The rise of short-term rentals (STRs), fueled by platforms like Airbnb and Vrbo, has created new opportunities for real estate investors and homeowners alike. However, the tax treatment of STRs is nuanced and often misunderstood. From the 30-day rental rule to material participation tests and real estate professional status (REPS), understanding the interplay of these rules is essential for maximizing tax deductions and minimizing audit risk.
Understanding Rental Activity Rules for Short-term Rentals
A rental activity is considered a passive activity even if the taxpayer materially participates in the activity, unless the taxpayer qualifies as a real estate professional. However, a taxpayer's activity is not considered rental activity if the following apply:
- The average customer’s stay is seven days or less.
- The average customer's stay is 30 days or less, and the taxpayer provides significant personal services with the rental.
- A property is rented for 14 days or fewer during the year and used personally for more than 14 days. In this case, the rental income is not taxable, and no expenses are deductible. This is often used by homeowners in high-demand areas for a specific event and is known as the Augusta Rule (IRC Sec. 280A(g)).
- The taxpayer provides extraordinary services, and the customer's use of the property is incidental in comparison to the services.
Understanding the Seven-day Loophole
If the average lease term for a property is seven days or less, then the property is considered a trade or business activity. If the taxpayer materially participates in that activity, then the losses from the activity can potentially be used to offset non-passive income (i.e., W-2 income). It is important to note that, depending on the services performed by the taxpayer, the income from this property may be subject to self-employment tax.
Understanding the 30-day Rule
As noted above, if the average property stay is 30 days or less, the activity may be treated as a non-passive trade or business, provided the taxpayer provides substantial services. If substantial services such as daily cleaning, concierge, meals, etc., are provided, then the activity may be classified as a trade or business, rather than a rental, even if the average stay exceeds 30 days. Significant personal services only include services provided by individuals. To be considered significant, one must consider the:
- Frequency
- Type of service
- Amount of labor performed
- Value of the services relative to the amount charged for the use of the property
For example, if the services provided are “hotel like,” then the activity could be categorized as an operating business, and the taxable income from operations could potentially be subject to self-employment taxes.
How To Qualify for Material Participation in Short-term Rentals
In order to treat STR income as non-passive and deduct losses against other forms of income, the taxpayer must “materially participate” in the activity. For each property under consideration, the IRS outlines seven tests for material participation to qualify as a short-term real estate investor. A taxpayer must pass one of the seven tests below to qualify:
|
Test 1 |
The taxpayer participates in the activity for more than 500 hours during the year. |
|
Test 2 |
The taxpayer performs substantially all the work to operate the short-term rental. |
|
Test 3 |
The taxpayer participates for more than 100 hours, and no other individual participates more than the taxpayer (including non-owners of the property, i.e., property manager, landscaper). |
|
Test 4 |
The taxpayer has significant participation in the activity of more than 100 hours, and the taxpayer’s combined activity in all significant participation activities exceeds 500 hours annually. |
|
Test 5 |
The taxpayer participated in the business for five of the 10 preceding taxable years. |
|
Test 6 |
The activity is considered personal service activity in which you materially participate for any three previous taxable years (whether consecutive or not). |
|
Test 7 |
The taxpayer has regular, continuous, substantial and provable participation in the business for more than 100 hours during the year. |
Short-term real estate investors are most likely to qualify for material participation under tests 1, 2 or 3. If the taxpayer qualifies under one of the tests, then STRs are not considered rental activities under the passive activity rules if the average stay is seven days or less, or 30 days or less with substantial services. Hence, if one of the tests is met, this opens the door to non-passive treatment, providing an opportunity for non-passive losses to offset non-passive income. Taxpayers should consult with their tax advisors to determine if Section 461 business loss limitations will impact their ability to deduct losses.
Grouping Short-term Rental Activities To Meet IRS Material Participation Tests
Taxpayers with multiple STRs may consider grouping them as a single activity for purposes of meeting the material participation threshold. This is allowed under IRS Reg. §1.469-4, but must be done with care, and taxpayers should take note of the following:
- Grouping must be reasonable and based on economic interdependence.
- A formal election must be made on your tax return.
- Once grouped, the activities are treated as one for all purposes, including disposition and audit risk.
Grouping can be a powerful tool for investors managing several properties with moderate participation in each. For taxpayers with a mix of STRs and long-term rentals, careful planning is required to optimize grouping and participation strategies.
Short-term Rental Tax Benefits and Advantages
Provided that the property meets the stated criteria, STRs enable investors to have income and losses available to offset other forms of earned income (to include W-2 income), creating substantial tax savings opportunities.
In addition, STRs in the right locality (i.e., near coastal or other highly desirable vacation destinations) are typically more profitable than long-term rentals, since the nightly rates charged on platforms like Airbnb can potentially outperform the income received from long-term property rentals.
STR properties also allow investors to potentially accelerate the deduction of many expenses, including advertising, mortgage interest, repairs and more. Leveraging current depreciation rules is potentially the most beneficial of all.
Under P.L. 119-21, or the "One Big Beautiful Bill Act," passed July 4, 2025, permanent 100% bonus depreciation was restored for property acquired after January 19, 2025. By utilizing the benefits of a cost segregation study and reclassifying a portion of your business property from a prescribed IRS life, which is typically 27.5 to 40 years, into shorter class lives, a taxpayer can dramatically accelerate short-term rental deductions via bonus depreciation rules.
Example
If you own a $1 million dollar property and you completed a cost segregation study, where as much as 25% of your purchase price could be recharacterized into a shorter asset life and fully depreciated. Current tax law could provide you with a $250,000 deduction and an immediate $87,500 estimated tax savings (at a 35% federal rate).
Disadvantages of a Short-term Rental Activity
Time Demands
Managing a STR property requires significantly more time than a long-term property rental. Owners must manage guest inquiries, marketing, cleaning between stays and other operational tasks.
Income Unpredictability
STR income can fluctuate due to seasonality and quiet periods, unlike long-term rentals that provide a steady monthly stream.
Property Suitability
Not all properties are ideal for STRs. Homes in popular travel destinations perform best, while those in less-visited areas may struggle to attract guests. For some properties, there may not be sufficient interest in justifying operating the property as an STR.
Meticulous Recordkeeping for Compliance
Detailed documentation is essential to track participation hours, tenant rental periods, personal use, and contractor and cleaning time to meet IRS requirements and avoid failing the hours test.
Local Regulations
Many local governments and homeowner associations impose strict regulations or even bans on STRs; ongoing research and monitoring are essential to remain compliant.
Short-term Rental Tax Strategy: Planning Around IRS Rules and REPS Limitations
STRs offer lucrative opportunities, but the tax rules are layered and often counterintuitive. Key takeaways include:
- Average rental stay is a key factor in determining if the activity is considered a rental activity.
- Material participation is essential for deducting losses.
- Grouping can help meet participation thresholds, but must be done properly.
- REPS does not apply to most STRs, but other paths to non-passive treatment exist.
The STR rules are unique to other types of real estate investing. Taxpayers should work closely with advisors to document participation, evaluate grouping elections and ensure compliance with IRS rules. With the right strategy, STR investors can “unlock” significant tax benefits while minimizing risk.
To help ensure your STR strategy is aligned with the latest IRS guidance and optimized for your financial goals, reach out to a Cherry Bekaert professional today. Our experienced tax advisors can guide you through the complexities and uncover opportunities tailored to your unique situation and investment portfolio.
Related Insights
