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Hey there, fellow real estate investors, FIRE enthusiasts, and tax aficionados! Welcome to "Real Estate is Taxing" – your go-to weekly podcast for all things real estate taxes, hosted by Natalie Kolodij, EA- Real Estate Tax Strategist and dry humor extraordinaire.
Each week, we're breaking down complex tax topics into bite-sized, understandable explanations, with no regard for how many obscure references it takes to get there.
Speaker: Welcome to Real Estate is Taxing,
where we talk about all things real estate
tax and break down complex concepts into
understandable, entertaining tax topics.
My name is Natalie Kalady, I'm
your host, and I am so excited
that you've decided to join me.
Microphone (Shure MV7): Hello.
Hello everyone.
And welcome to today's episode.
Today.
I want to circle back to the short-term
rental loophole a little bit.
But we are going to talk
about some of the guidance.
And court cases related to this topic.
So I'm a big fan of reading court cases.
I love reading tax court cases.
They just add a ton of context.
They add a lot of understanding.
And to me that is.
Immensely important.
Right?
That's what really helps us understand.
What is meant behind the law.
And not just have it be an
obscure thought on paper.
So all of that said.
We are going to dive into a
handful of court cases today
related to short-term rentals.
Some of these are not court cases,
they're revenue procedures, or revenue
reviews or guidance or things like that.
But we'll differentiate
what we're talking about.
But all of these relate
to short-term rentals.
The thing that prompted this.
So I have always had some court cases.
I've had sort of a folder of these.
And I referenced them in my
short-term rental classes.
I've always had some cases, but
I had a feeling there was more.
And not too long ago, someone
shared an article with me.
That was written by a pretty prominent,
like real estate related tax person.
And they said.
That the short-term rental loophole.
I was risky because the laws
that allowed it were outdated.
Because they were written
and existed before Airbnb and
short-term rentals really did.
And they also said that,
unfortunately, we didn't really
have any court guidance on this.
And neither of those things are true.
That's not how laws work.
Laws don't just become obsolete without
there being some kind of change to them.
Right.
So there are some laws.
That have been replaced with other laws
or they have been adopted over the years.
But there are plenty of
laws that were written.
In the forties and the fifties.
That are still what we use today.
So even if a law is from forever
ago, If it still applies to
the specific circumstance.
Then, if it applies to this
specific circumstance, so tax
laws, don't just become outdated.
And then the next statement.
That we didn't have any court cases
related to short-term rentals.
Also just not true.
There's quite a few.
So We are going to jump through some of
these court cases and revenue rulings.
And guidance related
to short-term rentals.
if you want to read through
the whole entire thing.
I'll provide a link in the show notes.
So.
That being said the first.
Case we have to look at today.
It's from 1965.
Now this case.
Is actually from the us court of
appeals comes from the ninth circuit.
And.
Did Airbnb exist in 1965?
No, it didn't.
But do you guys think that renting of
property has existed for centuries?
Yes.
And do you think renting property
for various lengths of time
has existed for centuries?
Also, yes.
So even though the like,
present most common.
Experience of short-term
rental didn't exist in 1965.
It's still existed as a, as a premise,
as something that could be clarified and.
Defined by law.
So this was actually not a tax court case.
This was from the us court of appeals.
So this was Dell, Dell?
No, D E L N O.
V Celebrita C E L E B R E Z E.
And in this case, this was the first
case I could kind of find earliest.
I could find.
At the end of the day, in this
case, what ended up happening?
This was a mixed use property
with some short term, some longer.
But those shorter term, Units
were almost more for in-home care.
Like they provided really
a little bit more to them.
It was almost like supervise rentals.
And so even though that was the
case, so some of these units
were rented on shorter basis.
And the taxpayer did.
A fair amount of what we would really
now consider substantial services.
So in this case, the taxpayer went in
a few times a month, like two to three
times a month and cleaned and maintain the
kitchens to make sure they didn't get to.
Like in too bad of shape.
They would clean the windows quarterly.
They had that professionally cleaned.
And in addition to this,
the taxpayer would even do.
Trash removal.
And not just from.
Like these shared areas,
which is incredibly common.
That's not a substantial service.
