In Chief Counsel Advice 202151005[1] the IRS discusses the lack of linkage between what is a rental for passive activity purposes under IRC §469(c)(2) and the exclusion of real estate rentals from self-employment income under IRC §1402(a)(1). The memorandum also discusses the application of the self-employment tax rules to two specific situations.

Rental Activities Under §469(c)(2) and the Self-Employment Income Exclusion for Real Estate Rentals Under IRC §1402(a)(1)

The memorandum begins by looking at the question of whether a determination that an activity is a rental activity under the passive activity rules of IRC §469(c)(2) determines if the activity involves “rentals from real estate” excluded from self-employment income under IRC §1402(a)(1).

Under IRC §469(c)(2), for purposes of the passive activity rules, a rental activity is a passive activity unless it meets the real estate professional rules of IRC §469(c)(7). The IRS has issued regulations under IRC §469 that define what is and is not a rental activity for purposes of IRC §469(c)(7).

IRC §1402(a)(1) provides that there shall be excluded from self-employment income “rentals from real estate and from personal property leased with the real estate.” However, the memorandum concludes that a determination that an activity is or is not a rental under the passive activity rules does not control if the income from the activity will be excluded from self-employment income as a rental from real estate under IRC §1402(a)(1).

The memorandum summarizes the rules for considering an activity as a rental under the passive activity rules for a taxpayer who is not a real estate professional:

Under § 469(c), a passive activity is generally any trade or business activity in which the taxpayer does not materially participate or any rental activity. Treas. Reg. § 1.469-1T(e)(3)(ii)(A) provides that an activity involving the use of tangible property is not a rental activity for a taxable year if for the taxable year the average period of customer use for the property is seven days or less.[2]

The memorandum goes on to note that the regulations specifically provide that characterizations under the passive activity rules do not impact the treatment of items under other IRC provisions:

Treas. Reg. § 1.469-1T(d)(1) provides that the characterization of items of income or deduction as passive activity gross income or passive activity deductions does not affect the treatment of items of income or deduction under provisions of the Code other than § 469. Therefore, whether amounts are passive activity gross income under Treas. Reg. § 1.469-2T(c) or passive activity losses under Treas. Reg. § 1.469-2T(b) is not determinative of whether those amounts are rentals from real estate under § 1402(a)(1) and Treas. Reg. § 1.1402(a)-4.[3]

Thus, the determination under the passive activity rules won’t control whether an activity is a rental of real estate for self-employment tax purposes. The memorandum concludes “whether an activity is a “rental activity” under § 469(c)(2) is not determinative of whether the exclusion in § 1402(a)(1) applies.”[4]

The passive activity rules can impact whether a deduction will be considered for other tax provisions, including reducing self-employment income if the passive activity provisions suspend the deduction of a loss, as the memorandum explains:

However, under Treas. Reg. § 1.469-1T(d)(3) a deduction that is disallowed for a taxable year under § 469 and the regulations thereunder is not taken into account as a deduction that is allowed for the taxable year in computing the amount subject to any tax imposed by subtitle A of the Internal Revenue Code.[5]

Although not directly addressed in the answers in the memorandum, if an activity was deemed to be part of self-employment income due to not meeting the rental of real estate definition in IRC §1402(a)(1), a loss still might not reduce self-employment income for a year if a deduction for the loss was barred by the passive activity rules.

Applying the Self-Employment Rental Real Estate Exclusion

So now we turn to the application of the rules under IRC §1402(a) to see if the activity is or is not part of self-employment income. The memorandum quotes from the regulations as follows:

Treas. Reg. § 1.1402(a)-4(c)(1) provides that rentals from living quarters, where no services are rendered for the occupants, are generally considered rentals from real estate under § 1402(a)(1), except in the case of real estate dealers. However, Treas. Reg. § 1.1402(a)-4(c)(2) provides,

Payments for the use or occupancy of rooms or other space where services are also rendered to the occupant . . . 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.

