EN
ES
Cut Your Tax Bill with the Short-Term Rental Tax Loophole
The short-term rental business is known for its strong cash flow. This is why this income opportunity has attracted many real estate investors. Another major draw is the tax benefits, with the so-called "short-term rental loophole" being a popular tax reduction strategy.
Even if managing rentals isn’t your full-time job and you’re a W-2 employee, you may still qualify for some tax-saving opportunities.
This article explores how property owners can leverage the STR tax loophole to lower their taxable income—even while working a traditional job.
What is the Short-Term Rental Tax Loophole?
The name is a bit misleading, as "loophole" suggests illegal actions, which is not the case here. A short-term tax loophole is a special provision in the tax code that allows you to offset active income with passive losses from real estate.
Perhaps "tax incentive" is a better way to describe the nature of this strategy. It involves treating short-term rentals as active business income and using depreciation deductions to archive tax savings.
In this way, you can use tax write-offs to reduce overall taxable income. High-income earners often employ this strategy because being in a high tax bracket comes with high costs.
How exactly do property owners use the short-term rental tax loophole to achieve lower tax liability?
Leverage Rental Property Depreciation
To explain these tax savings, we first need to understand how depreciation works in this context. Every property depreciates over time, which means losing value due to wear and tear and aging of its structure, systems, and components.
The government will treat this as a loss on paper if the properties produce rental income, regardless of whether their market value is actually appreciating. The IRS allows you to deduct this loss over a set period of time: 27.5 years for residential property and 39 years for commercial property, at a standard rate per year. Keep in mind that you can't depreciate land, only improvements (all structures on the land like a house and garage).
The catch is that not everyone can take this depreciation and reap the benefits in the form of lowering tax liability.
Eventually, you could take these passive losses and offset them against your earned income, W-2 income, and other forms of active income (which is what the short-term rental tax loophole is about). However, for non-real estate professionals to do so, they must satisfy certain criteria.
Before jumping into these requirements, let's clarify one more thing.
How Can Rental Income Become Non-Passive in the Eyes of the IRS?
Not going too much into history, the Tax Reform Act of 1986 changed the way taxes worked for real estate and short-term rental properties. Before that, income was treated as one; since this point in time, it has been divided into two brackets: passive and non-passive.
Rental income is considered passive income, while all income earned through work, such as W-2 wages and 1099 income, is considered non-passive. The problem is that normally, you can't write off passive losses against active income to reduce the tax burden. To do so, a person needs to have a real estate professional status or, alternatively, use a short-term rental tax loophole to make passive losses classified in the active income category.
Tax Benefits of Being in the Real Estate Business
Expenses in real estate can be depreciable, deductible, and deferrable. In short-term rentals, you can also lower your tax bill through deductible expenses like:
- Mortgage interest
- Insurance premiums
- Furniture, decor, and appliances
- Guest supplies
- Marketing and advertising
- Utilities
- Cleaning fees or supplies
- Airbnb management software subscription fees
- Property maintenance
- Fixes and repairs
- Property management fees
When you offset your rental passive losses against your active income using this loophole strategy, remember that the IRS considers you haven't entirely written them off but have deferred paying taxes to future periods, most likely upon selling the property (at a lower rate, though). Read until the end to learn about depreciation recapture.
Who Can Take Advantage of This Short-Term Rental Loophole Strategy?
Two kinds of people can benefit from the STR loophole strategy: real estate professionals and short-term rental hosts when meeting set criteria.
Real Estate Professionals
The Real Estate Professional Status (REPS) exception to the rule of non-passive income was created to allow real estate investors to use losses from rental properties against their active income. REPs can offset active income with passive losses with no problem.
Who are REPs? Real estate agents, brokers, developers, investors, and contractors in real estate, like those fixing and remodeling houses. The criteria are mainly spending 750 hours on real estate services during the year. This is why people with W2 jobs hardly ever could satisfy this requirement, as it is simply not feasible.
STR Hosts Eligible for Short-term Rental Tax Loophole
The "loophole" involves treating short-term rental operations as a service business. Essentially, STR is treated more like a hospitality business than a residential property. When you run STRs, you run an active business. This is how passive losses can change the category to reduce taxable earned income.
