What to Know About The Short-Term Rental Tax Loophole

Under certain IRS rules, your short-term rental property income can be classified as non-passive, even if you don’t qualify as a real estate professional. This means you may be able to use rental losses to directly offset your other active income, like your salary or business profits, potentially reducing your overall tax bill.

This is often referred to as the “short-term rental tax loophole”. In reality, it’s not a “loophole” at all but is simply a novel way to navigate our complicated tax code.

Let’s break down exactly how the short-term rental tax loophole works, what the IRS looks for, and the practical steps you can take to see if you qualify. We’ll also cover actionable strategies to potentially reduce your taxable net income from short-term rentals.

How rental activity is classified

The IRS generally considers most rental activity to be “passive.” This means that, under normal circumstances, any losses you incur from your rental property can only be used to offset other passive income—not your W-2 wages or business income. For many landlords, this limits the immediate tax benefit of rental losses, especially if their passive income is limited.

However, short-term rentals are different.

If the average rental period for your property is 7 days or less, the IRS does not automatically treat your activity as passive. In other words, you have the opportunity to classify your short-term rental as a non-passive activity, even if you don’t meet the strict requirements to be considered a real estate professional.

This allows you to potentially use your short-term rental losses to offset your other active income, which can result in significant tax savings.

Here are some key IRS rules and definitions to keep in mind as you consider how your short-term rental activity may be classified:

Average rental period: If the average stay of your guests is 7 days or less, or in some cases less than 30 days with substantial services provided, your rental may not be considered a traditional rental activity under IRS rules (see IRS Reg. §1.469-1T(e)(3)(ii)).
Material participation: To treat your short-term rental as non-passive, you must materially participate in the management and operation of the property. The IRS outlines several tests for material participation, which we’ll cover in the next section.
Substantial services: Providing substantial services (such as daily cleaning, meals, or concierge-type amenities) can also help classify your rental activity as short-term, especially if your average rental period is between 8 and 30 days.
Real estate professional status: Unlike long-term rentals, short-term rental owners do not need to qualify as real estate professionals to take advantage of this loophole—material participation in the activity is sufficient.
Documentation: The IRS expects you to keep thorough records of your rental activity, including guest stays, services provided, and your hours spent managing the property.

The material participation requirement

Material participation means you are actively involved in the day-to-day management and decision-making for your property. The IRS has established several tests to determine whether you meet this threshold.

The most common test for landlords is spending more than 500 hours per year on activities related to your short-term rental. These activities can include communicating with guests, cleaning and maintaining the property, handling bookings, and managing finances. If you’re the primary person responsible for these tasks, you’re likely to meet the material participation requirement.

There are other ways to satisfy material participation as well. For example, if you spend more than 100 hours on the activity and no one else spends more time than you, you can also qualify. It’s important to note that hours spent by your spouse can count toward your total if you file jointly.

The 7-day and 30-day rules

The length of time your guests spend at your rental is just as important for determining if your activity qualifies for the short-term rental tax loophole. The IRS uses specific rules based on the average length of guest stays to classify rental activities.

Meeting the 7 days or less rule

The most straightforward way to have your short-term rental activity treated as non-passive is to keep the average period of customer use to 7 days or less. This means that, on average, each of your guests stays at your property for no more than a week.

If you meet this threshold, the IRS does not consider your activity a traditional rental, and you’re eligible to treat it as a non-passive business (provided you also meet the material participation requirements).

Providing substantial services for longer stays

If your average guest stay is more than 7 days but not more than 30 days, you can still qualify for non-passive treatment if you provide substantial personal services to your guests.

Substantial services go beyond basic amenities and maintenance. They include offerings such as daily cleaning, regular linen changes, meal services, or concierge-style support.

The key factor is that these services are primarily for your guests’ convenience and are significant enough to make the rental more like a hotel stay than a traditional lease.

