The Short-Term Rental “Loophole”

There has been a lot of chatter on social media regarding the Short-Term Rental Loophole. Accordingly, we have got a lot of clients asking about this strategy and how they could potentially benefit from it. 
 
Let’s start with exploring the Short-Term Rental Loophole
 
Under U.S. tax law, rental real estate activities are generally considered passive activities meaning you can’t use the losses (which often from depreciation) to offset your active income such as wages or business profits. Any losses from the activities will simply carry forward to the next year and continue piling up to offset future passive income. However, short-term rentals can be treated differently if the following conditions are met:

1. The average rental stay must be seven days or fewer.

2. Material Participation – You must meet one of the 7 tests of material participation. The most common one used, however, is that an individual participates in the activity for more than 100 hours and such individual’s participation is not less than the participation in the activity of any other individual (Management company, contractors, cleaning, etc.) It is important to note that investor hours like analyzing the property or searching for a property do not count.

3. Businesslike operation – You must keep records, separate accounts, and treat the rental as an active business, not a hobby.

If these tests are met, then your short-term rental activity qualifies as a non-passive business and any losses can potentially offset income from:
 
 -W-2 wages
 -Business income
 -Investment income
 
This can translate into significant tax savings, especially in the early years of ownership.
 
Example

Let’s say you purchase a vacation home for $700,000 and rent it as a short-term rental on Airbnb or VRBO.

With cost segregation and bonus depreciation, you generate $150,000 of depreciation deductions in year one.

If you or your spouse materially participate, and the average guest stay is under seven days, those losses can potentially offset $150,000 of W-2 or business income producing a significant tax benefit.

Important Considerations

-Documentation is critical. Keep a log of hours worked, bookings, guest stays, and any management activities.

-Beware of personal use. Excessive personal use can disqualify the activity or limit deductions.

-Local laws matter. Many cities have restrictions or taxes on short-term rentals, always comply with local ordinances.

-The Market is Saturated. We have seen many investors utilize this strategy and while there is a nice upfront tax deduction, the performance of the property is underwhelming and losing cash which can negate any tax benefits received. Make sure proper due diligence is done and that it is a good deal.

-There is significant time involved. When a client asks about this strategy, my first question is, do you want to deal with a Short-Term Rental? Tenants are a pain, you have to constantly be on call. Is your time better spent just focusing on your primary career or business?

-There are always surprises with real estate. With any real estate, there is always something that needs to be fixed, the ac went out, the roof is leaking, the hot tub stopped working, the list goes on. These items are inevitable to happen and then you are out another $30k next thing you know!

The Bottom Line

The short-term rental rules offer a legitimate and powerful tax planning opportunity for investors who are willing to be actively involved in their properties. When executed correctly, this approach can transform rental real estate from a passive investment into an active income-offsetting tool, accelerating your wealth growth and improving cash flow.