The short-term rental tax loophole, colloquially referred to as the Airbnb loophole, is a tax deduction that can and should be utilized when renting a property out via short-term rentals. This method is especially useful for those who may not meet all of the criteria for Real Estate Professional Status (REPS), which allows real estate professionals to treat income as active rather than passive. For most seasoned investors and those in the know, the short-term rental tax loophole can be used in conjunction with other tax advantageous strategies, such as cost segregation studies.
What is the short-term rental tax loophole?
The short-term rental tax loophole allows income generated from short-term rentals, where the average stay is seven days or less, to be classified as active income rather than passive income. This classification enables investors to offset this income with real estate losses, such as those garnered by accelerated depreciation, reducing their overall tax burden.
The loophole revolves around Treasury Regulation Sec. 1.469–1T(e)(3)(ii)(A), which was originally intended for hotels and the hospitality industry. It’s now more commonly associated with Section 469, which reclassifies the property as a business and lets the owner claim all income as active rather than passive.
This means that a W2 employee who owns a short-term rental can classify all income (or losses) from their short term rental as ACTIVE income (or losses), which allows them to take advantage of one of the greatest tax benefits available to real estate investors: cost segregation.
Scenario | Total Income | Rental Loss | Taxable Income | Tax Rate (%) | Taxes Owed | Tax Savings |
---|---|---|---|---|---|---|
Without Short-Term Rental Deduction | $150,000 | $0 | $150,000 | 30% | $45,000 | $0 |
With Short-Term Rental Deduction | $150,000 | $20,000 | $130,000 | 30% | $39,000 | $6,000 |
How the short-term rental tax loophole works: Eligibility and requirements
Typically, in order for rental losses to be applied against active income, the individual who is filing taxes must qualify for “Real Estate Professional Status” (REPS). Real Estate Professional Status (REPS) is a classification that allows real estate professionals to take advantage of tax breaks by letting them claim that income derived from real estate is active rather than passive. This is a designation made on an individual’s tax return and is not connected to any formal real estate license. The most important thing to note here is that this tax loophole does not require a person to prove they have a REPS status.
This can be a bit of a quandary for real estate investors who are not able to obtain the documents or the required portfolio of assets that would be needed to change the status. Conversely, with the short-term rental tax loophole, as long as the eligibility and requirements are met, any property owner, whether Airbnbing their second home or doing a short term on their grandfather’s condo in Ft. Lauderdale, can take advantage. Here is what you need to do be be eligible.
Material participation tests
To qualify for the short-term rental tax loophole, investors must meet one of several material participation tests. These tests determine the level of involvement in the rental property to ensure it is classified as an active business rather than a passive investment.
500-hour rule
The 500-hour rule requires that an investor spend at least 500 hours in a tax year actively managing and operating their short-term rental property. This includes handling bookings, guest communications, maintenance, and financial management. For example, if an investor manages a beachfront property listed on Airbnb and dedicates over 500 hours annually to these activities, the rental income can be classified as active. This means the investor needs to spend time in the home, and be careful about things like allergies via tools such as pet screening.
100-hour rule
The 100-hour rule requires an investor to spend at least 100 hours on activities related to their short-term rental property, ensuring that no one else spends more time on the property than the investor. An investor who manages a condo rental in Denver and spends 120 hours annually on tasks like guest communication and booking management while hiring a cleaning service that spends only 80 hours meets this requirement. This means that you might want to think twice about hiring an Airbnb property management company for your short-term rental.
Substantial activities rule
The substantial activities rule is met when the investor performs most of the work related to the short-term rental property compared to any other individual or service provider. This can include responsibilities such as guest check-ins, maintenance, and marketing. An investor who owns a mountain cabin in Telluride, Colorado, and personally handles all guest interactions, cleaning, and maintenance while occasionally hiring a plumber for repairs satisfies this rule.
Significant participation activity (combined activities)
When you dedicate at least 100 hours to managing your short-term rental like an Airbnb and also participate in other real estate activities, you can combine these hours to meet the material participation requirement. If the total time spent across all these activities exceeds 500 hours within the tax year, you qualify. For instance, if you spend 120 hours annually managing your short-term rental and an additional 400 hours overseeing other rental properties belonging to various friends, family members, and general acquaintances, then you can qualify.
