Rental Property

[jsoles24]

My client purchased land in 2022. She intends to build tiny homes to offer for short term rentals on the land but has not yet started to build. She created an single member LLC for this business venture. 

I first completed a Schedule C for this business venture. But after doing further research on whether or not she provided "substantial services", which she will only provide in the future after each guests leaves the premises to prepare for the next guest, I moved all of the related expenses to a Schedule E. 

Is this correct? What are your thoughts?

[TaxGuyBill]

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@jsoles24 wrote:

My client purchased land in 2022. She intends to build tiny homes to offer for short term rentals on the land but has not yet started to build.

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With no services, it will end up Schedule E.  However, if it is not being rented yet, it doesn't go anywhere.  Any expenses would be capitalized.

[Just-Lisa-Now-]

cleaning between renters is not a substantial service, this will be Sch E, not C.  But youd only start using Sch E once shes got the rentals available for rent.

She may want to elect to capitalize the carrying costs of that land until its put in service, you'd want to include the 266 election with the return each year. 

[BobKamman]

Cleaning between renters is what many hotels and motels do now, and the IRS guidance is that those businesses go on Schedule C.  There is considerable fog, and little authority on where to draw the line between Schedule C and Schedule E.  One online source, without explaining why, says:

"Generally, you should report your Airbnb activity on Schedule C if the average rental period for the property is less than 7 days or if the average rental is less than 30 days, and you provide substantial services to the renter."

I see an increasing number of people who operate multiple Airbnb locations, often subleasing the property rather than owning it.  I don't have any Airbnb clients, but I think if I prepared a Schedule E for one I would have them sign an acknowledgment that they might be assessed SE tax if IRS does a project on that industry.  Also, that they're giving up substantial deductions for retirement accounts and QBI.  

[PATAX]

If those tiny homes are being built for midgets then your client will only receive half of the deductions.😉🤓 just joking.

[taxmo]

Even when using that 7 days exception to classify STR income as non-passive, it still can't go on Schedule C, it still goes on Schedule E.  The difference is that the tax loss isn't limited by the passive activity rules on form 8582.  Most professional tax software (including all the Intuit professional software products) have an option to specify that rental income is non-passive, and that will cause the Schedule E tax loss for that activity to bypass form 8582.  That's how you do it, not by putting it on Schedule C.   

Yes, there are many tax professionals, who think that STR income goes on Schedule C.  That is a very common misconception.  

The instructions for form 8582 have a well written explanation of it, so I would recommend reading the "Rental Activities" section of that for a clear explanation of that.

If you want a technical tax code-level explanation, when a rental activity has an average stay of 7 days or less and the taxpayer materially participates, then it is no longer defined as a rental activity under the passive activity loss rules in section 469 of the tax code.  But that only applies to section 469.   It is, however, still defined as a rental activity under IRC 1402 and 1.1402(a)-4, which excludes it from being subject to self-employment tax.  Self-employment tax is the defining differentiator in separating activities between IRS Schedule C and Schedule E, and that's why the instructions for those forms specify that rental activities without substantial services don't go on Schedule C.

There are only two situations when rental income can go on Schedule C.  One rare exception is for a real estate dealer (such as someone flipping houses) with some incidental rental income. The other is substantial services (such as daily cleanings *during* guest stays, which is not typical).  The treasury regs and tax court cases get into many specific examples, and it's well defined at this point what circumstances qualify for substantial services and which don't.  There can be some gray area in rare situations, but usually it's clear that 99% of STRs don't meet the substantial services test.  

I can also list tax court cases confirming this if you would like (I just don't have that list in my notes at the moment).  

You also mentioned rental arbitrage, which is somewhat more of a less well defined area (there are some tax court cases, but they have some additional factors that make it unclear if they can be widely applied), but usually the guidance on that is it should also go on Schedule E.

[BobKamman]

Decades-old Treasury Regulations and Tax Court cases have few examples, all from  pre-Airbnb days.  The law is extremely unsettled.