Renting Real Estate And Self-Employment Tax

 

I was looking at a tax return recently. There was an issue there that I did not immediately recognize.

Let’s go over it.

The client is a new venue for cocktail parties, formal dinners, corporate meetings, bridal showers, wedding rehearsals and receptions, and other such occasions.

The client will configure the space as you wish, but you will have to use a preselected list of caterers should you want food. There is a bar, but you will have to provide your own bartender. You can decorate, but there are strict rules on affixing decorations to walls, fixtures, and such. Nonroutine decorations must be approved in advance. You will have to bring your own sound system should you want music, as no system exists. The client will clean the space at the end of the event, but you must first remove all personal items from the property.

Somewhat specialized and not a business I would pursue, but I gave it no further thought.

The question came up: is this ordinary business income or rental income?

Another way to phrase the question is whether the income would or would not be subject to self-employment tax.

Let’s say you have a duplex. One would be hard pressed to think of a reasonable scenario where you would be paying self-employment tax, as rental income from real estate is generally excepted from self-employment income.

Let’s change the facts. You own a Hyatt Hotel. Yes, it is real estate. Yes, there is rental income. This income, however, will be subject to self-employment tax.

What is the difference? Well, the scale of the activity is one, obviously. Another is the provision of additional services. You may bring in a repairman if there were a problem at the duplex, but you are not going into the unit to wash dishes, vacuum carpets, change bed linens or provide fresh towels. There is a limit. On the other hand, who knows what concierge services at a high-end hotel might be able to provide or arrange.

We are on a spectrum, it appears. It would help to have some clarification on which services are innocuous and which are taunting the bull.

IRS Chief Counsel Advice 202151005 addressed the spectrum in the context of residential rental property.

First a warning. A CCA provides insight into IRS thinking on a topic, but that thinking is not considered precedent, nor does it constitute substantial authority in case of litigation. That is fine for us, as we have no intention of litigating anything or having a tax doctrine named after us.

Here is scenario one from the CCA:

·       You are not a real estate dealer.

·       You rent beachfront property via online marketplaces (think Airbnb).

·       You provide kitchen items, Wi-Fi, recreational equipment, prepaid ride-share vouchers to the business district and daily maid service.

Here is scenario two:

·       You are not a real estate dealer.

·       You rent out a bedroom and bathroom in your home via online marketplaces.

·       A renter has access to common areas only to enter and exit.

·       You clean the bedroom and bathroom after each renter’s stay.

I am not overwhelmed by either scenario. Scenario one offers a little more than scenario two, but neither is a stay at the Hotel Jerome.

Here is the CCA walkthrough:

·       Tax law considers rental income collected by a non-dealer to be non-self- employment income.

·       However, the law says nothing about providing services.

·       Allowable services include:

o   Those clearly required to maintain the property in condition for occupancy, and

o   Are a sufficiently insubstantial portion of the rent.

·       Nonallowable services include:

o   Those not clearly required to maintain the property in condition for occupancy, and

o   Are so substantial as to comprise a material portion of the rent.

The CCA considered scenario two to be fine.

COMMENT: I would think so. The services are minimal unless you consider ingress and egress to be substantial services.

The CCA considered scenario one not to be fine.

Why not?

·       The services are for the convenience of the occupants.

·       The services are beyond those necessary to maintain the space for occupancy.

·       The services are sufficient to constitute a material portion of the rent.       

I get the big picture: the closer you get to hotel accommodations the more likely you are to be subject to self-employment tax. I am instead having trouble with the smaller picture – the details a tax practitioner is looking for – and which signal one’s location on the spectrum.

·       Is the IRS saying that services beyond the mere availability of a bed and bathroom are the path to the dark side?

·       IRS Regulations refer to services customarily provided.

o   How is one to test customarily: with reference to nearby full-service hotels or only with other nearby online rentals?

o   In truth, did the IRS look at any nearby services in scenario one?

·       What does material portion mean?

o   Would the provision of services at a lower rent situs (say Athens, Georgia) result in a different answer from the provision of comparable services at a higher rent situs (say Aspen, Colorado)?

o   What about a different time of year? Can one provide more services during a peak rental period (say the NCAA Tournament) and not run afoul of the material portion requirement??