In reality, you need to put in significant work in an Airbnb business: handling guests, cleaning, setting up the property, and taking care of maintenance. Simply showing up to the IRS and saying, "Hey, I'm an Airbnb host; I want my tax deductions," - it won't work. You need to provide proof that you're actively involved in these activities, to have "a skin in the game."
How Do You Qualify for the Benefits of a Short-Term Rental Tax Loophole?
Property owners need to meet two criteria to reclassify their rental income as non-passive. One is to meet one of the six IRS exclusions from the definition of rental activity, and the other is to prove material participation in the property.
The Seven Days Rule or The 30-Day Exception
The income from your short-term rental has to be excluded from the definition of rental activity outlined by the IRS (IRS Publication 925).
If you meet any of these exclusions listed, you passed the first step toward the STR tax loophole:
- The average period of customer use of the property is 7 days or less. You figure the average period of customer use by dividing the total number of days in all rental periods by the number of rentals during the tax year.
- The average period of customer use of the property, as figured in (1) above, is 30 days or less and you provide significant personal services with the rentals. Significant personal services include only services performed by individuals.
- You provide extraordinary personal services in making the rental property available for customer use.
- The rental is incidental to a nonrental activity.
- You customarily make the rental property available during defined business hours for nonexclusive use by various customers.
- You provide the property for use in a nonrental activity in your capacity as an owner of an interest in the partnership, S corporation, or joint venture conducting that activity.
The most important are the numbers one and two. STR is established when the average guest stay is 7 days or less. Also, a host needs to perform significant services, which just means providing essential guest services like check-in assistance, cleaning between stays, property maintenance, and other hospitality-related tasks.
The Material Participation Test
The next step is to prove you spend your time actively self-managing your STR property. To materially participate means to be an active host who does the work, in laymen's terms.
The first three criteria are the most common scenario:
- You spent more than 500 hours on the short-term rental business.
- Your participation was substantially all the participation in the activity of all individuals in that tax year (this includes the participation of individuals who didn’t own any interest).
- You participated in the activity for more than 100 hours during the tax year, AND you participated more than any other individual (including individuals who didn’t own any interest) for the year.
- The activity is a significant participation activity (any trade or business activity in which you participated for >100 hours during the year and in which you didn’t materially participate under any of the material participation tests), and you participated in all significant participation activities combined for more than 500 hours.
- You materially participated in the activity (other than by meeting this fifth test) for any 5 (do not have to be consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity (non-income-producing) for three (doesn’t have to be consecutive) of the previous taxable years
- You can say that you participated in the activity on a regular, continuous, and substantial basis for more than 100 hours during the year (see IRS guidelines for relevant exclusions)
Most commonly, you either need to do all the work (No. 2), spend more than 500 hours managing your portfolio (No. 1), or spend 100 hours and more than anyone else involved in the management (cleaners, repairmen, criteria No. 3). In case of No. 3 pay attention that you cannot have anyone working in the business spending more time than you.
How to Prove Material Participation to the IRS
Material participation includes substantial activities like developing or improving the property, construction activity, operating the asset, and actively managing the property or the short-term rental business: handling guests, cleaning, and repairing.
You need to prove:
- Active involvement on a regular basis and the amount of work you do
- Type of work you do daily
Your participation in an activity includes your spouse’s participation (even if your spouse didn’t have any interest in the activity).
The way to prove material participation is by keeping track of all the work done on the management of your property and using time-tracking software. Sometimes, you can establish your participation in some other way. For example, you can show the services you performed and the approximate number of hours spent. Contact your CPA to help you understand the best way to prove participation.
Tax Strategies for Reducing Taxable Income
Depreciation is a powerful tool in the hands of real estate professionals. Here are some strategies you can use to accelerate depreciation for tax purposes.
Cost Segregation Study
Do you know that you can accelerate the appreciation by doing a cost segregation study? Cost segregation allows you to depreciate different building components at faster rates than the standard 27.5 years (residential) or 39 years (commercial).
Real estate professionals commonly use this strategy of breaking down a building into its individual components and depreciating each separately. Different components qualify for different depreciation periods: 5, 7, or 15 years, based on their typical lifespan. For instance, appliances depreciate over 5 years, utilities and electrical systems over 7 years, and landscaping and sidewalks over 15 years.
