Short Term Rental Tax Loophole: Qualify and Claim

The short term rental tax loophole is a strategy that allows Airbnb property owners, especially high-income earners, to claim major savings on federal taxes. In brief, this is done by writing off business expenses and accelerating depreciation to reduce taxable income. 

This article explores the STR tax loophole method in detail to provide you with all the information you need to check if you qualify and how you can take advantage of this.

This article is not tax advice and is only for informational purposes. You should always consult with a tax professional before making investment and tax-related decisions.

Understand the Short Term Rental Tax Loophole

The short term rental tax loophole provides income earned from renting out properties on a short term basis with tax advantages.This provision in the tax code helps Airbnb property owners decrease their level of taxable income, which makes it particularly beneficial for individuals in the high income brackets. However, some very specific conditions need to be met in order to qualify for this opportunity to save on taxes.

Typically, those who qualify for the Real Estate Professional Status (REPS) have the right to benefit from tax savings. But this IRS-designated status does not apply to most vacation rental property owners and hosts as it requires virtually professional-level engagement in the real estate industry, such as being a real estate agent, a property manager, a developer, or a professional investor.

To qualify for the REPS, you need to:

1. Devote more than 50% of your professional service to the real estate trade
2. Actively participate in the real estate business for more than 750 hours per year

The short term rental tax loophole allows hosts to access similar benefits without being officially recognized as real estate professionals. 

The short term rental tax loophole provides two main benefits:

Deducting STR business-associated expenses from taxable income to reduce the total amount. 

1. Deductible expenses include things like:

• Mortgage interest
• Insurance premiums
• Furniture, decor, and appliances
• Guest supplies
• Marketing and advertising
• Utilities
• Cleaning fees or supplies
• Airbnb management software subscription fees
• Property maintenance
• Fixes and repairs
• Property management fees

2. Accelerating depreciation further reducing taxable income

Essentially, the short term rental tax loophole permits Airbnb rental income to be classified as non-passive and be offset by real estate losses. This rule allows vacation rental owners to circumvent the passive loss limitations that typically apply to rental properties. According to these limitations, no more than $25,000 in passive losses can be deducted from ordinary income (W-2 wages).

To be eligible for this option, Airbnb hosts need to qualify for non-passive activity or show material participation in the management of their STR business. There are specific criteria that need to be met for both options, which will be discussed next.

Non-Passive Income and the Short Term Rental Tax Loophole

In order to benefit from the STR tax loophole, it’s crucial to understand the difference between passive and non-passive activity as related to the short term rental business and how to use it to your advantage to reduce your tax burden.

Passive income is earned with only minimal effort and provides financial freedom. Meanwhile, non-passive income requires an active involvement in order to be generated.

The US federal tax code defines rental properties as a passive activity and a source of passive income, by default. However, it also provides scenarios under which income from short term rental properties can be classified as non-passive, in which case owners can benefit from the short term rental tax loophole. 

This allows them to take advantage of regulations that were originally designed for hotels and other players in the hospitality industry as long as short term rentals operate in a way that’s similar to hotels.

For Airbnb properties to qualify for the passive income exception and be classified as non-passive activity, they need to meet the following standards:

1. The average guest stay should not exceed 7 days.
2. The average period for which a guest rents the property should be 30 days or less, and the property owner should provide basic services similar to those offered by hotels.
3. The host should deliver outstanding personal services to prepare the property for guests.
4. Rentals are considered incidental to the non-rental activities of the property owner.
5. The property is available for use during specific business hours, and it is not exclusive to any one guest.
6. Provisions of the property for use in activities performed by a partnership, S-corporation, or joining venture in which the owner has an interest is not treated as a rental activity.

Access to the benefits of the short term rental loophole, hosts need to have material participation in the business. As defined by the IRS, material participation requires regular, continuous, and significant involvement in a business activity over the course of a tax year. 

As related to vacation rental property owners, this means that they need to manage their property on their own or use only half-service Airbnb managers. Hiring a full-service property manager and being only marginally involved in your rental business does not suffice.

The next section discusses the test that STR owners need to pass for material participation. 