But the taxpayer would literally
go into the apartments.
Remove their bag of trash,
taken out to the dumpster.
In today's terms, like
kind of what we know today.
If someone was coming in a few times a
month and cleaning for me and cleaning my
windows and taking out my trash every day.
Those are probably substantial
services that's above and beyond the
standard of what you would receive.
In a longterm rental.
These are services that have
a substantial value to them.
However, in this case in 1965.
It was determined that in spite of that
happening, it wasn't on every unit,
but it was on a fair amount of them.
And it was like 15 units.
In spite of all of these services.
The court ruled that these were
essentially not substantial services.
They decided this taxpayer's income
was not subject to self-employment tax.
We only have self-employment tax
on rentals when they are providing
those substantial services.
And the court decided that
didn't come to that level.
Even though it was a handful of services
that did have a fairly decent value.
The big, final point.
Of the court in this case.
Was the idea that it
was close to impossible.
To fully separate.
The investment of someone's capital
into real estate with the requirement
of an investment of their time.
That.
In most circumstances, if someone was
buying property to rent, That there was
some time requirement kind of tied in with
conjunction to the money they put into it.
It wasn't typically one or the other.
Now I'm not super familiar
with the real estate market
in 1965 or what was standard.
My guess is there were less, less options
available for like property management.
We obviously didn't have the
same kind of technical and
digital tools that we have today.
So my assumption is that it was
much more common for anyone who
was a landlord at those times.
To have to kind of put some more
time into the overall maintenance
and management of their properties.
So the court basically said that it's
really hard to separate those two things,
your investment in real estate, with
the amount of time it takes to sort of
operate your investment in real estate.
So even though there was
multiple cleanings during the
month external cleanings on
windows and trash removal daily.
The court decided that that was still
not subject to self-employment tax.
So that's kind of a big win.
On our side of things, right.
We do not want rentals on schedule
C paying self-employment tax.
The next item of guidance that
came out was a revenue ruling.
And this was revenue ruling, 72 dash 3 31.
And this was actually an
example of a mobile home park.
And in this court case, the
taxpayer provided what we would now
consider very standard services.
They would maintain the like city
utility lines into the property.
They were maintaining the communal
like laundry area and bathrooms.
Like if there was a
shared public bathroom.
And they were also maintaining the road
that led into the community, like the
public road, if it snowed, if it needed
to be repaved, any of those things.
The property owner maintained.
They didn't do anything to the
people's individual mobile homes.
Just overall community maintenance.
And in this revenue ruling in 1972.
It was decided that those services.
We're outside of the normal scope.
Of what would be provided for
the rental of rooms or spaces?
Only for occupancy.
So this 1972 case.
This revenue ruling.
Decided that that income was indeed.
Subject to self-employment tax.
So that's a little kooky because.
Most of those are pretty standard.
But at the time it wasn't.
So this is why looking back
at these guidance points is
really important because you
can kind of see the progression.
Of where things adapted and where
the courts and guidance shifted.
So first, first case from court of
appeals, 1965, lots of services.
No self-employment tax.
1972 Riverland came out for a mobile
home park and said, yeah, self-employment
tax, even though all they're doing
is maintaining the shared spaces.
This then gets kind of contrasted.
In 1983.
So it's about 10 years later.
We have revenue ruling, 83 dash 1 39.
And in this example, We have
another mobile home park.
And this rev ruling is incredibly
important because it ends up.
Basically.
Replacing or voiding reveling
seven two dash 3 3 1.
It makes that obsolete.
No longer something
that can be relied upon.
It basically crossed it out, replace
it with a new train of thought.
So in between these two revel rulings.
1972, we have self-employment
tax for maintaining general
areas of mobile home park.
By 1983.
We have a rev ruling that goes the
other direction and says, don't worry.
We're not even looking at that
one from 10 years ago anymore.
It's obsolete.
In between these two.
In 1978, there was a
mobile home park case.
This was a tax court case.
And this was Bobo V commissioner.
And in this case, it was a lot
of the same things from that
earlier reveling, they maintained.
Utilities, they provided heat and light.
They kept public areas clean.
They collected trash from
like outside the properties.
