Let me start by clarifying a common misconception.
Is the short-term rental tax loophole really a loophole/gap/ambiguity in the tax law?
Not at all. It is labeled as a “loophole”, but it is not a loophole at all—it is a legitimate/lawful component of tax law that can help real estate owners save tax.
The Short-Term Rental Tax Loophole is a strategy that allows property owners to reduce their taxable income from short-term rental activities. This strategy is based on existing IRS tax codes, not actual illegal loopholes.
So, what exactly is this rule? How can someone practically use it to get legal tax benefits? What terms and conditions must be met?
Keep reading to find out!
Do You Know the Backstory of STR Tax Loophole?
Have you ever heard of Section 469 of the federal tax code? No?
The Tax Reform Act presented Section 469 back in January 1987 to shed light on passive activity rules. These regulations declared all the rental properties ‘passive’ by default.
However, soon in the mid-1990s, a new set of laws called the Real Estate Professional Status (REPS) exception was introduced due to involvement from the real estate industry.
These regulations allowed a few rental incomes to be ‘non-passive’ under some circumstances.
The Short-term Rental Tax Loophole is a set of rules that came out after the new revision to provide tax-related benefits to those who don’t qualify as Real Estate Professionals (REPS).
What Is Short-term Rental Tax Loophole?
The Short-Term Rental Tax Loophole is a scale to differentiate between passive and non-passive incomes real estate owners generate from their properties.
And suppose your rental activity comes out to be non-passive and meets the set criteria of this loophole. In such a case, it allows favorable tax treatment for your income.
To utilize the perks and benefits of this rule, you must meet the following criteria:
- Your rental activity/income should be non-passive
- You pass the material participation test
But how do you know that your income is non-passive? And/or did you pass the material participation test? I have mentioned the standards for both here:
Criteria for Your Rental Income to be Non-Passive
For the income your properties generate to be non-passive, it must meet any of the following exception criteria defined by the Internal Revenue Service (IRS) tax law:
Short Stays
If guests stay for an average of 7 days or less.
Short Stays with Extra Services
If guests stay for 30 days or less, and you provide extra services like daily cleaning, meals, or transportation. These services make the rental more like a hotel business.
You Provide Extraordinary Personal Services
If you offer extraordinary services beyond just a place to stay. For example, if you provide a private chef, guided tours, or spa treatments.
The Rental is Incidental to a Non Rental Activity
If your rental property is secondary to another business/not the main focus of your business.
For example, if you own a vineyard and occasionally rent out a guesthouse, the rental is just a small part of your main business.
Shared Use During Business Hours
If different people use your property throughout the day.
For example, if you rent out a meeting space in your building during business hours, it is treated as an active business instead of a regular rental.
Rental Used in a Business You Own
If your rental property is used by a business you are involved in (S corporation, partnership, or joint venture), and that business is not a rental company.
For example, if you own a startup that uses your house for company retreats, it is considered part of your business.
Standards to Pass Material Participation Test
Does your property meet one of these six situations? If so, you can qualify for non-passive income status. So, can you claim tax benefits? Well, not yet.
You must also pass the material participation test.
There are seven ways to meet this, and you must meet one of these.
500-Hour Rule
You work at least 500 hours on your short-term rental during the tax year.
This can include doing any tasks involved, such as guest communication, property maintenance, marketing, cleaning, or handling bookings.
You Do All Work Involved
If you do almost all the work required to run the rental business, and very little is done by anyone else (like property managers or contractors).
For example, if you manage bookings, handle guest requests, clean the property, and perform repairs yourself with little outside help.
100-Hour Rule
You work at least 100 hours on the rental during the year, working with someone else.
However, others (such as a co-owner, employee, or contractor) should work less or equal hours than you do—they must not work more than you.
This means that even if you don’t reach 500 hours, as long as your involvement is the most significant, you can qualify.
Your Participation Is Significance
If you are involved in multiple businesses (including your rental), your total work hours across all significant business activities (not just the rental) must exceed 500 hours for the year.
This applies if you run multiple rentals or if you manage other business operations in addition to your rental property.
Past Experience Rule
If you materially participated in your rental business for at least 5 out of the last 10 years.
This means if you actively managed your property for five years within the past decade, you don’t need to meet any other test for material participation.
Professional Service Requirement
If you provide specialized professional services related to the rental.
This includes work that requires advanced skills or education, such as legal, medical, engineering, accounting, or construction-related services.
You must have performed these services for at least three of the last taxable years.
Regular and Ongoing Involvement
If you regularly and continuously participate in managing the rental for more than 100 hours, even if you aren’t sure about the exact hours.
IMPORTANT! If you meet at least one of the standards for non-passivity (set 1) and then one to pass the material participation test (set 2), you are eligible for tax benefits under the STR tax loophole. |
How Airbnb Short-Term Rental (STR) Fall Under ‘Tax Loophole’?
According to the definition, Short-Term Rental (STR) is renting out a property for a maximum of 30 days or less on Airbnb or any other platform.
Now see Rule #2 of “Criteria for Non-Passive Rental”.
Since the host does provide extra services/amenities (answering queries, welcoming, cleaning, pet friendliness, toiletries, Wi-Fi, and other amenities), Airbnb STR is a non-passive income.
What about the material participation test?
