Schedule E or C? – Tax Smart Real Estate Investors (2024)

Investors and tax practitioners often ask us to weigh in on whether a short-term rental should be reported on Schedule E or C.

Schedule E is where you report rental activities and Schedule C is where you report trades or businesses subject to self-employment taxes.

Getting to the bottom of this question is not easy as the rules governing short-term rentals are complex and sometimes not as clear as we’d like them to be.

In this article, we’ll explore Sections 469 and 1402. We’ll show you that you can gain some clarity rather quickly as to how to report your short-term rentals.

We feel it’s important to add a disclaimer that you should always get your situation reviewed by a qualified tax professional. There may be other issues at play, such as the vacation rental rules or hobby loss rules, that impact your reporting.

The Section 469 Exception

While most rentals generate a tax loss even when they are cash flow positive (thanks to depreciation), the tax loss is “passive” because, under IRC Sec. 469, all rentals are passive by default unless the taxpayer qualifies as a real estate professional and materially participates in the rental activity.

Sec. 469 also says passive losses can only offset passive income. Excess passive losses are suspended and carried forward which creates issues for landlords in acquisition mode as depreciation deductions often create large tax losses in the early years of ownership.

Ideally, the landlord is able to recharacterize the losses as non-passive so that they can offset the landlord’s regular income, like W-2 and business income. Non-passive income is not subject to limitations described under Sec. 469.

As mentioned, one way to achieve this non-passive status is to qualify as a real estate professional.

Another way, however, is to own a short-term rental.

Short-term rentals are granted an exception to the definition of a “rental activity” under Sec. 469. This is a good thing for landlords who can materially participate in their rental activity but can’t meet the strenuous tests to qualify as a real estate professional.

(ii) Exceptions. For purposes of this paragraph (e)(3), an activity involving the use of tangible property is not a rental activity for a taxable year if for such taxable year –
See Also
Understanding the Difference Between Schedule C and Schedule E: A Comprehensive Guide by SRG Advisors LLC Schedule C vs Schedule E For Rental Property – Landlord Studio What Is Schedule C? Who Can File and How to File for Taxes Schedule E Explained
–(A) The average period of customer use for such property is seven days or less;
–(B) The average period of customer use for such property is 30 days or less, and significant personal services (within the meaning of paragraph (e)(3)(iv) of this section) are provided by or on behalf of the owner of the property in connection with making the property available for use by customers;
Treas. Reg. Sec. 1.469-1T(e)(3)

If a short-term rental meets one of the two tests above, then the activity is not a “rental activity” under Sec. 469 and is not by default passive. This means the landlord does not need to qualify as a real estate professional to overcome the default rule that all rentals are passive.

The landlord just needs to materially participate in the rental activity.

Material Participation in a Short-Term Rental

In order to materially participate in an activity, you must participate on a regular, continuous, and substantial basis and meet one of the seven material participation tests described in the Treasury Regulations.

The two easiest tests to demonstrate material participation are:

(2) The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
Treas. Reg. Sec. 1.469-5T(a)

If a landlord self-manages their rental and performs all the work, they’ll likely meet test #2 in that their participation is substantially all of the participation in the activity.

However, most short-term rental owners hire cleaners to help turn units in between guests. The cleaner’s time will count against a landlord for test #2.

For example, if a landlord spends 50 hours on the rental during the year and cleaners spend 30 hours, the IRS will argue that the landlord’s time is not substantially all of the participation. That’s when you look to test #3: spending 100 hours on the rental and more than anyone else.

If a landlord cannot meet one of the two tests above, they can explore the other five tests in Treas. Regs. Sec. 1.469-5T(a).

Example

You buy a $900,000 beach home and begin renting it out to tenants. Your stays average 7 days or less throughout the year which means you do not have a “rental activity” due to the exception in Treas. Reg. Sec. 1.469-1T(e)(3)(ii)(A). You also self-managed the activity, minus the cleaning crew, and you logged well over 100 hours and more than anyone else. Thus, you materially participated in the activity.

