The Short Term Rental Loophole

Short-term rentals offer more than just passive income. With proper planning, they can also provide significant tax advantages. By leveraging the short-term rental tax loophole, you can offset earned income (like wages or business income) with losses from your rental properties, even if you don’t qualify as a real estate professional.

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The Short-Term Rental Tax Loophole

Unlike long-term rental properties, short-term rentals are treated differently under tax law. If structured strategically, the losses generated from operating a short-term rental can be classified as active business losses rather than passive losses. This allows you to reduce your taxable income from wages or other active sources, potentially lowering your overall tax bill.

HOWEVER, there are many compliance requirements you need to meet to take full advantage of this tax strategy.

Key Requirements for the Short-Term Rental Loophole

A short-term rental is a property rented for less than 30 days at a time. Examples include single-family homes, townhomes, or vacation homes. However, tax treatment depends on key factors, including:

A. Rental Duration Requirement

To classify a property as a short-term rental business rather than a passive rental activity:

• The property must have at least two stays during the year.
• The average guest stay must be seven days or less.
  
  The formula to calculate this is: Total rental days during the year / # of times rented or renters

B. Material Participation Requirement

You must actively participate in managing the property. The IRS provides seven tests to determine material participation. Here are the most common:

1. 500-Hour Test: Spend 500+ hours managing the rental activity during the year.
2. Substantially All Work Test: Perform nearly all the work yourself.
3. 100-Hour and Most Time Test: Spend 100+ hours, and no one else spends more time on the activity.

For the full list, refer to the IRS Publication 925 link.

C. No Substantial Services Rule

To qualify for the short-term rental tax loophole, you cannot provide substantial services such as:

• Daily house cleaning
• Concierge services include transportation, being a tour guide, etc.
• Meals, for example, providing breakfast every morning like a hotel

A property qualifies as a business activity if it provides significant services. When classified as such, you must report income on Schedule C, which subjects any future profits to self-employment taxes (15.3%). 

Cost Segregation Study: Maximizing Deductions

A Cost Segregation Study is a tax strategy that accelerates depreciation on components of a rental property. Instead of depreciating the entire building over 27.5 years (residential) or 39 years (commercial), certain assets can be reclassified into shorter 5-, 7-, or 15-year lives, creating more significant deductions in the early years of ownership.

Benefits of Cost Segregation for Short-Term Rentals:

• Increases front-loaded tax deductions by accelerating depreciation in year 1 vs. over 39 years.

• Reduces taxable income, potentially eliminating rental profits from taxation.

• Enhances cash flow by deferring tax payments to later years.

• Allows for Bonus Depreciation—currently 40% in 2025 but phasing out over time. 

This strategy is especially beneficial if you meet the material participation requirements, as it allows rental losses to offset earned income, significantly reducing tax liabilities.

Real-World Example

Scenario: You own a short-term rental for 150 days with personal use for 14 days. You actively manage the property, spending 120 hours annually, and no one else spends more time. You decide to implement a Cost Segregation Study.

Breakdown:

• Material Participation: Passes the 100-Hour and Most Time Test. 

• Purchase Price (excluding land): $500,000 (Note: Land is not a depreciable asset—only the structure and eligible improvements qualify for depreciation.)

• Cost Segregation Study Results:

  • Identified 5-, 7-, and 15-year assets: $100,000

  • Bonus Depreciation (40% of eligible assets in 2025): $40,000 deduction

  • The remaining 60% of identified assets added back to regular depreciation basis: $60,000

  • Remaining building structure for standard depreciation: $400,000

• Regular Depreciation Calculation (Commercial – 39 Years)

  • Depreciable Basis: $400,000 + $60,000 = $460,000
  • Annual Depreciation: $460,000 ÷ 39 years = $11,795 per year

Final Tax Impact:

• Without Cost Segregation:

  • Only standard depreciation applies
  • First-year deduction: $12,821

  With Cost Segregation:

  • Bonus Depreciation (40% of $100,000): $40,000 deduction
  • First-Year Standard Depreciation: $11,795
  • Total First-Year Deduction: $51,795
  • Tax Savings: Assuming 35% Federal and 6% State Tax Rates, $21,236.

Our Final Thoughts

Implementing a Cost Segregation Study (CSS) for your short-term rental can be a game-changer regarding tax savings and cash flow optimization. By accelerating depreciation on specific assets and leveraging 40% bonus depreciation in 2025, you can significantly reduce your taxable income, putting more money back into your business.

In this example, the additional $15,980 in first-year tax savings demonstrates the power of strategic tax planning. However, proper execution requires expert guidance to ensure compliance with IRS regulations and to maximize your deductions effectively.

If you’re looking to optimize your tax strategy, now is the time to explore cost segregation and other tax-saving opportunities—apply to see how we can help you keep more of what you earn!

Disclaimer

The information provided is for general purposes and does not constitute tax, legal, or financial advice. Tax situations vary, and we recommend consulting with a qualified tax professional or attorney before taking any action. Spark Tax Services LLC is not responsible for any errors or the outcomes from using this information, and tax laws may change.

References:  

• Internal Revenue Service. (2019). Rev. Proc. 2019-38, 2019-42 IRB 942, 2019-36567.
  Retrieved from https://www.irs.gov/pub/irs-irbs/irb19-42.pdf

• Internal Revenue Service (IRS). "Revenue Procedure 2019-38: Safe Harbor for Rental Real Estate Businesses." Internal Revenue Bulletin 2019-42, September 24, 2019. Accessible at: https://www.irs.gov/pub/irs-irbs/irb19-42.pdf.