Is Rental Income Subject to Self-Employment Tax?

Posted by Mckenna Duncan on Aug 5, 2022

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Even Albert Einstein struggled to understand the intricacies of income taxes, famously stating, “The hardest thing in the world to understand is the income tax.”

For many people, taxes may be mysterious but don't require too much individual effort. The company they work for withholds what they need, and an accountant settles up in April. However, it seems more complex for investors to ensure that everything is accounted for and properly categorized.

What Is Self-Employment Tax?

Self-employment income is what people earn when they work for themselves. Self-employment taxes consist of Social Security and Medicare taxes that would be withheld on their behalf if that person was being paid by an employer but must instead pay on their own. Self-employed individuals calculate the amounts using Schedule SE with form 1040 or 1040-SR. Plus, these taxpayers can deduct the employer-equivalent portion of the tax from their adjusted gross income since self-employed persons pay the employer and employee shares.

The tax rate is 12.4 percent of income for Social Security benefits and 2.9 percent for Medicare. The Medicare portion is effective for all income, but the Social Security contribution is limited to earnings up to $147,000 for 2022.

What Is Self-Employment Income?

Self-employment is typically defined as operating a business, being a sole proprietor, or working as an independent contractor. Good examples include people who run service companies like consultants and accountants, and those who offer products for sale, either through a retail operation or online. Earning income from passive activities like rental properties is generally not considered self-employment, and the investor usually doesn’t have to pay a self-employment tax. Instead, landlords will often track their rental income and expenses on a Schedule D, transferring the results to their 1040 for inclusion in overall income.

There are some exceptions that would likely affect the determination of whether rental income is self-employment. For example, suppose the landlord is providing services to the tenant that go beyond housing. Perhaps the landlord runs a dog walking service for their tenants or offers cleaning on a scheduled basis. These additional services may change the nature of the income from passive to active and require the calculation of self-employment taxes. Also, individuals who work in the real estate profession full-time, like brokers, must report their earnings as self-employment and include rental income in the total. For this definition, the individual must work at least 750 hours annually in real estate and devote at least half their work time to related activities.

What about Short-Term Rentals?

This question is increasingly asked concerning short-term rentals that operate more like hospitality companies. If property owners are engaged in offering units for short stays and providing services to the visitors, they may cross the line between occupancy and hospitality. For example, a traditional bed and breakfast operation is likely considered hospitality. However, a room rented on a platform like VRBO may still be a rental if the owner doesn't offer any “hotel” amenities. The rules may be in flux as the industry evolves, and taxpayers should consult their advisors about the specifics of their situation.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.

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