Should I file my Airbnb or nightly rental income on Schedule C or Schedule E?

Should I file my Airbnb or nightly rental income on Schedule C or Schedule E?

Ask two dozen CPAs that question and you’ll probably get a pretty even split. Ask them why they think that and you’ll probably get half a dozen different answers, but the biggest thing you’ll hear is: “It’s a gray area.”

I looked all over the Internet for the definitive answer, and what I found was absolute chaos. So, of course, I had to do my own research to figure out which side of chaos felt right for me. Unlike a lot of the posts I read while trying to sort it out, I’m going to show my work so you can decide for yourself where you fit.

Just so we’re clear: I’m not a certified professional accountant. I am not a tax expert. I don’t know anything about your overall tax situation, which will factor heavily into your decision on how to file. I’m simply showing you how I arrived at my conclusion so that you might use it to help you reach your own. Consult a tax pro (or 20) to find out what you should do.

Why does Schedule C or E even matter?

There are two big differences between the tax treatment of these two forms as they pertain to real estate. In general, Schedule C is the form you fill out for active-income businesses, while Schedule E is the one you fill out for passive-income businesses.

The advantage to Schedule E is that you are not required to pay self-employment taxes (currently 15.3%) on the income you report there. You are, however, limited in writing off losses. You can only write off losses up to your passive income, and then carry forward future losses in perpetuity until such time as you have enough passive income to offset those losses.

The advantage to Schedule C is you get to write off losses of up to $25,000 against your non-passive income immediately, lowering your tax burden in that year. However, you’ll be on the hook for those self-employment taxes.

Ideally, unless you’re changing your business model, this isn’t something you waffle on. Pick a lane and stick to it unless circumstances change.

Passive, active – what’s the big deal?

Why does the IRS even care about this distinction anyway? Well, let’s say you have a healthy income and would be subject to hefty income taxes. A great way to get around that and still build wealth was to buy a rental property, rent it out and deduct not only your expenses but also the depreciation for the property. Find the right deal, and you could use a big loss on paper to offset your regular income. You pay less in income tax, and your property value appreciates. Win-win.

Surprise! The IRS didn’t win there, so the tax code was updated to institute Passive Activity Loss Limitations (IRS form 8582 – instructions here). PAL limitations prevent your real estate losses (which they consider a passive investment in most cases) from offsetting too much non-passive income.

The IRS seems to have a distinct preference for rental real estate activities to be passive income, and if you want it to be non-passive you’ve got to meet some very specific criteria to do that.

To recap: Generally speaking, passive income goes on Schedule E and non-passive income goes on Schedule C. And that’s where the confusion begins.

Does a nightly rental qualify as rental real estate?

The crux of the problem is this: If you rent a room or a home on the nightly rental marketplace, do you have rental real estate, or are you running a hospitality business?

For the majority of this post, I’m going to be referencing guidance from this IRS Audit Technique Guide on Passive Activity Loss. I found this to be the most helpful tool in figuring out how to parse the weirdness that is the U.S. tax code. The document notes that it isn’t intended to be used as an authority, but it does give you a lot of clues as to the intent and approach of the actual tax code.

For starters, let’s assume you’re not a real estate professional. If you are, that changes things and you are subject to a little different treatment. Everything after this pertains only to everybody else.

If you’re in the normal rental real estate business of leasing space to long-term renters, you’re always looking at Schedule E. That’s a cut and dried area.

The sticky part for nightly rental arrangements is tucked into the definition of a “passive activity.” There are several exceptions, the first being:

“An activity is not a rental activity if any of the following apply.

1. 1. The average period of customer use is:
      a. 7 days or less, or
      b. 30 days or less and significant personal services were provided in making the rental property available for customer use.”

OK, that’s a major issue for the typical Airbnb host. If the average rental period is 7 days or less, your activity IS NOT a rental activity, which means it’s not a rental real estate activity, which means it isn’t assumed to be passive.

Where do we go from here?

Let’s look at that second part of the exception, which is often cited in articles. Here’s the explanation from IRS Publication 527, Residential Rental Property.