When people would put out their
trash cans, And in this court case.
It was determined that those things
did not generate self-employment tax.
So 1972 rev ruling says the up doing
all these kinds of communal area
things create self-employment tax.
Six years later, the tax
court says, no, it doesn't.
That's not doing a substantial service.
To the tenant to like,
make their stay better.
It is not something provided for the
convenience and improvement of their
actual occupancy of the location that has
a substantial value where like they're
paying more rent for these services.
They were like on any
property, maintaining.
Like the communal spaces and the road
and making sure trash doesn't pile up.
Those are just normal.
That's just has to happen for any rental.
So 1978 tax courts, like, Nope.
That is not self-employment tax.
We're not doing it.
So then, like I said, by
1983, we have that RiverLink.
Which agreed with it.
It was a similar case.
But in that rev ruling
eight three dash 1 39.
This mobile home park did
all of those same services.
The communal areas.
Cleaning up trash,
maintaining utility lines.
But.
This mobile home park
also had extra facilities.
So in this circumstance,
they also had a recall.
Which had a card area and a pool room,
an auditorium, a theater with a stage.
And they were all staffed by employees.
And on top of that, it was noted that they
would host numerous recreational events.
So in this case, This 1983 rev ruling.
They decide that this is what is
subject to self-employment tax.
This is obviously far above and
beyond those earlier two cases
related to mobile home parks.
It's not just maintaining somewhere
for you to park your home.
They're providing extra spaces.
They're providing people
to run those spaces.
They are providing events.
They are giving you all kinds of
extracurricular activities and people
there to set it up and keep track of it.
So that's the level.
Where we have self-employment tax.
So this reveling specifically made.
That initial one revenue ruling 72, 3 31.
Obsolete.
What they basically determined.
In this ruling, is that whenever we're
looking at a short-term property or
any kind of rental property, really.
But when you are analyzing this, there
kind of has to be a two-step approach.
And that's what they took here.
And that's what they
suggested pretty much.
So step one.
Is figuring out if there
are services provided.
For the convenience of
the occupant, right.
Are they providing something?
That is directly related to their stay to
make it easier to make it better, or is
it just sort of overall maintenance items?
So that's the first step.
Even after you identify those things.
Because could it be argued that
picking up trash for someone
is for their convenience.
Absolutely.
But it's also not uncommon.
So first step is figuring
out if their services.
The second step.
Is then you need to figure out.
Whether the value of
those services provided.
Makes up a material portion of the
payments being collected for rent.
From the occupants.
So this was a super important revenue
ruling because it gives us this
mindset and clearly states this.
Two step approach.
And I get asked this quite a bit
from taxpayers and tax professionals.
Who will say, Natalie, we
have a short-term rental.
We do provide this service, but we
don't do these other five services
that are typically seen as substantial.
Is it subject to self-employment tax
or from only doing this one thing?
And like with a lot of things in
tax, the answer is, it depends.
But this is the consideration.
What we learned from this 1983
rev ruling this two step approach.
So if a property is providing any kind
of services, You then have to look
at, do they have a substantial value?
Is the amount.
Where the value of these services,
does that make up a material portion?
Of the amount.
That the occupant is paying in rent.
If it doesn't, if these are things that
on their own are pretty insubstantial
Then they're not as substantial service,
they're just sort of an incidental.
So keep that in mind.
Two part approach are there
services and if there are.
What's the real value to them.
If it's not a large amount.
Then it's likely, still not
subject to self-employment tax.
Microphone (Shure MV7)-1: by
this point, we're really sort of
starting to set a standard, right?
Like we are starting to prove.
What they consider a substantial service.
We are getting some good, clear examples
of the differences that are looking at,
and we get to take this and move forward.
So there are a handful of more cases.
That relate to this and some of them.
Actually came from a unique angle.
Which there's a handful of court cases.
That came into play.
Because of taxpayers applying
for retirement benefits.
So when you go to apply for
social security or like certain
insurance benefits, you need to
have a certain amount of quarters
that you paid in to the system.
So there were several cases.
We're taxpayers who owned real estate
were trying to argue that it did
qualify for self-employment tax.
They wanted to switch it over
to being schedule C non-passive
and paying self-employment tax.