Short Term Rental Material Participation

Material participation in a short term rental business can be confirmed by what the IRS refers to as material participation tests.

To qualify for material participation, an Airbnb host needs to meet any one of these 7 tests:

1. You allocated more than 500 hours to the business activity over the year.
2. Your participation in the activity over the tax year substantially accounts for the entire participation of all individuals, including those who do not own an interest in the activity.
3. You participated in the activity for more than 100 hours over the tax year, and your participation was at least as much as the participation of any other person, including those who don’t own interests in the activity.
4. The Airbnb business qualifies as a significant participation activity (i.e., a business activity to which you allocated more than 100 hours during the year and which doesn’t count as material participation under another test), and your participation in all significant participation activities amounts to more than 500 hours.
5. You qualified for material participation in the activity for any 5 of the last 10 immediately preceding tax years.
6. This is a personal service activity (i.e., an activity which involves the performance of personal services in the health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting fields or any other business in which capital is not a material-income-producing factor) in which you have materially participated in any 3  preceding tax years.
7. Your participation in the activity was regular, continuous, and substantial and exceeded 100 hours during the tax year.

Importantly, even if you and your short term rental business operations satisfy one of the 7 material participation tests above, this is not valid in case a person other than you receives compensation for managing the business and/or another person spent more time managing the activity than you did over the course of the tax year, whether compensated or not.

As soon as you satisfy any of the 7 tests listed above, your vacation rental business no longer falls under the rental activity category and turns into a non-passive activity.

While the material participation tests look daunting, short term rental owners are frequently able to meet one or more of them and reduce their tax burden.

The three most commonly met criteria for material participation for short term rentals are:

1. Test #1: As long as you spend more than 1.5 hours/day on average on managing your short term rental, the total participation will add up to more than 500 hours/year. You can achieve this by providing cleaning and laundry services, offering home-made meals, and organizing tours of the area.
2. Test #2: If you are a DIY Airbnb host, work with neither a co-host nor a property manager, and don’t hire professional housekeeping services, you do the majority of the work. This qualifies as material participation in your rental business.
3. Test #3: In case you have a co-host or a half-service property manager who does less than half the work, and you allocate more than 17 minutes/day to the property, you’re covered once again.

If you own vacation rentals and are significantly involved in their management, it’s a must to check if you qualify for material participation through one of the 7 tests. Keep in mind that you need to test each rental separately rather than your overall participation in all of them. In case you are eligible for the short term rental tax loophole on any of your Airbnbs, you can save on taxes and make more money from your business.

The Best Ways to Prove Material Participation 

In order to pass the material participation test and benefit from tax savings, you need to prove that you are indeed actively involved in the management of your short term rental and meet the criteria. The IRS will not simply take your word for granted.

There are two main factors that the IRS focuses on in order to determine material participation:

1. Amount of work: You have to be consistently engaged in the management of your STR for a certain minimum number of hours per tax year. This is covered by some of the 7 tests for material participation that aim to measure the time that you spent on your rental business.
2. Type of work: In addition, the Airbnb business owner needs to be involved in the day-to-day operations of the property to prove regular participation.

The best ways to prove material participation in managing your short term rental are:

• Keeping work logs to document your exact involvement in the business including specific tasks and hours
• Maintaining work calendars to prove that you have actively managed your short term rental throughout the year
• Filling in timesheets to provide a detailed breakdown of all the work that you have done on your property over the year
• Writing appointment diaries to show the time and duration of meetings with guests, contracted maintenance staff, and other service providers

While keeping track of all the work you’ve done on the management of your property to prove material participation can be very tedious, it’s worth it taking into consideration the associated tax benefits. 

To make your life easier, you should get time tracking software that will help you organize the process and download or print out the necessary work logs and timesheets to bring to the IRS during tax season.

Depreciation of Short Term Rental Tax Loophole Strategy

With the STR tax loophole method, property owners can leverage accelerated depreciation strategies. In real estate investing, depreciation is important as investors can deduct the cost of their property over time (usually 27.5 years for rental properties) to reflect its gradual loss in value due to normal wear and tear. This is one more way to reduce taxable income and minimize taxes.

