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When is a rental not a rental?

All over the country, business owners rent property they own personally to their businesses. In addition, many thousands of other persons own condominiums and other dwellings which they rent to families on vacation or own as investments. All must beware, however, since certain "rental" activities are not exempt from self-employment taxation. Careful planning is required in order to avoid the potential for coming under the self-employment tax umbrella.

The key to deciding when a "rental" activity is subject to self-employment tax lies in Sec. 1402. Under Sec. 1402(a), net earnings from self-employment means "the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business." Sec. 1402(a)(1) specifically excludes from the definition of net earnings from self-employment "rentals from real estate and from personal prop with the real estate." Under Sec. 1402(c), the definition of trade or business is the same as that found in Sec. 162 (with certain exceptions). Sec. 162 requires that a trade or business involve a regular, continuous and substantial investment of time and resources on the owner's part. While on its face Sec. 1402 appears to contain a blanket exclusion of real estate rentals from the definition of net earnings from self-employment, further reading of the regulations yields a different answer. Regs. Sec. 1.1402(a)-4(c)(2), under the caption "Rentals from living quarters," provides:

Payments for the use or occupancy of room 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.... 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.

Thus, rentals must be analyzed closely to determine whether the owner's involvement is of such significance that it rises to the level of "regular, continuous and substantial" and would thus be characterized as a trade or business. Revenue rulings and court cases have provided some guidance. One of the most recent cases is Stevenson, TC Memo 1989-357, in which the taxpayer owned and rented portable signs, as well as "buying, assembling, storing, renting, selling, repairing and maintaining" them. He argued that the language of Sec. 1402 with respect to rentals should be broadly construed and was intended to exclude more than just real estate rentals from the definition of net earnings from self-employment. The court rejected this argument, relying on the lower court decision in Delno v. Celebrezze, 347 F2d 159 (9th Cir. 1965). In addition, the court went into an intensive analysis of the activities undertaken by Stevenson in furtherance of his business, and concluded that his involvement was sufficient to characterize this activity as a trade or business.

In Rev. Rul. 57-108, the IRS was asked to determine if rentals of furnished beach houses were subject to self-employment tax. A taxpayer owned several beach houses, which he rented to vacationers. The taxpayer cleaned the houses after each occupant and offered maid service to the occupants. In addition, he offered services to renters, including "instruction in swimming, boating and fishing, conducting fishing parties, delivering messages and mail, furnishing bus schedules and church information and any other services deemed necessary for the convenience and comfort of the guests." The Service concluded "that the various services rendered to the guests in the instant case, when considered in the aggregate, constitute services which are primarily for the convenience of the guests and are other than those usually or customarily rendered in connection with the rental of rooms .... Accordingly, it is held that the rental income received by the individual under the circumstances does not constitute excluded rentals from real estate and such rental income should be included in computing net earnings from self-employment."

Both Stevenson and Rev. Rul. 57-108 highlight the need for a rental to be a trade or business in order to be considered net earnings from self-employment. Thus, a triple net lease of property under which the lessee is responsible for all costs of operation would not be net earnings from self-employment. Similarly, rentals of living quarters with no services provided to the tenants would also not be included. Persons who rent property to related parties must be especially careful since the IRS scrutinizes such arrangements in detail.

While most taxpayers would view the avoidance of self-employment income tax as an advantage, there could be benefits to classifying rentals as net earnings from self-employment. Such income could be used to support a qualified plan or simplified employee pension plan. In addition, such income can be offset by self-employment losses from other activities. Given that the determination of what is a trade or business is based on the facts and circumstances of each case, taxpayers have the option to treat different properties differently. Activities can be structured so that property under net leases will be grouped together and property for which significant services are rendered will be grouped together, thus achieving different treatment for self-employment tax purposes.

As a practical matter, rentals that do constitute a trade or business should be shown on Schedule C rather than Schedule E. This is noted on the heading to Part 1, Schedule E, which reads, "Report income and expenses from the rental of personal property on Schedule C." The instructions to Schedule E further clarify the matter by noting, "If you provided significant services to the renter ... do not use Schedule E. Instead, report the income on Schedule C."
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Author:Greene, Jeffrey J.
Publication:The Tax Adviser
Date:Aug 1, 1993
Words:1002
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