Because they didn't
have enough time put in.
To now qualify for the benefits that
they were looking for in retirement.
So there's a handful of these cases,
but one of my favorite ones or the
one that I think was kind of most
clear, we had this case in 1986.
And this was another court of appeals.
So this was a ninth circuit
court of appeals case.
And this was a Holohan B heckler.
So.
In this example.
This taxpayer had actually.
Reported a piece of real estate
that they owned for years and years.
This was a commercial office building.
And they were leasing it to
an army recruiting office.
Now part of their lease.
Specifically required.
And this wasn't from the taxpayer.
This was from like the military
requirement for using this space.
Required that the taxpayer
did clean the office and the
bathroom of the office daily.
They would sweep, mop and
buff the floors monthly.
And they would wash
all of the windows and.
And kind of the X.
Exterior.
Quarterly as well.
So these were quite a few services.
The taxpayer was providing.
That were outside of the norm.
But they hadn't been
reporting it that way.
Historically, they did not report
this as a schedule C rental
subject to self-employment tax.
They were reporting it on
schedule E as a passive rental.
And then when they went to apply for
benefits and found out they didn't
have enough time paid in and they
kind of looked over the requirements.
The taxpayer said, oh,
well, wait a minute.
I was doing a lot of these things that
would be more of a substantial service.
So I'm going to amend.
Three years of tax returns.
So the taxpayer went back and amended
three years of their returns to
move their rental, to schedule C and
to pay self-employment tax on it.
So that they would have enough
quarters paid in to qualify
for these retirement benefits.
And ultimately in this court of appeals.
They landed on the decision
that, that didn't qualify.
That the services that this
taxpayer was providing.
Did not subject them
to self-employment tax.
They said that these.
These services that are to me
above and beyond the standard,
but, you know, cleaning daily,
that's pretty above and beyond.
Monthly cleaning the floors.
That's pretty above and beyond.
They ruled that it was merely
incidental to the effective
operation of the building.
And that it did not subject the
taxpayer to self-employment tax.
They lumped it in the same category
as the removal of trash, the
installing of like water coolers
and air conditioning filters.
They almost set in my mind, a separate
precedent for commercial office space.
They, what is considered standard.
For maintaining an office space
where there's going to be multiple
people in and out of there.
It's not like one tenant,
typically one person who is just
staying there and responsible.
They were saying that this is part of
the standard operations of offices.
So we've now had this established
pattern that for a mobile home park.
Doing the general grounds,
keeping, maintaining the premises,
maintaining those shared spaces.
Not self-employment tax.
That is standard operations.
And now this court case kind of says that,
you know, in an office building, setting.
These more frequent cleanings because
there's going to be potentially
the public coming in there.
It is going to be shared
by numerous employees.
It's not just like a family saying
there that the person who owns the
property, maintaining it a little more
for that sort of public use almost.
Is standard is part of the industry.
So it's kind of an interesting case
because that is what we would consider
today to be substantial services, if
provided that way in relation to any
kind of a vacation rental, right.
So the comparison we typically
use now is looking at a hotel for
what is a substantial service.
And examples of what you
would get in a hotel that are
substantial are going to be.
Services during your stay that
have a value daily cleaning,
fresh sheets for us linens.
Cleaning and vacuuming day to day.
All of those things we would consider.
Items that could shift it over to
being subject to self-employment tax.
But in this case, what we're
seeing is very similar.
Frequency of services.
But sort of a different
scope of what is done.
Are considered normal with
the realm of office building.
So kind of an interesting
counterpoint here that was 1986.
We had another case
with a lot of services.
No self-employment tax.
There were a handful of other cases.
That were somewhat related to this
where There was a case in 1967.
So it kind of an older case.
And in this one, they
were trying to decide.
The property had been
incorrectly reported for a while.
There.
And essentially what happened
was it wasn't reported jointly.
So then later on one of the taxpayer
or spouse, one of them had much
more paid in than the other, even
though they shared and all of
the management of the properties.
They provided services together.
This was schedule C property.
But.
The court in that one was like, Nope, you
don't have a clear proof of who did what?
So we can't reallocate.
So not super related, but just
something to be mindful of.