Participate in the business for five of the previous ten taxable years
Consistent involvement in the short-term rental business for at least five of the last ten years qualifies you as materially participating, regardless of the number of hours you invest. An investor who has actively managed their mountain cabin rental for six of the past ten years, even if their recent involvement has decreased, meets this requirement.
Engage in a personal service activity for three of the previous ten taxable years
If you have spent time on non-income-producing activities related to your rental business for at least three of the last ten years, you fulfill the material participation criteria. An investor who dedicated the past three years to renovating and preparing a lakeside property for rental use—without yet generating rental income—meets this standard.
Why does classifying income as active vs. passive matter?
When you are classifying the income derived from the property as active and not passive, this means that in the eyes of the IRS, you are putting more blood, sweat, and tears into management, upkeep, and business-related issues, and thus are eligible for a variety of tax deductions. Below is some of what you can claim via the short-term rental tax loophole.
Deductible Items | Details/Examples |
---|---|
Maintenance and Repairs | Fixing roof leaks, painting, plumbing repairs |
Utilities | Electricity, water, gas, internet services |
Property Management Fees | Fees for managing bookings, cleaning, and maintenance |
Platform Fees | Airbnb or VRBO listing fees, commission fees |
Marketing Expenses | Social media ads, website creation, local advertising |
Cleaning Supplies | Detergents, cleaning materials, hiring cleaning services |
Guest Amenities | Toiletries, linens, coffee, welcome baskets |
Mortgage Interest | Interest paid on property mortgage |
Property Taxes | Local property taxes on the rental |
Home Office | Proportionate household expenses like utilities, mortgage interest |
General Depreciation | Depreciate property over 27.5 years (excluding land) |
Cost Segregation Studies | Accelerated depreciation for specific components over 5, 7, or 15 years |
Travel Related to the Property | Transportation, lodging, meals for property-related trips |
Property Insurance | Insurance premiums for the rental property |
Liability Insurance | Insurance to cover guest-related risks |
CPA and Legal Fees | Tax preparation, accounting services, legal advice for rental operations |
Short-term rental tax loophole example
Let’s give an example of Sarah, an investor in Miami, Florida, who owns a beachfront condo that she found via a free skip tracing tool and rents out on Airbnb to people who want to enjoy Miami’s nightlife and beach activities. To maximize her tax benefits, Sarah takes advantage of the short-term rental tax loophole by ensuring she meets the 500-hour rule for material participation.
By dedicating over 500 hours a year to actively managing her rental property—handling bookings, guest communications, and maintenance—Sarah qualifies her rental income as active income. This classification allows her to offset rental income against her W-2 income from her full-time job, avoiding the passive activity loss rules. Additionally, Sarah benefits from other tax strategies like deducting property management fees, utilities, and maintenance costs directly against her rental income.
Category | Short-Term Rental Tax Loophole | Non-Short-Term Rental Tax Loophole |
---|---|---|
Gross Annual Rental Income | $100,000 | $100,000 |
Expenses (Maintenance, Utilities, etc.) | $30,000 | $30,000 |
Net Rental Income | $70,000 | $70,000 |
Additional Deductions (Active Participation) | $20,000 | $0 |
Taxable Rental Income | $50,000 | $70,000 |
Other Income (W-2 Salary) | $150,000 | $150,000 |
Total Taxable Income | $200,000 | $220,000 |
Effective Tax Rate | 24% | 24% |
Total Taxes Paid | $48,000 | $52,800 |
Tax Savings Due to Loophole | $4,800 | $0 |
Depreciation: The large tax loophole no one is using properly
Although reclassifying your income as active rather than passive can save you everything from mortgage interest to cleaning supplies, depreciation is by far the tax loophole with the greatest potential for tax savings. Let’s be clear here; you don’t need to qualify for the short-term rental tax loophole to qualify for depreciation. If you are walking, talking, circulating blood, and have a property, you can claim it, and you don’t even need to hire a real estate CPA. Many reading this might have heard of straight-line depreciation, which allows you to depreciate the life of the building by 27.5 years for a single-family home, condo, or multifamily building. What many are not familiar with or think only applies to big-shot developers in LA and NY is cost segregation studies.
