The short-term rental tax loophole is a powerful tax strategy trusted by CPA’s for real estate investors to reduce taxable rental income by using property-related losses to offset their earned income.

This article breaks down the basics of how to take advantage of the short-term rental loophole, and what a strategic approach to short-term rental taxes looks like.

Let’s dive into the STR tax strategy.

What is the Short-Term Rental Tax Loophole?

The short-term rental loophole has saved people thousands of dollars a year in taxes because it doesn’t require you to be a real estate professional. It can be found in the tax code under Reg. Section 1.469-1T(e)(3)(ii)(A), and defines exceptions to the definition of “rental activity”.

Straight from the tax code, here are the six ways in which income for a rental property can be excluded from the definition of a rental activity, and thus not automatically passive:

1. The average period of customer use for such property is seven days or less.
2. The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers. This could include services like a hotel would provide, such as daily cleaning or meals.
3. Extraordinary personal services (same as above) are provided by or on behalf of the owner of the property in connection with making such property available for use by customers (without regard to the average period of customer use).
4. The rental of such property is treated as incidental to a non-rental activity of the taxpayer.
5. The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers.
6. The provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not a rental activity.

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The History of Short-Term Rental Tax Loophole

Back in the 1980s, the Tax Reform Act of 1986 was passed. It was a top priority during President Reagan’s second term and served to decrease federal income tax rates in certain tax brackets. It also changed the way taxes worked for short-term rental properties.

Prior to this Act, individuals could take losses for rental properties against active income without any caveats. There was no such thing as passive activities, only business activities. Controversy existed around this as it applied to highly paid professionals, specifically doctors and attorneys, but the allowance applied across the board.

Here’s why people cared:

These highly paid professionals would buy a rental property, depreciate that property, then take the losses against their high income. Through lobbying and various initiatives, The Tax Reform Act introduced Section 469 of the tax code, which is the Passive Activity Rules. When Section 469 and the associated regulations were crafted, their primary aim was to prevent investors from using rental properties as tax shelters to significantly reduce their tax liabilities. These rules made all rental properties passive by default. At that point, there was no way to make rental properties non-passive.

Through additional rounds of lobbying, especially from the real estate industry, a new law was passed in the mid-1990s called the Real Estate Professional Status (REPS) exception. Real property trades or business owners were then allowed to use losses from rental properties, classified as non-passive. To qualify as a Real Estate Professional, you must work 750 hours and more than your total working time in real property trades or businesses.

Material Participation Tests for the Short-Term Rental Tax Loophole

We mentioned before that earning a real estate professional status is one way to turn losses on rental properties.

However, this isn’t typically an option for highly paid professionals like doctors or lawyers, because they don’t have half of their working time to work in a real estate business. The good news is that the short-term rental tax loophole can help and doesn’t require real estate professional status.

The exceptions to the definition of rental activities in the tax code listed above can also turn losses non-passive if you, the short-term real estate investor, meet one of seven material participation criteria. These tests will determine whether you qualify based on your use of and involvement in your short-term rental property.

Here’s the material participation criteria:

1. Spend more than 500 hours on the short-term rental business
2. Do substantially everything for the STR business
3. Spend more than 100 hours on the activity and no one other individual spends more time than you do
4. Significant participation activity for more than 100 hours, and your combined activity in all significant participation activities exceeds 500 hours
5. Participating in the business for five of the 10 previous taxable years
6. Personal service activity (non-income-producing) for three of the previous taxable years
7. Regular, continuous, provable participation in the business for more than 100 hours

The first three are the ones the majority of short-term real estate investors qualify for.

Once you meet one of these tests, and your short-term rental is excluded from the definition of a rental activity, then it is considered non-passive.

STR Income and Non-Passive Losses

The goal of ticking these boxes is to use your short-term rental for non-passive losses. This is what you want because non-passive losses can offset non-passive income. If you can meet the criteria, your short-term rental will save you money on taxes and maximize your losses.

That’s the first big component of a short-term rental tax strategy. The second is depreciation.

Depreciation for Your Short-Term Rental Tax Strategy

If you get a savvy real estate CPA, they’re going to lead you through leveraging depreciation for your short-term rental.

Here’s what they will help guide you on:

• Having a cost segregation study on your property
• That cost segregation will reclassify certain components of your property from 39 39-year life (depreciation life for an STR property) into 5 and 15-year life. This is for tangible personal property, land improvement property, and qualified improvement property.

Here’s why this is powerful:

5 and 15-year property can generally represent anywhere from 20-30% of a property’s purchase price.

Example: if you had a $1 million dollar property and did a cost segregation structure, anywhere from 20-30% could be resegregated and fully depreciated. This would give you a $250,000 deduction.

This is powerful because your losses are non-passive, and that tax loss can be used to offset taxes on your W-2 income.

What’s Changing About Depreciation for Short-Term Rentals?

2022 was the last year of 100% bonus depreciation. It is currently slated for a phased-out approach.

This is what to expect:

• In 2025, it will drop down to 40%.

The $250k deduction would become $100k. 

• In 2026, it will drop down to 20%.

The $250k deduction would become $50k.

• In 2027, it will disappear completely.

It may be changed and extended, but this was the plan

To be clear: The short-term rental depreciation loophole itself is not on the chopping block and may never be on the chopping block. However, thanks to Trump’s Big Beautiful Bill — 100% Bonus Depreciation is back and Law Again. You can depreciate your property at 5 or 15 years instead of 39 years, which still represents an opportunity for savings.

