When you work for a wage you trade your time and talent for money. This is traditional earned income and you must pay income tax on that money. Taken from http://www.taxbraix.com/
Earned income is the most taxed form of income. With personal tax rates ranging from 10% to 35%, this amount can easily add up. Earned income is also subject to other taxes as well, such as social security and Medicare taxes, which are 12.4% (half paid by employer) and 1.45%. Therefore, earned income can be taxed at almost a rate of 50%!
When you collect traditional rent, this type of income is called "passive income" because you don't trade time for the money you get. It's less work to get the money, but it's a bigger investment on the outset to buy the house to then rent it, and it's a bigger risk since at any time things in a house can break. Repairs cost money.
You still must pay income tax on passive income, but you don't have to pay certain other taxes (social security, Medicare, etc.) on it. However, the real benefit of passive income is that you can deduct reasonable and direct expenses from your profit.
We are sort of in the middle as Airbnb.com hosts who own our home. On the active side: we use hours of our time to prepare our house for guests, clean the house, respond to guests, and manage the listing. On the passive side: we own the home and collect rent for the use of rooms.
With the help of our accountant we decided that defining our business properly would be a good idea. We are essentially running a Hospitality business much like a hotel. We have the ability to offset our income with expenses directly involved with running the business.
Here's a list of things that could be deducted and things that can't be (for more info, see this article: http://www.wsrp.com/the-irs-simplifies-repair-regulations-for-small-businesses/):
- Supplies for guests
- Expenses for repairs and maintenance
- Utilities for the percentage of time guests are using the house exclusively
- Insurance premiums for your business
- Personal supplies
- Utilities for the percentage of time you are personally using your house
Keep for later:
Records of improvements (substantial permanent purchases) to your home (as long as you're not using it solely as a business.) These costs add up and can reduce the tax you pay on home sale profit later. But that's a whole other topic that I'd love to cover in another article :)
Other Tax Topics:
In some places (Pennsylvania is one of them) an Airbnb host has to pay Hotel Occupancy Tax. This used to be a big fear for hosts here in PA and a huge frustration for the government, but Airbnb fixed the problem by charging guests the tax upon booking and submitting the tax directly to PA.
At tax time, Airbnb may or may not send hosts a 1099 for reporting income. It depends on a lot of factors, mostly the amount of money and bookings you've made in the year. Now, just because you don't receive a 1099 doesn't mean that you don't have to report any of your earnings, but it's likely that you can offset your income with a lot of business related expenses. So, by the time you're done computing how much actual profit you made, it might not amount to very much that's taxable.