Tracking and reporting correctly for who?
Is actually doing the services on
a property, like whose rental is
this or whose business is this?
Because whether something is marked
for taxpayer or spouse or join.
It's going to impact the amount
paid into your account, the taxpayer
spouse to that specific person's
social security sort of their credit.
There was another case in 87.
That was Woodworth.
And this was a us district court case.
And this one was a little bit interesting
because this was a partnership.
Where it was a passive rental, but
one of the partners was who did all
of the maintenance on the property.
And this isn't uncommon.
So this taxpayer did all of the
repairs and handyman services.
They did pretty much everything possible.
And if it got to a point where something
was too complicated, they called in.
You know, an outside contractor.
The kind of unique piece to this.
Was that, that taxpayer was also
being paid for their services.
It wasn't like, it was just
their job within the partnership.
They were operating it
as a separate business.
So even though the partnership was their
only customer, they weren't doing handyman
services for just the general public.
They never advertise that.
They only did work for this
building, this specific partnership
with a commercial building in
it that they were part owner of.
But they maintain it fully separately.
They charged fees for it.
They kept it tracked as a
separate business, separate set
of books, separate bank account.
All of these different things.
And part of what almost
got him kind of caught up.
Was even though he was being paid.
For these services.
So outside of the income and expense of
the partnership, he received a specific
payment for the repairs and handyman work.
He did.
He almost never received
an actual check for it.
He would just reinvest what he was
being paid into the partnership.
So he would have more equity
in there and kind of, they.
He would have more contributed
capital and more funds he
had put into the partnership.
So he never really received,
like in hand the payments.
He did constructively.
Like they use were payments
issued to him and then booked as a
reinvestment back into the partnership.
So at the end of the day, because of the
way it was structured, so specifically
and run as a separate business and
he was receiving specific payments.
They ultimately decided that it did
qualify for self-employment tax.
So those constructive payments he
received, even though they never
hit his bank account, he booked
them as income and reinvested it
right back into the partnership.
They were allowed to count that as
income and quarters that counted towards
paying in for his social security credit.
So that was kind of interesting.
The other key point that the
court really reiterated with this.
Was that it wasn't fair to just say
that these services were part of
the partnership, income or expense.
Because it wasn't something incurred
and it wasn't something where all of the
partners were receiving payment for it.
It's not like the entirety of everyone
in the partnership was affected by this.
This extra work and the income from
it only related to the one taxpayer.
So that was kind of a big sticking
point for them where they said
this was really run separately.
From the operations of the building.
So something to be mindful of.
I know that there's quite a
few taxpayers who they want
to set up property management.
But only manage their own properties.
This is a good case to look
at for precedent for that.
Because it walks you through some
of what they liked and didn't
like about how this was set up.
And it could help give you some more
guidance to make sure that you and
your attorney and tax professional.
Have your management company set up
in a way that it is valid and not
just considered kind of intermixing.
So that was the Woodworth case from 1987.
That was a us doctor.
District court case.
We had another unique case.
A little bit obscure, but same category.
2013, this one was a Morehouse case.
And this related to land rental.
But what was interesting with this case?
Was that he was part, the
taxpayer was part of a program.
Part of a government program So this
program would pay you a certain amount.
To maintain your land in a way to
encourage wildlife that was natural
to the area or to help, you know,
replenish local wildlife populations
or plants that needed to be replanted
that were kind of local to the area.
So basically to bring specific amounts
of lands back to their original state.
And in this case, the taxpayer.
I was saying that.
It was not subject to self-employment tax.
They said I don't do
anything on the property.
I have these hundreds,
maybe thousands of acres.
And the government pays me to make
sure they have certain plants and
that, you know, they're not overgrown
in this way and kept kind of according
to these specifics and I pay a third
party to maintain that land for me.
So all I'm doing is getting paid
for the use of my land and then
someone else's maintaining it.
I'm not providing a service.
And in that case in 2013 the
court did decide that that was
subject to self-employment tax.
Because they were like,
this is above and beyond.
Just renting someone, your land with no.
Other stipulation or no other
use to it, no other anything.
They had to do a fair amount of
work month to month to keep all of
this acreage meeting the criteria.