Treas. Reg. § 1.1402(a)-4(c)(2) lists examples of situations where services are rendered for the convenience of occupants, such as hotels, boarding homes, warehouses, and storage garages.[6]

The memorandum also points the reader to the Tax Court’s 1978 Bobo decision:

In Bobo v. Commissioner, 70 T.C. 706 (1978), acq. 1983-2 C.B. 4, the Tax Court considered a mobile home park that provided leased trailer park units with utility hookups, sewage facilities, and laundry facilities. The Tax Court held that the net rental income from the rental of the trailer park units was excluded from the owners’ NESE[7] under § 1402(a)(1). The court relied on Delno, infra, in setting the standard for when services are considered not rendered for the occupant,

[Section 1402(a)(1)] should be applied to exclude only payments for use of space, and, by implication, such services as are required to maintain the space in condition for occupancy. If the owner performs additional services of such substantial nature that compensation for them can be said to constitute a material part of the payment made by the tenant, the “rent” received then consists in part of income attributable to the performance of labor which is not incidental to the realization of return from passive investment.

Bobo at 709 (citing Delno v. Celebrezze, 347 F.2d 159, 166 (9th Cir. 1965) (relating to parallel Social Security eligibility provisions). Again relying on Delno, the Tax Court first determined that the phrase, “’usually or customarily rendered’ . . . must be read with emphasis upon the closing phrase ‘for occupancy only.’” Bobo at 710. The court reasoned that an analysis of whether services are rendered solely for the convenience of the occupants pursuant to Treas. Reg. § 1.1402(a)-4(c))(2) is a question of fact based on “whether [the services rendered] are required to maintain the space in condition for occupancy and, if not, whether [the services rendered] are substantial.” Id. at 710-11; see also Johnson v. Commissioner, 60 T.C. 829, 832-33 (1973) (stating, “any service not clearly required to maintain the property in condition for occupancy be considered work performed for the tenant, and not for the conservation of invested capital,” in support of a narrow construction of the exclusion from NESE for rental real estate).

Ultimately, the court determined that, even though the trailer park furnished laundry services that were “clearly rendered for the convenience of the tenant and not to maintain the property in condition for occupancy,” the tenants’ payments for the laundry services were not “substantial enough to classify all the tenants’ [rental] payments as received for ‘services to the occupants.’” Id. at 711 (citing Treas. Reg. § 1.1402(a)-4(c)(2)). Accordingly, the court held the payments at issue were rental from real estate excluded from NESE.[8]

Using these cited sources and others, the memorandum then looks at two fact situations. The memorandum describes the first situation as follows:

The taxpayer is an individual who directly and solely owns and rents, in the course of a trade or business, a fully furnished vacation property via an online rental marketplace. The taxpayer is not a real estate dealer within the meaning of Treas. Reg. § 1.1402(a)-4(a). The taxpayer provides linens, kitchen utensils, and all other items to make the vacation property fully habitable for each occupant. In addition, the taxpayer provides daily maid services, including delivery of individual use toiletries and other sundries, access to dedicated Wi-Fi service for the rental property, access to beach and other recreational equipment for use during the stay, and prepaid vouchers for ride-share services between the rental property and the nearest business district. For the year at issue, the average period of customer use of the vacation property is seven days, and therefore the activity is not considered a rental activity for purposes of § 469 pursuant to Treas. Reg. § 1.469-1T(e)(3)(ii)(A) In addition, the taxpayer materially participates in the activity within the meaning of § 469(h)(1) and Treas. Reg. § 1.469-5T and, therefore, the activity is not a passive activity within the meaning of § 469(c).[9]

In this situation, the IRS finds the activity does generate self-employment income, not being an exempt rental of real estate under IRC §1402(a)(1):

