Laying Down the Law: Tax Strategies for Short-Term Rentals
September 1, 2022
In many cases, a simple business decision concerning the corporate structure of the holding company for a rental property can result in substantial tax savings for the owner. Most investors understand the benefits of owning rental properties in a single asset entity such as a limited liability company. But many investors do not fully appreciate critical difference between a C corporation or an S corporation, and most investors elect to organize their company with the Subchapter C election.
The Subchapter C election is the presumptive corporate status under IRS rules. On the other hand, the S corporation has special tax status with the IRS and therefore may have tax advantages depending on the company’s use and circumstances. The names derive from the IRS code: “C corporations” are taxed under Subchapter C and “S corporations” are taxed under Subchapter S of the code.
To elect the special tax status, the organizer of the business must elect Subchapter S status on the IRS Form 2553 and all relevant S corporation requirements must be met. (Or if the company has already been organized as a C corporation, then the owner may file the IRS Form 2553 to convert the C corporation to an S corporation.)
Importantly, regardless of the tax election status, C corporations and S corporations both enjoy limited liability protection, and are legally distinct entities so that the members (owners) are not typically personally liable for business debts and liabilities.
For owners of short-term rental properties, S corporation treatment of the holding company for the rental property may be beneficial. For example, although rental income is generally exempt from employment taxes, pursuant to the IRS, if the owner provides “substantial services that are primarily for the renter’s convenience, such as regular cleaning, changing linen, or maid service, the owner may be responsible for self-employment tax. Substantial services do not include the furnishing of heat and light, cleaning of public areas, trash collection, etc. See IRS Publication 527. But if services are rendered for the renters and the services rendered: (1) are not clearly required to maintain the space in a condition for occupancy; and (2) are of such a substantial nature that the compensation for these services can be said to constitute a material portion of the rent, then self-employment taxes likely apply.
Examples: concierge services, daily changing of beds, providing food and beverage, providing recreational lessons, providing information about local attractions, providing vehicles, providing mail delivery to renters, etc.
If the owner and the owner’s tax professional determine that employment tax applies, then the owner should consider electing Subchapter S status for the company and then pay the owner a modest annual salary for services rendered. In that case, the total rents and distributions from the company to the owner would not be subject to employment tax; instead, only the owner’s salary would be subject to self-employment tax. This could be a substantial tax savings to the owner because the current combined self-employment tax is 15.3%, consisting of 12.5% for social security and 2.9% for Medicare.
TAKEAWAY: Short term rental owners should consult with their tax professional to assess whether their business model subjects the owner to self-employment tax. And if the business operations do lend themselves to employment tax, the owner should consider electing the S corporation status for the company to minimize employment tax.
Attorney Christopher Charles regularly represents short-term rental operators and property managers. If you or someone you know is actively involved in short term rentals or thinking about entering the short term rental market, contact us today to schedule an office meeting or virtual consultation with one of our real estate attorneys.
Christopher J. Charles is the Founder and Managing Partner of Provident Law ®. He is a State Bar Certified Real Estate Specialist and a former “Broker Hotline Attorney” for the Arizona Association of REALTORS ® (the “AAR”). Mr. Charles holds the AV ® Preeminent Rating by the Martindale-Hubbell Peer Review Ratings system which connotes the highest possible rating in both legal ability and ethical standards. He serves as an Arbitrator and Mediator for the AAR regarding real estate disputes; and he served on the State Bar of Arizona’s Civil Jury Instructions Committee where he helped draft the Agency Instructions and the Residential Landlord/Tenant Eviction Jury Instructions. Christopher regularly teaches continuing education classes at the Arizona School of Real Estate and Business, and he can be reached at chris@ProvidentLawyers.com or at 480-388-3343.