Typically, real estate investing is a passive activity. Profits are subject to income tax—not self employment tax. An active trade or business, on the other hand, is likely subject to the full 15.3% self-employment (SE) tax. Since a flipping or wholesaling business is considered an active business, house flippers may be subject to the full 15.3% self-employment tax, which can lead up to a $21,068 hit to your earnings. Same can be true for many Airbnb rentals.

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Not every flipper or Airbnb landlord will benefit from an S Corp election taxation. However, enough do that you should consider it as an option. Let’s take a closer look.

Why the IRS may see flipping as active income

Some real estate investors aren’t really investors (at least according to tax laws). They are property developers who renovate and rehab. In other words, they’re flippers. Profits from real estate flipping may be subject to both income tax and self-employment taxes. Flipping is an active business. That translates to ordinary income taxes at your marginal rate as well as self-employment tax and/or payroll taxes. This depends on how the deal is structured. Compare flipping to buy and hold investing, where investors are relying on passive income.

Just as with any other active trade or business, an S Corp election may be a good way to save self-employment (SE) taxes. There are a few things flippers should know about organizing and defending their real estate portfolios. Chief among these is how to construct an asset protection strategy that adequately defends against lawsuits:

• How frequently do you plan to make transactions? Many flippers will have a property bought and sold inside of a year, for example. Certain entities are better for frequent transactions.
• Licensing and other operations issues. A savvy house flipper may want to get a real estate license (or work with a team member who has one), even if doing so isn’t legally necessary. What’s best for you in terms of daily operations may come down to personal preference.
• What percentage of business is your flipping activity? If you are exclusively a flipper, you will almost certainly require a different approach than an investor with only minor flipping activity—or who doesn’t rely on flipping transactions for profit.

It’s vital that those engaged in active real estate flipping find a way to limit inherent liabilities. For many flippers, the LLC with S Corp election helps square both the issue of liability and how to formalize the flipping business.

Related: LLC vs. S Corporation: Which Is Better for Real Estate?

Airbnb rentals: substantial services can trigger SE taxes

If you are renting part of your home as an Airbnb for 14 days or less, you do not have to report or pay taxes on that income at all. Nice, right? Of course, you cannot deduct related expenses either. If you have Airbnb properties, you may have an active trade on your hands (rather than a passive real estate investing business).

Normally, income reported on Schedule C is subject to the SE tax, but that’s not always the case for rental properties. When your average stay is less than seven days, it is considered a business and not a rental activity, and is reported on Schedule C.

Schedule C is the tax form filed by most sole proprietors. As you can tell from its title, “Profit or Loss From Business,” it is used to report both income and losses. Many times, Schedule C filers are self-employed taxpayers who are just getting their businesses started.

If you are renting out a property using Airbnb or a similar service, and want to completely avoid the SE tax, then it is important not to provide substantial services to your guests. As long as you are simply renting out your Airbnb and providing no additional services, you will avoid the 15.3% self-employment tax, even if it is reported on Schedule C.

What are substantial services?

For a rental property to be subject to the self-employment tax, you would provide substantial services such as:

• Changing linens
• Providing fresh towels
• Cleaning the rooms during a guest’s stay
• Providing hotel-like conveniences such as a coffee maker and coffee
• Providing vehicles, bikes, or excursion options

This is because you are now providing a more hotel-like service, which is considered a business and subject to the self-employment tax.

Related: Airbnb Real Estate Investing: 6 Pros and Cons

What to do if you provide these services

Make sure you are properly tracking and deducting all your rental expenses, including depreciation. As we know, this “phantom expense” can cause a property to show a loss for tax purposes—or at the very least significantly reduce the net income. Next you should put your Airbnb properties in an S Corp, or an LLC taxed as an S Corp. This can split your income between W-2 wages, which are subject to the self-employment tax, and distributions, which are not.

Keep in mind that if you’re already earning $137,700 or more before your Airbnb income, you will only pay the 2.9% Medicare portion of the tax (1.45% for the employer and 1.45% for the employee, or 2.9% total) because the Social Security portion of the tax is capped on $137,700 of income.

Would you consider using an S Corp for your flipping or Airbnb business–why or why not?

Share with a comment below!