The net rental income in Fact Situation 1 is not excluded from NESE under § 1402(a)(1) because the taxpayer provides substantial services beyond those required to maintain the space in a condition suitable for occupancy. See Bobo, 70 T.C. at 710; Rev. Rul. 83-139. Whether services are considered rendered for the occupant is based on the particular facts and circumstances in each case. See Hopper, 94 T.C. at 548 (1990). Here, the payments made to the taxpayer for these services are for the convenience of the property’s occupants. The services go beyond those clearly required to maintain the space in a condition for occupancy and are of such a substantial nature that the compensation for these services can be said to constitute a material portion of the rent. Thus, the payments are not excluded under § 1402(a)(1) but rather are included in NESE. The characterization of this activity as not a passive activity within the meaning of § 469(c) does not affect whether the activity is excluded from NESE under § 1402(a)(1).[10]

In a footnote, the IRS notes that if the activity was treated as a passive rental activity under §469 and incurred a loss that was suspended, that loss would not reduce self-employment income as was noted earlier:

If the activity were a rental activity under Treas. Reg. § 1.469-1T(e)(3) and, therefore, a passive activity under § 469(c), a loss generated by this activity would still be limited for purposes of computing NESE under § 1.469-1T(d)(3).[11]

That is, while the loss is still a loss from self-employment, the fact a deduction is not allowed will serve to bar reducing self-employment income.

The second fact pattern is outlined as follows:

The taxpayer is an individual who directly and solely owns and rents, in the course of a trade or business, a fully furnished room and bathroom in a dwelling via an online rental marketplace. The taxpayer is not a real estate dealer. Occupants only have access to the common areas of the home to enter and exit the room and bathroom and have no access to other common areas such as the kitchen and laundry room. The taxpayer cleans the room and bathroom in between each occupant’s stay. For the year at issue, the average period of customer use of the vacation property is seven days, and therefore the activity is not considered a rental activity for purposes of § 469 pursuant to Treas. Reg. § 1.469-1T(e)(3)(ii)(A). In addition, the taxpayer materially participates in the activity within the meaning of § 469(h)(1) and Treas. Reg. § 1.469-5T, and, therefore, the activity is not a passive activity within the meaning of § 469(c).[12]

In this case, the memorandum concludes this activity is an excluded rental of real estate for purposes of determining self-employment income:

The net rental income from Fact Situation 2 is excluded from NESE under § 1402(a)(1) because the taxpayer does not provide substantial services beyond those required to maintain the space in a condition suitable for occupancy. See Bobo, 70 T.C. 706 at 710; Rev. Rul. 83-139. Services the taxpayer provides to clean and maintain the property to bring it to a suitable condition for occupancy are not relevant in applying Treas. Reg. § 1.1402(a)-4(c)(2) because such services are not furnished primarily for the convenience of the property's occupants. See Hopper, 94 T.C. at 547. Further, services provided for the convenience of occupants must be substantial, and whether provided services are substantial depends on the facts and circumstances of each case. See id. at 548. Specifically, the services provided for the convenience of the occupants must be of such a substantial nature that compensation for them can be said to constitute a material part of the payments made by the occupants. See id. at 546 (citing Delno, 347 F.2d at 166). No such services are provided in Fact Situation 2. The characterization of this activity as not a passive activity within the meaning of § 469(c) does not affect whether the activity is excluded from NESE under § 1402(a)(1).[13]

[1] Chief Counsel Advice 202151005, December 23, 2021, https://www.taxnotes.com/research/federal/irs-private-rulings/legal-memorandums/label-doesn%e2%80%99t-determine-rental-self-employment-tax-exclusion/7cqp3 (retrieved December 23, 2021)

[2] Chief Counsel Advice 202151005, December 23, 2021

[3] Chief Counsel Advice 202151005, December 23, 2021

[4] Chief Counsel Advice 202151005, December 23, 2021

[5] Chief Counsel Advice 202151005, December 23, 2021

[6] Chief Counsel Advice 202151005, December 23, 2021

[7] Net self-employment income

[8] Chief Counsel Advice 202151005, December 23, 2021

[9] Chief Counsel Advice 202151005, December 23, 2021

[10] Chief Counsel Advice 202151005, December 23, 2021

[11] Chief Counsel Advice 202151005, December 23, 2021

[12] Chief Counsel Advice 202151005, December 23, 2021

[13] Chief Counsel Advice 202151005, December 23, 2021