So.
Again, in this case, they decided that
was subject to self-employment tax
because it was so different from the
standard expectation of a land rental.
Kind of interesting to look at
it next to the earlier case.
Of the army recruiting office, where
it was part of their contract, that the
taxpayer had to do these extra services,
specifically the daily cleaning, the
quarterly cleaning of the windows,
the monthly floor cleaning and waxing.
That was also per a specific
contract and they decided it was
not subject to self-employment tax.
Because those services, as
it related to normal office
rental, Weren't that different.
But in this case, the extra planting
and mowing and tilling and all of these
things that were very specific with very
specific species and certain criteria.
That was very different than
the standard land rental.
So not all things are black and white.
They're going to look at.
What services the taxpayer's providing.
If there are services.
What they are, if they're substantial.
And how they relate to that industry.
That's the other thing
we're seeing, right?
That the expectations.
Related to a mobile home park.
An office building or land rentals
are going to be very different.
So those are some of the key cases.
And then pretty recently.
We did have a court case that came up
that related to short-term rentals.
In somewhat of an unexpected way.
This case was related to a yacht rental.
But the big takeaway from this.
And this was a Rogerson.
V commissioner case this was in 2023.
So this was very recent.
And same kind of argument here
as with short-term rentals, where
they were arguing, it was going to
stay passive or it was going to be
non-passive based on the length of stay.
And the key takeaway from
this most recent case.
Was that they hadn't had any guest
stays by the end of that year.
So the year when they put it in service
and it might've been available to rent,
which does make it in service, but no
one had technically stayed in it yet.
And so for the argument.
Of a rental of real property.
So like a boat with living
facilities on it could qualify.
If the average guest stay is
seven days or less, that it
can potentially be non-passive.
That was the argument
made by the taxpayer.
And the court said, but you
don't have any guests for us
to average and amount of stay.
We have no way to know if your
first guest is going to stay
for a hundred days or two days.
So this very recent 20, 23 case.
Really reinforced what a lot of us have
been saying, which is, if you are going
to put your short-term rental, In service
before your end, you're going to try
to do the short-term rental loophole.
Make sure you have at least two
different stays at fair market value.
So that you can prove an
average and you can prove an
average of seven days or less.
If you've put it in service, but
don't have anyone stay in it yet.
Then you cannot prove it is
non-passive for the year.
Even if it's in service, you can start,
you know, depreciating it as soon as
it's ready and available for rent.
All of that still happens.
But we can not meet the criteria
to prove it is non passive.
And this very recent court case
kind of reaffirmed what a lot of us
have been saying in the tax world.
So that was a lot of information.
Like I said, I am.
I'm huge on court cases.
And this was actually like my night,
Friday night, I was up till three in
the morning because I would find one
case and then it would lead to another.
Cause it would say, you know, this,
this court referenced this other case.
Well, okay.
Now I'm going to go read that case.
So that was my wild, Friday
night was staying up late.
Reading through pages
and pages of court cases.
But I find it super interesting.
To me, this is the in between the lines
that is really important to add context.
Because there's so much of it depends.
When it comes to tax scenarios and part
of the difference between a tax preparer.
And a tax strategist or planner.
Is the ability to look at things
like this and form a position.
There's lots of things in tax
that are not black and white.
Where you as the taxpayer or
your tax professional, who
you pay to help with this?
Need to say, we believe we can
do this based on a, B and C, or
we believe we can't or didn't, or
shouldn't have because of AB and C.
That's what makes someone a tax
planner versus just a tax prepare is
kind of that deeper understanding.
So.
I hope you guys have
found this really helpful.
And if you are someone who loves reading.
Interesting court cases.
As much as I do.
I will go ahead and link to these
cases and these show notes and
these rev rulings, and you guys
can check them out for yourselves.
Read a little more.
If you have any followup questions, feel
free to join us in the Facebook group.
There is one for tax professionals
and one for real estate investors.
I will link both below as well.
And as always, if you guys have
liked this episode or found
value, please share the show.
Review it.
Leave it a good rating,
whatever you'd like to do.
And as always.
I will talk to you guys next week and
I hope you have a fantastic weekend.