Once a short term rental qualifies as material participation, the owner gains access to bonus depreciation. This is a tax incentive that allows you to immediately deduct a large portion of the property sales price instead of writing it off over the useful lifetime of the property. 

That’s why it’s also commonly referred to as the additional first-year depreciation deduction. Moreover, the bonus appreciation makes it possible to deduct short-lived capital improvement expenses, such as replacing the cooling or heating system in the rental.

Between 2018 and 2022, the 100% bonus appreciation rule was applicable under federal legislation. This means that before 2022, short term rental property owners could deduct the entire purchase price of their investment property in the same year. For instance, if in 2022 you bought a vacation rental for $350,000, you could deduct $350,000 that same year.

In 2022, a new phase-out approach was introduced, which aims to eliminate the bonus appreciation aspect of the STR tax loophole by 2027.

The schedule for the phase-out approach looks like this:

• 80% in 2023: If you purchased a property for $350,000, you could deduct $280,000 in the same year.
• 60% in 2024: You can deduct $210,000 right away.
• 40% in 2025: You can deduct $140,000 immediately.
• 20% in 2026: You can deduct $70,000 in the same year.
• 0% in 2027: You cannot deduct any amount right away.

This means that if you invest in an Airbnb property this year, you can deduct an average of $218,063 this year, considering an average home value of $363,438 in the US market. This is a significant tax benefit which can serve as an additional stimulus for those considering buying a short term rental in the near future and opting for self-management as their preferred short term rental management solution. Indeed, the sooner you purchase a self-managed vacation rental, the more you will be able to benefit from bonus depreciation. This will not be a viable option under the current legislation after 2027.

Tips for Reducing Taxes for Short Term Rental Properties

The short term rental tax loophole offers property owners and hosts an important way to decrease taxable income, but simply qualifying for this tax benefit doesn’t guarantee minimizing your tax bills. There are certain strategies that investors can apply in order to lower their taxes to the bare minimum.

Here are a few proven tips for effectively reducing taxes on short term rentals:

• Deduct everything you can: Airbnb hosts frequently underestimate the variety of business expenses that can be depreciated against rental income. To maximize your tax profits, check whether this is a deductible expense every single time you spend money on your short term rental, no matter how small the payment is. Over the course of a year, small expenditures can accumulate to large amounts, not to mention over the course of the lifetime of your business.
• Keep track of all expenses: Make sure that you keep records of all costs that you incur on your Airbnb rental, both small and big. Moreover, it’s not enough to simply write down expenses; you also need to keep proof such as receipts and invoices. Being organized is crucial to lower your tax bill.
• Make use of depreciation: Depreciation applies not only to the actual real estate property but also to many of the fixtures, furnishings, and appliances that you install in it that are needed for your Airbnb business operations. Write off the decreasing value of any applicable items in order to maximize tax savings.
• Get a cost segregation study: A cost segregation study identifies all rental property-related expenses that can be appreciated over a shorter period of time: 5, 7, or 15 years. This applies to costly items such as landscaping, plumbing, electrical fixtures, and HVAC systems. Once you know the useful lifetime of each item in your property, you can speed up depreciation where applicable to save more on your taxes.
• Introduce energy-efficient improvements to your property: Opt for energy-efficient fixtures, appliances, and amenities to benefit from tax credits. This will help you save on your energy bill as well.

As a savvy STR investor, you need to plan your tax strategy before the beginning of the new tax year. You should analyze your property and list down all ways in which you can reduce your taxable income. If taxes are not your forte, it’s worth considering a consultation with a tax professional such as a CPA or a financial advisor to maximize tax savings from your short term rental property.

Bottom Line

With Airbnb-style investments, you can make money in the short term, benefit from real estate appreciation, and save on taxes with the short term rental tax loophole. While this strategy might seem complicated and demanding, it’s worth checking if you qualify in case you spend a considerable amount of time on managing your business and offer hotel-like services. Deducting business expenses and depreciating assets faster can lead to major reductions in your taxable income and huge tax savings.