One wonders how much this CCA has reinforced online rental policies such as running-the-dishwasher and take-out-the-trash-when-you-leave. There is no question that I would advise an Airbnb client not to provide daily services, whatever they may be.

I also suspect why our client set up their venue the way they did.

Reporting Income Below A 1099 Filing Requirement

 

I am looking at a case that reminded me of a very recent telephone call with a client.

Let’s talk about the client first.

It is tax season here at Galactic Command as I type this. The client sent me the paperwork for the joint return.  She included a note that she had withdrawn from her 401(k) but had not received a 1099.

“Do I have to report it, then?” she asked.

This is a teaching moment: “yes.” The answer is “yes.”

One is required to report his/her income fully and accurately, irrespective of whether one receives a 1099 or other information reporting. I, as a tax CPA, might not even be able to sign as preparer, depending upon the size and consequence of the numbers.

I had her contact the investment company and request a duplicate tax form. It was for the best, as the company had withheld taxes on the distribution.

Let’s look next at the Legoski case.

During 2017 John Legoski (John) had a job and a side gig. His gig was buying stuff online and selling said stuff via drop shipments. He was paid via Amazon Payments. He in turn paid for stuff using PayPal. He received a 1099 from Amazon Payments for $29,501.

Which he did not report.

The IRS caught this, of course, because that is what computerized matching does. That notice does not even go past human eyes before the IRS mails it.

His argument: he thought that his gross receipts did not meet the minimum reporting threshold for third-party payments.

COMMENT: For 2017, a third-party settlement company was required to issue John a 1099-K if (1) gross payments to John exceeded $20,000 and (2) there were more than 200 transactions.

I presume that John had less than 200 transactions, as he certainly was paid more than $20 grand. But it doesn’t matter, as he is required to report all his income whether or not he received a 1099.

The IRS wanted taxes and penalties of $9,251 on the $29,501.

Seems steep, don’t you think?

That is because the IRS did not spot John any cost of goods sold.

Push back, John. Send the IRS your PayPal account activity. That is where you bought everything. It may not be classroom accounting, but it is something.

John … did not do this. He did not provide any documentation to the IRS, to the Court, to anybody.

John, John, … but why?

Bam! The Court disallowed him a cost of goods sold deduction.

Next were the penalties on the unreported income (which was not reduced for a cost of goods deduction).

The Court wanted John to show reasonable cause for filing his tax return the way he did.

John, listen to me: you are not an accountant. You are barely a novice gig worker. You didn’t know. This was undecipherable tax law to you. You botched, but you did not do so on purpose.

However, his failure to provide a PayPal activity statement where he paid for EVERYTHING HE BOUGHT FOR RESALE did not put the Court in a forgiving mood.

The Court decided he was responsible for penalties, too.

And I would bet five dollars and a box of Girl Scout Thin Mints that John made little to no money from his gig – heck, he probably lost money - but this escapade cost him over $9 grand.

Let me check. Yep, John appeared before the Court pro se. As we have discussed before, this does not necessarily mean that he showed up in Court without professional representation. From the way it turned out, though, I feel pretty confident that he winged it.

COMMENT: For 2022 the 1099 reporting for this situation has changed. The $20,000/200 transactions requirement is gone. The new law requires a 1099 for payments over $600. Yep, you read that right.

Our case this time was Legoski v Commissioner, T.C. Summary 2021-15.

IRS Does Not Want You To Call Next Week

So I am reading the following headline:

      IRS Asks Taxpayers to Resist Calling Next Week

I am wondering when our tax system became a Saturday Night Live skit.

The IRS does have a point. Next week includes Presidents Day and is usually one of the busiest weeks for the IRS phone lines.

The IRS wants people to instead to visit the website www.irs.gov and take advantage of the online tools there.

I try to be sympathetic – I truly do. However I cannot help reflect that we never see the following headlines:

Chick fil-A Asks Customers To Stay Away

Apple Has Nothing To Sell You

Honda Asks Potential Buyers Not To Visit Dealerships

Why the difference between the government and an actual-operating-accountable- produce-something-legitimate-or-we-go-out-of-business company?

If you even have to ask ….