It’s quite easy for most Airbnb STR hosts to meet the Material Participation Test because:
- Many hosts work at least 10 hours per week, adding up to 500+ hours per year (meeting Rule #1).
- Most hosts handle all or nearly all of the rental work themselves (meeting Rule #2).
- Even hosts with a team usually participate 100+ hours per year and, more than anyone else on the team (meeting Rule #3).
Since Airbnb hosts actively manage their rentals and meet the material participation test, they can easily qualify for the STR tax loophole and take advantage of tax savings.
What Are Benefits of Short-Term Rental Loophole?
The STR tax loophole helps property owners save on taxes when they rent their homes for short stays on Airbnb, Vrbo, Booking.com, Expedia, Agoda, etc.
It provides these tax benefits:
Offset Active Income
Normally, rental income is considered passive, meaning losses can only be deducted against other passive income.
However, with short-term rental, if you meet certain IRS rules, your rental income can be classified as active. This is a big deal because it allows you to deduct rental losses from your regular job income or business income.
This could lower your overall taxes, especially if you have high expenses related to your rental.
Deduct Property Expenses
Running a short-term rental comes with many costs. The good news is that most of these expenses are tax-deductible via the ‘loophole’ thing. This includes:
- Repairs and maintenance (fixing appliances, painting, etc.)
- Utility bills (electricity, water, internet)
- Real estate taxes
- Property management fees
- Cleaning and supplies (toiletries, bedding, etc.)
- Mortgage interest
Since these expenses reduce your taxable income, you end up paying less in taxes. However, make sure you keep good records to maximize these deductions.
Depreciate Your Property
You can also benefit from depreciation with short-term rentals.
Depreciation lets you write off the cost of your property over time. The tax law IRS introduced considers depreciation (or other value loss) deductible expense.
Instead of deducting it all at once, you spread it out over several years. Each year, you can deduct a portion of these costs, which helps lower your taxable income.
In addition, you can even use bonus/accelerated depreciation to lower your tax bill quickly.
While depreciation is for the building, bonus depreciation applies to things inside, like:
- Furniture (beds, couches, tables)
- Appliances (stoves, refrigerators, washers)
- Security systems
- HVAC system
If you buy any of the applicable assets for your rental property, you can deduct a big chunk of the cost in the first year under the additional depreciation.
This can be a huge tax benefit, especially if you’ve recently invested in upgrades.
Use Cost Segregation for Faster Deductions
Cost segregation is a strategy that speeds up depreciation.
Instead of depreciating the entire property as one unit, a tax professional can break it down into different parts. Some parts (like lighting, flooring, or kitchen cabinets) can be depreciated faster.
These parts are then depreciated over a period of 5, 7, or 15 years.
The purpose is to find which parts of the property depreciated faster. Once identified, use them to get large tax benefits for faster depreciation.
What You Can Claim Via Short-Term Rental Tax Loophole?
Active rental means you put more effort into your ‘rental’ venture to make it grow.
IRS allows you to claim these expenses via short-term rental gains:
- Utilities
- Maintenance and Repairs
- Property Management Fees
- Platform Fees (such as Airbnb, Vrbo, or Booking.com listing/commission fee)
- Marketing Expenses
- Cleaning Supplies
- Guest Amenities (welcome baskets, linens, toiletries, coffee)
- Mortgage Interest
- Property Taxes
- Home Office
- Travel Related to the Property (lodging, transportation, meals for rental trips)
- Property Insurance
- Liability Insurance
- CPA and Legal Fees
Along with these expenses, you (as an STR host on Airbnb or other OTA platforms) can utilize the property depreciation as well as bonus/accelerated depreciation.
Conclusion
The Short-Term Rental Tax Loophole isn’t a loophole in the traditional sense but a legitimate tax strategy based on IRS regulations.
If you are into short-term rental businesses and meet the set criteria under these laws, you can claim the tax benefits provided by the tax laws.
Airbnb hosts can easily qualify for the set standards and reduce their tax burden.
If used correctly, this strategy can turn short-term rentals into a powerful financial tool and maximize tax savings while fully complying with tax laws.
FAQs - Short Term Rental Tax Loophole
Can a W-2 Earner Use STR Losses to Offset their Regular Income?
Yes, but only if the W2 earner meets material participation criteria and defines their rental income as “non-passive”. If that happens, they can use STR losses— from running expenses and depreciation—to reduce the taxes you owe on your W-2 income.
How Can You Qualify for Short-Term Rental Tax Loophole?
To qualify for the short-term rental tax loophole, ensure the average guest stay is 7 days or less. And meet material participation rules by actively managing the rental (at least 500 hours or 100 hours doing more than anyone else).
Is STR Tax Loophole Under Thread Due to Phasing-out Depreciation?
The STR tax loophole itself remains intact despite the fact that the IRS phasing out the bonus depreciation gradually:
- 80% in 2023
- 60% in 2024
- 40% in 2025
- 20% in 2026
- 0% by 2027
While this phasing-out reduces the immediate depreciation tax benefits of STR investments, the loophole itself is not under direct threat.
Will the STR Loophole Be Closed Soon?
It doesn’t look like it. Some people worry that the IRS will shut it down, but there are no laws or proposals to do so right now. Since these tax rules were originally made for hotels and similar businesses, it will be difficult to change them.