Common mistakes to avoid with the short-term rental tax loophole

It’s easy to accidentally make missteps that could limit your tax savings or attract unwanted IRS attention. Here are some of the most common mistakes landlords should watch out for:

Misunderstanding the average stay requirement: If your average guest stay exceeds 7 days—and you don’t provide substantial services for longer stays—you may not meet the IRS’s criteria for non-passive treatment.
Inadequate record keeping of your involvement: Without detailed logs of your hours and activities related to managing your property, you may have a hard time proving you materially participated, which is required to claim non-passive losses.
Overlooking personal use limitations: If you use your property for personal purposes for more than 14 days per year, or more than 10% of the total days it’s rented to others at fair market value (whichever is greater), the IRS may treat your property as a personal residence rather than a rental, limiting your ability to deduct losses (IRS Publication 527).
Failing to document guest services provided: If you rely on the “substantial services” exception for stays longer than 7 days, you need clear documentation of the services you provide to support your tax position if audited.

Using depreciation for bigger tax savings

By combining cost segregation and bonus depreciation with the short-term rental tax loophole, you can potentially “turbo-charge” your tax savings and free up even more cash flow for future investments.

You’re probably familiar with standard straight-line depreciation, which spreads deductions over 27.5 years for residential investment property. But, there are ways to front-load more of these deductions into the early years of ownership.

One powerful technique is cost segregation. This strategy involves breaking down your property into different asset categories like appliances, flooring, landscaping, and furniture that can be depreciated over much shorter periods (typically 5, 7, or 15 years).

By working with a qualified cost segregation specialist, you can identify these components and accelerate your depreciation deductions, reducing your taxable income even further in the first few years.

Another opportunity is bonus depreciation. Under current tax law, you can immediately deduct a significant portion of the cost of qualifying property in the first year it’s placed in service.

Qualifying property generally includes most tangible personal property with a useful life of 20 years or less, such as appliances, furniture, and certain improvements to the property (but not the building itself).

For properties placed in service between late 2017 and the end of 2022, 100% bonus depreciation was available. The rate began to phase down in 2023 and 2024: 80% in 2023, 60% in 2024, and 40% in 2025.

However, new legislation has now restored 100% bonus depreciation for qualifying property placed in service on or after January 20, 2025, through the end of 2029. Short-term rental property owners who meet the material participation requirements can typically take advantage of this benefit.

Example:

Let’s say you purchase a short-term rental property for $500,000 and, through a cost segregation study, you identify $100,000 worth of assets (like appliances, flooring, and fixtures) that qualify for 5-year depreciation.

With 100% bonus depreciation now restored for qualifying property placed in service on or after January 20, 2025, you could deduct the entire $100,000 of those assets immediately in the first year, rather than spreading it over 5 years.

This can dramatically reduce your taxable net income, especially when combined with the non-passive loss treatment from the short-term rental loophole.

Can the loophole be used for foreign properties?

If you’re considering a vacation rental abroad or already own a foreign property, can you use the short-term rental tax loophole to reduce your U.S. tax bill? In many cases, the answer is yes with a couple of important caveats.

The short-term rental tax loophole can apply to foreign properties if you meet the same requirements as you would for a U.S. rental: your average guest stay is 7 days or less (or up to 30 days with substantial services), and you materially participate in managing the property.

If these conditions are met, you may be able to treat your foreign rental activity as non-passive, allowing you to use losses from your foreign short-term rental to offset other active income on your U.S. tax return.

If you’re planning to use the property for personal vacations as well as short-term rentals, remember that the same personal use limitations apply. Too much personal use can restrict your ability to claim losses, so keep careful records of how the property is used throughout the year.

Planning your short-term rental tax strategy

Maximizing your tax benefits is about more than just knowing the rules. You need to stay organized, document your activities, and make strategic decisions year-round.

That’s where Stessa can help. You can easily categorize transactions, upload and organize receipts, and use the platform’s notes and document storage features to log your hours and activities, helping you create a clear record of your material participation throughout the year:

Automated income and expense tracking: Organize and categorize transactions automatically from connected bank, lender, credit card, and property management accounts with no extra fee or add-on required.
Financial reporting: Generate income statements, net cash flow reports, balance sheets (with the paid Stessa Pro plan), and more, all within the platform.
Real-time performance metrics: Get 24/7 visibility into your portfolio’s performance with no third-party software required.
Smart receipt scanning: Add expense receipts to your transactions ledger quickly and accurately via mobile scans and email forwarding, reducing the risk of losing or misplacing vital receipts.
Unlimited properties: Add as many short-term vacation rentals as you like.

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