Airbnb hosting is new and exciting; unfortunately, the tax law is very grey. But if you err on the conservative side of the grey areas, then you might just save yourself a lot of time, money, and headache. Trust me, getting audited is no fun. So here are 5 simple concepts you need to know to make a smarter decision:
1. You’re paid like a business
The first thing that triggers an automatic audit is when the system receives a 1099-K from Airbnb on your behalf and then determines that you did not properly report your Airbnb income.
Passive income from rental properties generally receives a check monthly from the renter. But Airbnb is classified by the IRS as a third party payment provider like PayPal. As such at then end of the year, Airbnb issues you a 1099-K. A copy of this 1099-K gets sent out to the IRS and their automatic system reconciles your 1099-K against your filed return (usually against schedule C). If there is a discrepancy, the IRS automatically sends you a notice.
We had an Airbnb client who went through this issue. He was able to explain his way out with some guidance, however, many take a wrong path and end up paying more in taxes and tax prep fees for amended returns. To be safe, file Schedule C unless you have enough evidence to support your claim that your Airbnb gig is a passive activity and you didn’t provide substantial services.
2. You’re closely similar to other businesses
Most Airbnb’ers will fall under the Schedule C category just like most businesses do. You may have a tax preparer who tells you otherwise and it’s probably because they don’t know much about Airbnb. When they hear rental properties, they quickly assume you should file on Schedule E. But Airbnb’ing your space is more involved than just renting and collecting passive income. Airbnb is closely related to bed and breakfast operations (air bed&breakfast, duh!) and hotel chains which are both taxed as businesses and NOT passive activities.
Does your listing offer amenities as part of guests’ stay?
If the answer is yes, then it may appear that you’re offering services for the convenience of your guest, which by the IRS definition, is providing substantial services. Many tax court cases zeroed in on what’s considered ‘substantial’ so make sure you take a stance that you can back up.
When you book a hotel, it is reasonable for guests to expect that their nightly rate includes a clean room, bed with clean linens, cable TV, soap, shampoo, clean towels, coffee pot, microwave etc. These are provided for your convenience. Similarly, many Airbnb listings includes similar services and guests takes into considerations these amenities when booking so keep in mind that an IRS agent could make the same comparison.
3. You act like a business
Most Airbnb’ers rent their place out less than 30 days. The IRS says that if you’re renting your place less than 7 days on average or less than 30 days on average AND provide substantial personal services, then your activity is no longer “rental” but that of a business. So you’re Airbnb income should be reported on Schedule C and not on Schedule E.
Airbnb’ers can generate losses in the early years especially if they invest in business assets to furnish or redecorate their space. But the IRS questions losses because, in their minds, no one would operate a business to lose money unless it’s a hobby or a tax loophole. So the IRS created limitations on what losses can be deductible against ordinary income.
Back in the old days, people who made a lot of money on their W-2 income felt the pinch of getting taxed at the highest tax bracket. So one of the tax loopholes available was to buy real estate properties and allow the equity to build up while operating at huge losses. The huge passive losses could offset ordinary income so high earners paid way less in taxes. The IRS caught on, shut down the party, and ended the loophole.
Fast forward to today, you can only offset your active losses against ordinary income. Passive losses can only be offset against passive gain. So if you’re operating in a loss for multiple years on Schedule C, you have a higher chance of an audit.
4. The IRS and local governments want to classify you as a business
If you act like a business, get paid like a business, and provide services similar to other businesses that pays Self-employment taxes, then you must be a business! Uncle Sam wants his fair share and he’s going to get it one way or another. Either the hosts or Airbnb is operating a business so someone has to pay up for the Self-employment tax.
Airbnb is a third party platform like EBay and Craigslist that processes payments between the hosts and guests. Airbnb is different than Uber and many sharing economy companies that hire independent contractors, therefore, hosts are the most likely target of the IRS. It’s really hard to claim that you’re not a business when you (or a management company) handles the nightly bookings and provide personal services to your guests like hotel chains.
Your local government also wants to classify you as a business. Hotel and motel chains collect transient occupancy tax (or hotel tax) from their guests and remit the payments to the local government. The tax is used to fix the roads, beautify the city, and promote tourism. Regardless if transients stay at Airbnb or hotels, the city still needs their hotel tax from transients. So either Airbnb or the hosts (a.k.a., business owners) are required to collect from the transients and remit the payments to the city.
5. Don’t writeoff your business and personal space
Many Airbnb’ers rent out their extra room or entire spot when they’re on vacation. Problem is, many of these spaces are not exclusively used for business; some uses the spare room for their personal stuff. The fastest way to get audited is if you deduct both the personal and business portion of your home expenses. There are many court cases related to shared spaces in which the tax courts ruled that common spaces are considered personal space. So make sure your calculation is flawless, otherwise, years of back taxes, interest and penalty will haunt you.
Our general professional guidance is to file your returns on Schedule C unless you can substantiate that you should be on Schedule E. Contact one of our Levee tax professionals who will properly calculate the business percentage of your home expenses that is tax deductible.