States and municipalities charge occupancy taxes in varying amounts. These taxes are sometimes referred to as lodging tax, room tax, sales tax, tourist tax, or hotel tax.
- The taxes are paid by guests, but hosts are typically under a duty to collect the taxes and remit them to the state or municipality. Some companies, including Airbnb, collect and submit the taxes on the host’s behalf in various jurisdictions.
- Since occupancy taxes are paid by the guest, and are not the host’s expense, they are not deductible from income, or reflected on the host’s tax return.
- Guest Fees.
- Airbnb and other companies usually charge their hosts a percentage fee, or “guest service” fee, for using their platform. Airbnb advertises the fee as 5–15% of the price for the room. Since this fee is paid by the host, it’s deductible as a business expense, and reported on the host’s tax return.
- Value Added Tax (VAT).
- Value Added Tax is a consumption tax assessed on goods and services as they travel through the supply chain. The U.S. doesn’t have a VAT, but many Asian and European countries do. For example, when a miller sells flour to a baker, the baker will pay a VAT.
- When the baker bakes the bread and sells the loaf to the supermarket, the supermarket will pay a VAT. When the consumer purchases the bread from the supermarket, the consumer will also pay a VAT. A host pays VAT on purchases for business, and will also pay VAT on room rentals. Since VAT is not payable on U.S. source income, hosts liable for VAT should consult an overseas advisor.
Rules for engaging in the 'Sharing Economy' these days go far beyond the vacation rental rules. Experiences come in all shapes, sizes and duration, and tax reporting varies accordingly. I hope the discussion in this article makes reporting a little easier. Please feel welcome to contact me if you'd like to talk more about this fascinating new industry.