The Short-Term Rental Tax Loophole: What Investors & High W2 Income Earners Need to Know About a Popular Tax Reduction Strategy

The Short-Term Rental tax loophole is a powerful tool for high-income earners looking to reduce their tax burden. 

This loophole specifically applies to properties rented out for short periods. Unlike long-term rentals, which are usually classified as passive income, STRs are often treated as active businesses. 

Platforms like Airbnb and VRBO have popularized this strategy, making it accessible for more people to leverage it for tax savings. As a specialized deduction our clients can leverage on top of standard deductions, it’s one of the ways Royal Legal solutions helps people achieve financial freedom.

Let’s take a closer look.

How the STR Tax Loophole Works

The STR tax loophole allows property owners to classify their rentals as active businesses if they have rental periods averaging less than seven days. By doing so, owners can use the losses from these rentals to offset their earned income. This can be particularly beneficial for high W-2 and 1099 earners, who are subject to higher tax rates. 

This loophole essentially allows you to treat the income differently than passive rental income, giving you an opportunity to reduce your tax burden.

Comparing STR Tax Loophole and Real Estate Professional Status

While both the STR tax loophole and Real Estate Professional Status (REPS) offer ways to use rental losses to offset earned income, there are key differences. 

REPS requires that you spend more than 750 hours and over half your working time on real estate activities. 

For those who earn high W-2 income but can't qualify as real estate professionals, the STR loophole is a great alternative. The STR loophole offers a simpler route to offset income through shorter participation requirements.

If you actively manage your properties and meet certain participation thresholds, we can show you how to leverage this loophole to significantly reduce your tax liability by offsetting a portion of your taxable income through material participation. 

What is the Material Participation Test for the STR Tax Loophole?

To take advantage of the STR tax loophole, investors need to pass the material participation test. This involves meeting one of seven criteria designed to show active involvement in the rental business. 

Key benchmarks include spending 500+ hours on rental activities, being solely responsible for business activities, or dedicating more hours than anyone else involved in the business. Each criterion offers a unique pathway to proving material participation.

Qualifying for the STR loophole requires more than simply owning a rental property. You need to actively participate in managing the property, keep thorough records, and meet one of the material participation requirements. 

To qualify under the material participation rules, activities that count toward your hours include property maintenance, marketing, communication with guests, and general property management. 

The required criteria for material participation include:

1. Spending 500+ hours on your STR business.
2. Being the sole participant responsible for STR activities.
3. Spending at least 100 hours more than anyone else on the business.
4. Combining significant participation activities to reach 500+ hours.
5. Involvement in the activity for 5 out of the last 10 years.
6. Participating in the activity for 3+ years if it is a personal service.
7. Continuous, regular engagement in the business.

Meeting any one of these criteria can enable you to use the STR loophole to offset your active income with rental losses. Note: Hours spent on investor activities like arranging financing do not count.

Depreciation for Your Short-Term Rental Tax Strategy

Bonus Depreciation allows property owners to immediately deduct a large percentage of the cost of certain assets. Bonus depreciation is an IRS tax code that lets you “depreciate” the value of certain assets that make up a rental property more quickly than normal.

Instead of getting a tax write off over the useful life of a property, you’ll be able to get a larger deduction in the first year the asset was placed in service. By depreciating the cost of eligible assets up front, you can free up cash flow, reduce the tax liability for your business, and possibly even qualify for a lower tax bracket.

For the STR it allows the taxpayer to take a large depreciation in year one, which lowers their taxable income.

Rental Property Depreciation, on the other hand, enables you to deduct the cost of the property itself over time. This becomes a key strategy for reducing taxes, especially for STRs.

A cost segregation study helps to reclassify parts of your property from a standard 39-year life to shorter lifespans like 5 or 15 years. This allows for accelerated depreciation and can result in significant tax savings. Even as bonus depreciation phases out to 0% by 2027, conducting a cost segregation study can still maximize your property’s depreciation benefits.

Additional Strategies to Reduce Taxes on Short-Term Rental Properties

To further reduce taxes on your STR properties, you should maximize all property-related deductions. You can leverage depreciation not only for the property but also for furnishings and equipment. 

Self-managing your short-term rentals not only helps you qualify for the loophole but also maximizes the time you spend on active participation. By handling the day-to-day operations yourself, you ensure that your hours count toward the material participation requirements.

Meticulous tracking of all STR expenses, such as repairs, utilities, and home office costs, can ensure you take advantage of every deduction. Royal Legal will provide you with a financial team, including a real estate CPA and tax advisor, to optimize your tax strategy.

Properties with Multiple Units

If you own properties with multiple units, qualifying for the STR loophole can be even more beneficial. Managing multiple units means additional opportunities to accumulate hours that count towards the material participation test. 

The rules remain the same, requiring careful management and documentation of each unit.

When to Avoid Qualifying for the STR Loophole

The STR loophole is not always the right fit for every investor. If you have low or moderate income, or if you do not have the time to meet the material participation requirements, it might be best to explore other strategies. 

Overcommitting to the loophole without the ability to follow through could lead to noncompliance issues with the IRS.

Challenges & Considerations: What's Changing About Depreciation for STRs?

The depreciation rules for STRs are changing, particularly the phasing out of bonus depreciation. By 2027, bonus depreciation will be reduced to 0%, limiting the immediate tax advantages previously available. 

This change requires careful planning to ensure compliance and to maximize benefits before the phase-out. Staying up to date on tax laws and consulting with a CPA are crucial for navigating these challenges effectively. Royal Legal will guide you through the process.

Final Thoughts: Tax Strategies for Short-Term Rentals

Short-term rentals offer substantial tax advantages if approached strategically. The loophole provides opportunities for high-income earners to offset their active income, but it requires careful planning and adherence to IRS guidelines. Engaging with knowledgeable financial professionals and using property management tools can help you stay compliant and capitalize on the available benefits. As the landscape of STR tax strategies continues to evolve, staying informed and adaptable is key to long-term success.