Owning rental properties can be incredibly profitable, but the tax side of being a property owner can be confusing. Most property owners look for ways to lighten the tax load and maximize profits.
The short-term rental tax loophole is a popular tax break amongst rental property owners. This tax code provision might allow you to classify your rental income a little differently, allowing you to offset a portion of your rental income with other active income sources.
This guide explains how the short-term rental tax loophole works. It also outlines the rules and red flags to watch out for to leverage this strategy effectively.
What is the short-term rental tax loophole?
The Internal Revenue Code categorizes income and losses into passive and non-passive activities.
Under U.S. tax law, income and losses from rental properties are typically considered passive activities. This means you can generally only use rental losses to offset other passive income, not earned income like W-2 wages or business income.
Typically, you must qualify for real estate professional status (REPS) to avoid having rental income and losses deemed non-passive. However, achieving REPS status is impractical for many property owners, especially full-time working physicians, due to its time-intensive requirements.
However, short-term rentals (STRs) can bypass these passive activity rules under specific conditions, allowing owners to use rental losses to offset their earned income.
According to the tax code, there are several scenarios in which a rental property can qualify as a short-term rental:
- Average rental period. The average stay of guests is seven days or fewer.
- Shorter stays with services. The average stay of guests is 30 days or fewer, and the property owner or manager provides substantial services, similar to those a hotel offers. Personal services might include daily housekeeping, meals, vouchers for local attractions, or access to a vehicle.
- Extraordinary personal services. Providing exceptional personal services in connection with renting out the property allows the rental income to be considered non-passive, regardless of the average duration of guest stays. An example of extraordinary personal services might be a rental home with a private chef.
- Incidental rentals. A rental property in this category is secondary to the property owner’s non-rental activity. For example, say you own a vineyard that offers tours and wine tastings. Occasionally, you rent out a small guest house on the property. The rental income is non-passive since the short-term rental business is secondary to the vineyard operations.
- Business hours. This type of short-term rental is available for non-exclusive use by various customers during defined business hours. For example, say you own a property that can be rented as an event venue during regular business hours. Even if you have short-term renters staying on part of the property, you may still qualify for the short-term rental tax loophole because you aren’t renting the property exclusively to one customer.
- Partnership or S corporation. You can use the property for activities carried out by a partnership or S corporation in which you have an ownership interest without these activities being classified as rental activities. For example, suppose you are a partner in an S corporation and occasionally rent out a property you own to the business for company retreats or team-building activities. The rental fee is non-passive income since the property use is integral to the business operations (a non-rental activity).
- Material participation. If you meet any of the above exclusions, the last hoop to jump through is meeting material participation requirements. This involves actively managing the property beyond minimal involvement.
When you meet these criteria, the IRS treats your short-term rental activities as non-passive, and you can deduct losses from the rental against W-2 wages or active business income.
Grouping to meet material participation tests
Grouping rules allow you to combine rental properties with other business activities for tax purposes. This is useful when you need to meet material participation requirements or want to offset losses across activities.
There are a couple of ways to approach grouping. First, you can make an election to group two or more rental properties as a single activity, making it easier to meet material participation criteria.
For example, say you’re a medical professional who owns several short-term rental properties. Due to the time-intensive requirements, it’s impractical to try to qualify as a real estate professional or meet material participation requirements on any one property. However, grouping multiple rental properties into one activity might allow you to meet the material participation tests.
The second option is to combine a rental with an active business. For example, suppose you have one entity that owns real estate and an operating company that pays rent to the real estate entity. In that case, you may be able to group the short-term rental property with your business. This lets you use expenses from the real estate business to offset income from the operating entity.
Common deductions for short-term rental owners
Short-term rental property owners can benefit from several tax deductions, directly reducing taxable income. Some of the most common include:
- Mortgage interest paid on loans used to buy, build, or substantially improve the property
- Repairs and maintenance costs for fixing or maintaining the property, including supplies and contractor fees
- Utilities like electricity, internet, water
- Operating expenses like property management fees
- Travel expenses if you travel to inspect or manage the property
- Property taxes paid to state and local tax authorities
Depreciation: The key to minimizing taxable rental income
One of the most valuable tax deductions for real estate investors is depreciation. Depreciation lets property owners write off the cost of the structure over its useful life. According to IRS rules, residential rental property has a useful life of 27.5 years, while commercial rental property has a useful life of 39 years.
For example, say you own a home that qualifies as a short-term rental. The property’s purchase price was $300,000, but $50,000 of that is the value of the land. Land isn’t depreciable according to the tax code, so your depreciable basis is $250,000.
Each year, you can deduct $9,091 ($250,000 / 27.5 years) from your rental income to reduce your tax bill.
The value of depreciation is a non-cash expense. So even though you still have that $9,091 in cash profit each year, you don’t have to pay taxes on it.
Potential IRS red flags and how to avoid audits
The IRS tends to scrutinize tax strategies that significantly reduce taxable income. To avoid red flags, potential audits, and penalties when using the short-term rental tax loophole, make sure you follow these best practices:
- Document material participation. Maintain detailed records of the hours you spend managing the property and the tasks you perform. Examples include guest communication, cleaning, marketing, and maintenance. Many free and paid apps and software are available via search engines that can help you keep detailed records.
- Keep accurate financial records. Record all income, expenses, and deductions accurately and support your tax deductions with receipts and invoices.
- Understand personal use limits. If you use the property personally, make sure your personal use doesn’t exceed the IRS thresholds. The property is considered a personal residence if you use it for more than the greater of 14 days or 10% of the total days you rent it to others at a fair rental price during the tax year. Excessive personal use can disqualify the rental as a business activity.
- Avoid inflated expenses. Deduct only legitimate expenses directly tied to the property. Overstating deductions — especially often-abused write-offs like travel and meals — can attract IRS scrutiny.
- Work with professionals. Leveraging the short-term rental tax loophole is complex. Work with an experienced tax advisor to ensure you meet the material participation tests and other requirements.
Ready to maximize tax savings using the short-term rental tax loophole?
The short-term rental tax loophole is a valuable tool for real estate investors to offset earned income and reduce their tax burden, even if they can’t qualify for real estate professional status. However, all tax strategies require adhering to IRS rules and maintaining adequate documentation.Working with a knowledgeable tax expert can help you manage these details, ensure you’re staying compliant with the IRS and create a tax plan that fits your unique financial situation. Schedule a free Tax Discovery Session with Cerebral Tax Advisors to avoid costly mistakes and make sure you’re taking advantage of the best tax strategies available to you.