The Short-Term Rental (STR) Loophole is a tax strategy that utilizes short-
term rental properties like AirBnbs to generate income while concurrently
writing off depreciation (non-cash expenses) to reduce taxable income. It
allows you to take paper losses from your rentals and use them to offset
your W2/business income. You can offset your ordinary/ W-2 income with
passive losses that are being generated from your STR business. These
are not cash losses but are merely tax losses. Thus, your STR business is
still making money on paper. Money is hitting your bank account, but you
get to tell the IRS you have a loss. And you’re able to use that loss to offset
your high earning W-2. There are plenty of doctors, dentists and other
professionals that have high earning jobs, invest in short term rentals, and
use those losses to offset their income. And they’re able to do this without
being a real estate professional. Let’s dive a little deeper.

To understand how STR Loophole works, we should first understand the
difference between passive and non-passive income (or loss).
Taxpayers have two types of income: active and passive. Any business
activity where you do not materially participate in generating income or loss
is considered passive. For example, owning a rental property you lease to
long-term tenants is considered passive, as owners do not spend enough
time running the business to be considered non-passive. On the other
hand, if you regularly and consistently participate in the day-to-day
management of the rental property, then the income generated is
considered non-passive.
Internal Revenue Code Section 469 generally disallows taxpayers from
offsetting active income with passive losses. Thus, a taxpayer cannot offset
their wages with losses sustained by rental activities if such losses are
considered passive, which they typically are.
However, exceptions to this rule can be found in Treasury Regulations
Reg. Section 1.469-1T(e)(3)(ii)(A), which outlines six exceptions to the
rules defining rental activities:

– A guest stay lasts no more than seven days on average.
– The average period that a guest uses the property as a rental is 30
days or less and the owner provides basic services that are on par
with what a hotel might offer.
– Owners provide extraordinary personal services to make the property
ready for us.
– Property rentals are treated as being incidental to the non-rental
activity of the owner.
– Use of the property is available during defined business hours and it’s
not exclusive to any one guest.
– Any provision of the property for use in activities conducted by a
partnership, S-corp or joint venture the property owner has an interest
in is not a rental activity.
Classifying your losses as non-passive is key because you can apply the
loss to your W-2 income or self-employed business income. Thus, the
“Seven-Day Rule” is particularly relevant for those who own and operate
short-term rental properties such as vacation homes and Airbnb or Vrbo
listings.
The second important part of the STR tax strategy is, you must prove that
you materially participated in your STR business to earn that non-passive
tax characterization.

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There are two ways you can prove material participation.
One, you can qualify as a real estate professional by spending more than
half your time (at least 750 hours a year) materially participating in real
property business. Most investors aren’t looking to spend more time
running their real property business than working in their current jobs, so
this option typically isn’t feasible.

Option two is to prove that you materially participated in running your STR
business by fulfilling any one of the 7 Material Participation Tests.
According to IRS Publication 925, short term rental property investors must
satisfy at least one of the “material participation” requirements listed therein
as to a given tax year:

1. You participated in the activity for more than 500 hours.
2. Your participation was substantially all the participation in the
activity of all individuals, including individuals who did not own
any interest in the activity.
3. You participated in the activity for more than 100 hours and at
least as much as any other individual (including individuals who
did not own any interest in the activity).
4. Your participation in the activity is a “significant participation,”
meaning more than 100 hours but not meeting any other
material participation test, and your total time on significant
participation activities exceeded 500 hours.
5. You materially participated in the activity for any five years
(whether or not consecutive) out of the 10 im- mediately
preceding tax years.
6. The activity is a “personal service activity” in which you
materially participated for any three consecutive or
nonconsecutive preceding tax years.
7. Based on all the facts and circumstances, your participation in
the activity was “regular, continuous, and substantial.”

The first three are the most common and easiest material participation tests
to hit, especially in the context of short-term rental investors.
Once you meet one of these tests, and your short-term rental is excluded
from the definition of a rental activity, then it is considered non-passive.

If you’re new to the world of real estate taxes, you might be wondering why
you would want to have a loss on your short-term rentals to begin with.
That’s because these losses are typically generated from the non-cash
expense called a depreciation deduction. Depreciation tracks the
deterioration of a building over a period of many years. It can create tax
deductions even though you may have generated positive cash flow.

By utilizing a process known as cost segregation study and a tax incentive
called bonus depreciation, it’s possible to significantly increase this
depreciation expense in the first year of operation. Doing a cost
segregation study will allow a significant amount of depreciation to be taken
in the earlier years of the study. This means that you will speed up your tax
deductions, and your net taxable income will go down, meaning more
money in your pockets.

The cost segregation will reclassify certain components of your property
from 39-year life (depreciation life for an STR property) into 5- and 15-year
life. 5- and 15-year property can represent anywhere from 20-30% of the
short-term rental purchase price.

For example, if you had a property where the house was worth $1M and
did a cost segregation study, anywhere from 20-30% could be eligible for
bonus depreciation. Assuming 25% was eligible, with bonus depreciation at
80% in 2023, this would give you a $200,000 deduction.

If you’re a higher-income earner in the upper tax bracket, this $200,000
deduction could be worth up to $74,000 in tax savings. This is a highly
effective way to save on taxes because your losses are non-passive and
you’re able to use that loss to offset your high earning W-2.

To effectively implement the STR Loophole strategy, you will first want to
invest in a short-term rental property, ensure it is rented out for an average
stay of seven days or less and materially participate in managing your STR
property. The STR Loophole presents a valuable opportunity for STR
investors to reduce their income tax liability by classifying their rental
activity as an active trade or business.

By taking advantage of this strategy, investors can deduct property
expenses from active income, potentially offset losses against other
business income and avoid self-employment tax on rental earnings.
Performing a cost segregation study on the individual taxpayer’s property
and circumstances can determine the viability of this tax position and may
open up additional tax savings.

While substantial financial benefits are available, it is essential to meet IRS
criteria, keep detailed records, understand depreciation, and stay informed
about local regulations.

As always, leveraging our expertise to buy a cash-flowing short term rental
property and consulting with one of our Certified Cost Segregation
Professionals as well as real estate CPAs can help investors navigate the
complexities of the tax code and make the most of the short-term rental tax
strategy.