Your short-term rental activity is non-passive as a result. You hire out a cost segregation study and the study indicates that you are able to claim $180,000 of first-year bonus depreciation. This creates a large, non-passive, tax loss that you use to offset your W-2 and/or business income.

Ultimately, materially participating in the short-term rental saves you $60,000+ in taxes in the year of acquisition.

Where Tax Pros Make Mistakes

Many tax professionals think that because a short-term rental is not a “rental activity” under Sec. 469, due to the exception described above, it must be reported on Schedule C as a trade or business.

This can’t be further from the truth.

Just because a rental activity is not a Sec. 469 rental activity doesn’t mean that it trips the self-employment tax rules under IRC Sec. 1402.

It also doesn’t mean that the short-term rental activity can’t be reported on Schedule E.

A simple way to challenge a tax professional who claims a short-term rental is subject to Schedule C reporting is to ask them how Sec. 1402 applies. We discuss this below.

Schedule C vs. E

In general, landlords want short-term rentals reported on Schedule E. This is because reporting on Schedule C will subject the net rental income to self-employment taxes in years of positive income.

You may think it’s not a big deal because after accounting for depreciation, rentals produce tax losses. But short-term rentals can surprise you and produce taxable income even after depreciation.

To determine whether a short-term rental is reported on Schedule C or E, we ask: did the landlord provide services to the tenants that trip Sec. 1402?

If the answer is yes, report the short-term rental on Schedule C. If no, Schedule E.

The services that trip Sec. 1402 are not the same as the “significant personal services” described in Treas. Reg. Sec. 1.469-1(T)(e)(3)(ii)(B) above (see “The Section 469 Exception” paragraph above).

We’ve pasted below what services do trip Sec. 1402:

(2) Services rendered for occupants. Payments for the use or occupancy of rooms or other space where services are also rendered to the occupant, such as for the use or occupancy of rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, or payments for the use or occupancy of space in parking lots, warehouses, or storage garages, do not constitute rentals from real estate; consequently, such payments 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. The supplying of maid service, for example, constitutes such service; whereas the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, the collection of trash, and so forth, are not considered as services rendered to the occupant.
Treas. Reg. Sec. 1.1402(a)-4(c)

If you provide services “primarily for the convenience” of your tenants other than those that are customarily rendered in connection with renting rooms, then you have a Sec. 1402 activity.

And if you have a Sec. 1402 activity, the rental is reported on Schedule C and the income is subject to self-employment taxes.

What are services “primarily for the convenience” of your tenants?

Piecing together Tax Court cases shows the following:

Room service
Making beds
Furnishing linens and towels
Providing laundry service
Preparing and serving meals
Sweeping and mopping floors
Dusting and cleaning
Washing dishes
Cleaning bathroom fixtures
Emptying trashcans (in room)
Replacing scattered or misplaced articles

If you don’t provide these services to your guests while they stay at your property, then you likely have a reasonable basis to report your short-term rental on Schedule E. This is true even if your short-term rental is not a “rental activity” thanks to the Sec. 469 exception.

Takeaways

Owners of short-term rentals are afforded a special exception to the Sec. 469 definition of a “rental activity” which means that these landlords don’t need to qualify as a real estate professional to have a non-passive activity. They still need to materially participate.

This is good news for taxpayers who will have difficulty meeting the strenuous real estate professional tests. Taxpayers will full-time jobs can still benefit from bonus depreciation if they own short-term rentals.

Many tax professionals mess up the reporting of short-term rentals, mainly in that they think the rentals should be reported on Schedule C. This is generally only true when the landlord provides services as described in Treas. Reg. Sec. 1.1402(a)-4(c).

In our experience, most short-term rental owners do not provide the services described in Treas. Reg. Sec. 1.1402(a)-4(c) and have a Schedule E rental activity, even though it’s not a “rental activity” under Sec. 469.