There has been longstanding debate about the extent to which landlordship constitutes “having a real job.” It’s a question about the nature of work and productivity: What are you providing to society? What are you producing for other people to use?
The purpose of this article is not to settle the debate, or even to take a specific stance on it. But there is a question that I think belongs in this debate, and I rarely see it mentioned. In fact, it might not be common knowledge. The question is as follows: If being a landlord is a “real job”, then why is not subject to self-employment tax?
The Internal Revenue Code loves landlords. Nowhere is this more evident than in the exception of rental income from self-employment tax. There are some misconceptions about this exclusion, which I will try to clear up here. We’ll also discuss the impact that that is exception may be having on our economy.
Self-Employment Exclusion
Self-employment income is taxed at 15.3 percent starting after the first $400. It is a common tax to which most earned income is subject, in one form or another. For example, W-2 employees pay in the form of Federal Insurance Contributions Act (FICA) tax.
Rental income is specifically excluded from the definition of “net earnings from self-employment” under IRC § 1402(a)(1). Behold the fine print of the Code:
There shall be excluded rentals from real estate and from personal property leased with the real estate . . . unless such rentals are received in the course of a trade or business as a real estate dealer . . .
This doesn’t necessarily cover all income which could be construed as being from a rental. For example, if you run a hotel or inn, or provide substantial services beyond merely the rental of the property, then you would struggle to meet the IRS definition of a “rental” according to CFR § 1.1402(a)-4, and your income may be subjected to self-employment tax after all. But this does not apply to most landlords.
Passive or Active?
There is a common misconception that “passive income” is not subject to self-employment tax, whereas “active income” is. While this is certainly the case in some areas of tax law, it is not the case with real estate rental income.
Rental income is always excluded from self-employment tax. This is true of landlords who actively participate in the business just the same as it is for landlords who passively earn real estate income. The income may qualify for the Qualified Business Income Deduction (QBID) or be recharacterized as active income (ala Real Estate Professional Status). Still not subject to self-employment tax.
The income may require as much organization, labor, and complexity as a typical business. The income may be earned by a sole proprietor, a partnership, or even a corporation. There could be one investor in the property, or one thousand. Still not subject to self-employment tax.
Whether passive or active, rental income is excluded from self-employment tax, which is a major tax benefit to landlords.
What About Self-Rentals?
A “self-rental” is a rental property which generates rental income at the expense of a closely held corporation. Under § 469(c), self-rental income may be recharacterized as active income against which passive activity losses may not be deducted. However, if the self-rental has a loss, then it remains as a passive activity loss.
Self-rentals are common when a shareholder of a corporation (especially S-Corporation) owns real estate, but does not want to face the potential future tax consequences of distributing the real estate back out of the corporation. So, the arrangement is often made that the corporation will pay a fair market rental rate to conduct business outside of the property.
Even in this arrangement, the rental income from the closely-held corporation is not subject to self-employment tax!