Cost segregation studies 101
Cost segregation studies reclassify a property into separate asset classes, and by separating them, you can claim shorter life spans for different asset classes. For instance, by performing a cost segregation study on a rental property, you can reclassify items like appliances and carpeting as 5-year assets instead of the standard 27.5-year schedule for the building itself. This reclassification allows you to accelerate depreciation and take larger deductions in the earlier years of ownership, reducing your taxable income more quickly. Below is an example of a property done with and without a cost segregation study.
Bonus depreciation
Bonus depreciation allows property owners to immediately deduct a significant portion of the cost of eligible assets, like furniture or appliances, in the first year of purchase instead of spreading the deductions over several years. This tax incentive can greatly reduce taxable income in the initial year, boosting cash flow for Airbnb hosts and real estate investors.
Cross segregation study example vs. short-term rental tax loophole or no loophole
Let’s now revisit Sarah, who has now doubled down on her tax savings, and wants to take advantage of a cost segregation study. Check out how she fairs after the cost segregation.
Category | Short-Term Rental Tax Loophole | Non-Short-Term Rental Tax Loophole | Cost Segregation Study |
---|---|---|---|
Gross Annual Rental Income | $100,000 | $100,000 | $100,000 |
Expenses (Maintenance, Utilities, etc.) | $30,000 | $30,000 | $30,000 |
Net Rental Income | $70,000 | $70,000 | $70,000 |
Additional Deductions (Active Participation) | $20,000 | $0 | $35,000 |
Taxable Rental Income | $50,000 | $70,000 | $35,000 |
Other Income (W-2 Salary) | $150,000 | $150,000 | $150,000 |
Total Taxable Income | $200,000 | $220,000 | $185,000 |
Effective Tax Rate | 24% | 24% | 24% |
Total Taxes Paid | $48,000 | $52,800 | $44,400 |
Tax Savings Due to Loophole | $4,800 | $0 | $8,400 |
As you can see from the figures, a cost segregation study significantly increases your deductions due to accelerated depreciation, allowing you to write off $35,000 instead of $20,000. This higher deduction lowers your taxable rental income to $35,000 compared to $50,000 with the standard short-term rental tax loophole. With this reduced taxable income, your total taxable income also drops to $185,000 instead of $200,000. As a result, you pay less in taxes—$44,400 compared to $48,000—leading to a tax savings of $8,400 with the cost segregation study, nearly doubling the savings of $4,800 from the standard tax loophole.
It’s important to note here that we are extra conservative with our estimates, and don’t include bonus depreciation. In many cases, as much as 30-40% of a property can be reclassified, and with bonus depreciation, much more money can be saved and rolled over into the future, like Net Operating Losses.
Do you own a short-term rental?
If you own a short term rental and have NOT had a cost segregation study completed on your property…you are leaving (on average) $40,353 in tax savings this year on the table (that’s the average tax savings we find for our clients when performing a cost segregation study on their property).
If you’d like to speak with a member of our team for a confidential, 1-1 consultation and estimated benefits of a cost segregation study, click here to schedule a call with one of our Cost Segregation Advisors today.
FAQ
What types of properties are eligible for the short-term rental tax loophole?
The short-term rental tax loophole applies to properties rented out on a short-term basis, where the average guest stay is seven days or less. This can include various types of properties, such as single-family homes, condos, apartments, and even rooms in a host’s primary residence, as long as the property meets the criteria for short-term rentals.
Can you combine the short-term rental tax loophole with other tax strategies?
Yes, the short-term rental tax loophole can be combined with other tax strategies to maximize your tax savings. In our example, investors can use this loophole alongside cost segregation studies, which allow them to accelerate depreciation on certain components, leading to even greater deductions. If you use a HELOC, and have a revolving credit line, in times of high interest, it’s great for cash-flow to use the the SHRTL and other strategies.
How do I prove material participation for the short-term rental tax loophole?
To prove material participation in the short-term rental tax loophole, you need to demonstrate that you have actively participated in managing and operating the rental property. This can be shown through logs of hours spent on activities like guest communication, booking management, maintenance, and other operational tasks. Meeting one of the material participation tests, such as the 500-hour or 100-hour rule, is essential to qualify for this tax benefit.
What are the potential downsides of using the short-term rental tax loophole?
While the short-term rental tax loophole offers significant tax benefits, there are potential downsides to consider. The IRS closely scrutinizes claims of material participation, and failing to meet the requirements could result in penalties or back taxes. Additionally, using this loophole may affect your eligibility for other tax deductions or benefits, depending on your overall tax situation.