“Generally, Schedule C is used when you provide substantial services in conjunction with the property or the rental is part of a trade or business as a real estate dealer.

Providing substantial services.

If you provide substantial services that are primarily for your tenant’s convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C.”

The basic argument is that if you’re providing “substantial services,” like making breakfast or driving someone to and from the airport, or doing the kinds of things they would expect in a hotel, then you’re running a hospitality business and that’s non-passive income all day long. So if you want to avoid Schedule C, that’s a no-no.

I’ve seen articles suggest if you’re not providing substantial services, you can file on Schedule E in all cases. I don’t find that to be the case.

Then I’ve seen some flow charts from big-name accounting firms online that also say if your average rental period is less than 8 days, you’re running a business and you file Schedule C.

However, that’s not where the IRS stops. And that’s where I had to start.

Are you a material girl (or boy)?

Remember that PAL Audit Technique Guide from earlier? That came in super helpful here.

On page 32 of that PDF there’s a section titled Vacation Rentals in a Nutshell. It says:

“Many condos, vacation cottages, time-shares, hotels, motels, and bed and breakfasts have an average rental period of seven days or less. As a result, these activities are not defined as rentals, but instead are treated as businesses. Net losses from these activities are passive unless the taxpayer materially participates. Because many of these activities have a management company and may not be near to the taxpayer’s residence, materially participating may be difficult.

Sub-Issues
• Activities with an average rental period of 7 days or less are defined as businesses, not rentals. Therefore, the active participation standard and the $25,000 rental real estate allowance do not apply to these types of activities. Losses, if passive, go on Form 8582 line 3b, not 1b.”

Notice that businesses where the average rental period is less than 7 days are expressly disallowed from the small-landlord $25,000 special exemption allowance. That means if you end up filing on Schedule E, you’re not allowed to use that rental real estate exemption to front-load losses because in the eyes of the IRS you aren’t running a rental real estate operation. (Schedule C would make them non-passive losses that you could write off.)

The next big question is whether you materially participated in the operation.

What is this material participation standard? You are considered to materially participate if you can answer yes to any of the following questions.

“1. The taxpayer works 500 hours or more during the year in the activity.
2. The taxpayer does substantially all the work in the activity.
3. The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
4. The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
5. The taxpayer materially participated in the activity in any 5 of the prior 10 years.
6. The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
7. Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

Note: The first four tests look to a set number of hours of participation in the tax year. The next two tests look to material participation in prior tax years. The final test looks to the facts and circumstances, but is highly restrictive.”

How you answer these questions is actually the key determinant of whether you should file Schedule C or Schedule E.

Who is doing the work?

In my case, the key factor keeping me from crossing over from passive to non-passive is my housekeeper.

My rental is over two hours from my home, and there’s no way I’m driving back and forth every week to clean it. So I hire someone to do that. It takes her at least 4-5 hours between every rental to get it ready for the next guest, which means she puts in more hours than I do, especially when it’s rented 3 to 4 weekends a month.

For me, that’s why I file Schedule E.

However, if my rental were nearby and I were doing the cleaning myself, I most certainly would pass tests No. 2 and 3 based on the amount of work. That would bump me over to Schedule C because I would be a material participant.

That’s really why I found so many articles and forum discussions about this topic lacking. They didn’t dig deep enough into the tax code to get to this material participation test.

However, two people who run an Airbnb and do not offer substantial services could have to report their income differently depending on whether they are the ones cleaning the room or home.

Which one is better?

Whether you want to file on Schedule C or Schedule E ultimately depends on your overall tax situation.

If you are renting enough that you incur real expenses and take depreciation, but not enough beyond those two things to realize profit, you probably want to qualify for Schedule C so that you can write those things off. Since carrying forward losses indefinitely means you won’t realize the tax benefits until you sell the property.

If you are able to make money consistently on your property even after the expenses and deductions, you probably don’t want to get hit with self-employment taxes and should structure yourself to land in Schedule E.

Have I mentioned you should consult your own accountant or tax attorney? Because I’m not that person.

So there you have it. Hopefully my foray into parsing the tax code helps you on your own journey down the rabbit hole!