Why would you do that?
- Accelerated tax deductions - Instead of waiting 27.5/39 years, you can claim larger deductions sooner
- Improved cash flow - Faster depreciation means lower taxable income in early years
- Higher tax savings - Money saved today is worth more than money saved years from now
This is also true for bonus appreciation:
Bonus Depreciation
Another way to accelerate depreciation is by applying for bonus depreciation.
Tax Cuts and Job Acts in 2017 passed this law that you can write off depreciation in year one. Instead of depreciating a property gradually, you frontload the depreciation and immediately deduct a large portion of the property sales price.
It's the government's incentive to stimulate the economy, but currently, bonus depreciation is scheduled to phase out by 2027. The best time was by 2022 when you could deduct 100% of depreciation paper losses.
100% in 2022: You deduct 100% right away.
80% in 2023: You deduct 80% right away.
60% in 2024: You deduct 60% right away.
40% in 2025: You deduct 40% immediately.
20% in 2026: You deduct 20% immediately.
0% in 2027: No immediate deductions.
In 2027, it will be over with bonus appreciation, at least for now (it could be extended or reintroduced sometime in the future).
Is the STR Tax Loophole Ending in the Future?
No, it is not. The bonus depreciation is phasing out, which only means you won’t be able to deduct depreciation losses upfront (unless the government extends or reintroduces the bonus later). However, you can still take a normal depreciation deduction at the standard yearly rate. In short, the STR tax loophole isn’t going away.
Word of Caution
Let's address a few possible pitfalls you should be aware of before continuing with this strategy.
Depreciation Recapture
A STR tax loophole, cost segregation study, and bonus depreciation are strategies to deduct passive losses, but they have a few caveats. If you decide to sell the property, you may become subject to paying depreciation recapture. At this point, it's about a 25% capture rate.
One way to get around depreciation recapture (if you still need to sell the property) is to use a 1031 exchange, which allows you to defer capital gains taxes by reinvesting the proceeds into like-kind property. Real estate investors use this method a lot.
No Property Manager Can Be Involved
An STR tax loophole is a strategy for self-managing hosts who are also property owners. Hiring a property manager would prevent you from passing the material participation test and, therefore, cannot be eligible for the tax incentive.
Track the Time of Your Vendors to Pass Material Participation Tests
When you apply for the material participation test, one of the most common criteria for W-2 workers to meet is participating in the activity for more than 100 hours during the tax year and more than any other individual involved in hosting, such as cleaners and vendors. Make sure you track not only your participation time but also your vendors' time.
Comply with Local STR Rules
Being a short-term rental host means operating in an area where local regulations and zoning laws permit it. Check whether you need a special permit or if local rules restrict your ability to run an Airbnb business, such as allowing rentals only for properties you live in.
State Tax Implications
The strategies we’re discussing apply to federal taxes, but you still need to check whether state laws align with federal rules. Issues may arise if your property is in another state and you must file multiple state tax returns. Since you need to prove material participation, it’s generally better if your vacation rental property is closer to you.
How Does This All Come Together?
The short-term rental tax loophole is a valuable strategy for property owners who are actively managing their rentals to reduce their tax liability. By meeting the IRS criteria, hosts can classify rental income as non-passive, allowing them to offset active income (such as from their W-2 job) with depreciation and other deductions.
Property owners can accelerate their tax savings even further with cost segregation and bonus depreciation (as long as this bonus rule doesn't phase out). However, proper documentation and compliance are key. Consulting a CPA will help you maximize benefits while staying within IRS guidelines. Don't skip this, because the IRS is watching you.
Did you know you can step up your game as an STR host even if you're self-managing your property?
iGMS is a tool for Airbnb and short-term rental hosts that automates much of the manual work from guest messages to channel manager synchronizing bookings across platforms. It will be your ally while doing the material participation test and jumping all the hoops to get these tax deductions and reduce your tax burden.
About the Author
Zorica Milinkovic is a B2B SaaS writer who is passionate about psychology, marketing, and, when inspiration strikes, cooking. You can find her on LinkedIn.