A comprehensive short-term rental tax strategy is still the best way to get maximum benefits from short-term rental investments.

Why It’s Considered a Loophole

Investors often ask, “Why is the STR loophole called a ‘loophole’ if it can be found in the regulations, IRS publications, and upheld in several tax court cases?”

The term “loophole” has caught on within the STR and real estate communities, but it stems from the original intent of the regulations and the context in which they were written.

The STR exception is considered a loophole because, at the time the code and regulations were written, they were intended for hotels and motels. The writers of these regulations likely couldn’t foresee the proliferation of platforms like Airbnb and VRBO, which have created a vast marketplace for short-term rentals that can be managed remotely and booked easily by users from their smartphones. This unforeseen usage is what makes the STR exception a loophole in the eyes of many.

Common Short-Term Rental Loophole Mistakes

Jumping into the short-term rental (STR) market can be a lucrative venture, but it’s not without its pitfalls. 

Here are the most common mistakes and how to avoid them:

Mistake #1: Misclassifying Your Property as a Short-Term Rental

• How to Avoid It:
  • Ensure your property has an average stay of 7.0 or less for the year.
  • Ensure your rental provides substantial services to meet STR criteria when using the 30-day or less exception.

Mistake #2: Misunderstanding the “Less Than 7 Days” Rule

Another common error is misunderstanding the “less than 7 days” rule. Some investors think they can achieve this by having one tenant sign multiple short leases. Extensions to an existing stay are counted as part of the original period.

• How to Avoid It:
  • Track each tenant’s use periods accurately.
  • Avoid manipulating lease agreements to fit the rule; instead, aim for genuine short-term stays.

Mistake #3: Ignoring Personal Use Days

If you use the property for more than 14 days or 10% of the total rental days, it’s considered a personal residence. This means you can’t claim tax losses associated with personal residences, affecting your overall tax strategy. The good news is that if you’re staying at your property to perform repairs or maintenance on a “substantially” full-time basis, it is not considered a personal use day, even if others are at the property.

• How to Avoid It:
  • Keep meticulous records of personal use days versus rental days.
  • Refrain from using your STR for personal purposes beyond the allowed limit.
  • Make strategic use of repair and maintenance days that are not classified as personal use days.

Mistake #4: Failing to Track Contractor Hours for the “100 Hour” Test

The most popular form of material participation requires you to work at least 100 hours on your property and spend more time on it than anyone else. Many investors fail to track contractors’ and cleaners’ hours, which can undermine their claim of material participation if audited by the IRS.

• How to Avoid It:
  • Maintain detailed logs of your hours and any contractor and cleaners’ hours spent on the property.
  • Use property management software to help track and document these hours.

Mistake #5: Overlooking Local Regulations

Many local governments have started imposing strict regulations or even bans on short-term rentals, especially in residential neighborhoods.

• How to Avoid It:
  • Research local STR regulations thoroughly before investing.
  • Stay updated on any changes in local laws that could affect your rental.
  • Consider underwriting properties and mid-term and long-term rentals in case unforeseen regulations prevent you from renting out your property.

Will the STR Loophole Be Closed?

Some investors believe this opportunity is too good to be true and that eventually this “loophole” will be closed. Let’s delve into the current landscape and future possibilities.

It appears unlikely that changes to the Internal Revenue Code or associated regulations will come directly through legislation. While we can never be too sure what the future holds, there has been no mention of such changes in recently proposed legislation at the time of this writing.

The original purpose of these regulations, which are intended for hotels, combined with the complexity and political maneuvering required to enact such changes, makes it improbable in the near term.

Can You Use It on a Foreign Property?

1. Material Participation: You must be actively involved in the rental activity. This means you have to engage in the operations of the activity on a regular, continuous, and substantial basis. The IRS has several tests to determine material participation, such as spending more than 500 hours on the activity during the year.
2. Substantial Services: If the average rental period is between 7 and 30 days, you must provide substantial services to qualify for non-passive treatment. Substantial services could include daily cleaning, providing meals, or offering concierge services.
3. Tax Reporting: Rental income from a foreign property must be reported on your U.S. tax return. You will need to convert the rental income and expenses from foreign currency to U.S. dollars.

But, the Caveat: No Bonus Depreciation

One significant caveat to using the Short-Term Rental Loophole on a foreign property is that you cannot use bonus depreciation.

The U.S. tax code restricts the use of bonus depreciation to property predominantly used within the United States. Instead, you must use the Alternative Depreciation System (ADS), which spreads the depreciation deductions over a longer period, significantly weakening the strategy.

Tax Strategies for Short-Term Rentals

As you can see, investing in short-term rentals can be an incredibly effective way to save money on your taxes. Getting into the game with Airbnb or similar platforms, and expanding your earning potential by accumulating additional properties, is a tactic used by high-net-worth individuals nationwide.

It does require tactical know-how and an understanding of the tax code. It also requires the help of a team, specifically a real estate CPA, a lawyer, and some administrative assistance, cleaners, and more.

While there is a learning curve and a few tips to get started, if you really want to, you can be looking at major savings on your tax bill by investing in short-term rentals.

Partner with our team for this game-changing strategy. Schedule a Free Consultation.

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