STR Tax Loophole Guide

Quick Answer

The short-term tax loophole strategy uses depreciation techniques to offset the costs of components of your property and subtract it from your W2 tax income payments, provided that you pass the IRS passive income requirements and the material participation test.

Introduction

There are plenty of different tax strategies that can help you save up costs by exploring various loopholes and applying them to your own short-term rental. Today, we’ll be covering something that’s called the “short-term rental (STR) tax loophole that’s specifically beneficial for high W2 income earners with the extra time to manage a rental property.

This strategy can help you save up on some pretty hefty federal taxes if you follow our guide correctly. We’ll teach you the ways of this tax strategy and how to meet the Material Participation Test of the IRS.

The Short-Term Rental Tax Loophole vs. Real Estate Professional Status

As an investor, you’d ideally like to be recognized by the IRS with an official Real Estate Professional Status (REPS). It’s specifically unique to property traders, investors, and agents, among others involved in real estate dealings. It provides valuable tax exemptions like removing passive activity loss limitations and being able to deduct losses from the entirety of your taxable income instead of the usually passive income.

However, being acknowledged with REPS requires a harsh and demanding process that not everyone can meet. This is where our nifty short-term rental tax loophole enters. It provides a similar level of tax benefits to entities with REPS by redefining rental activity and changing the tax process for the revenue your rental generates.

With this tax strategy, you’re essentially using the income generated from your short-term rental business and offsetting it using your taxable income by deducting the depreciation and your other expenses. The great thing about this loophole is that it’s exempted from the “passive limitation rules” mentioned for individuals with REPS, providing a similar level of deductions despite not applying for the official Real Estate Professional Status. It can potentially save you a lot of money on taxes that you can use to reinvest in your STR.

The IRS Passive Income Exemption Requirements

To fully take advantage of this loophole, we first have to differentiate between passive and non-passive activity. Any of your rental activities that fall under the “passive” category will fall under the jurisdiction of this loophole, allowing you to use it for deductions.

Luckily, the IRS has its own set of conditions that have to be met to be considered for the passive income exception; these are:

• The average length of stay of each guest does not exceed seven days.
• On average, guests should occupy the property as a rental is 30 days or less, and the owner also provides services similar to those of a hotel.
• The owner is able to deliver an exceptional level of personal service that prepares the rental for use.
• Rentals aren’t the major source of the owner’s non-rental activities.
• The property is accessible during specified business hours and isn’t exclusive to a distinct guest.
• Providing the property for activities carried out by a partnership, S-corporation, or joint venture in which the property owner holds an interest is not regarded as a rental activity.

If your short-term rental meets these qualifications, then you can use our guide to benefit from the STR tax loophole for big tax savings.

The IRS Material Participation Test

Although the Short-Term Rental (STR) Loophole offers easier access than the Real Estate Professional Status (REPS), you can’t exactly sit back and do nothing. The IRS continues to require substantial involvement in the rental operation, which is why you need to have some extra time on your hands to handle your property and not leave everything to the hands of a management company.

Thus, the IRS Material Participation Test was established. It’s composed of seven different criteria that are used by the IRS to determine if you’re actively involved in a trade or business, or in this case, in your STR.

Fortunately, you only need to meet 1 out of the 7 criteria to pass the test.

1. More than 500 Hours of Participation – the individual has participated in an activity for at least 500 hours during the year.
2. Substantial Participation – the individual’s participation covers the vast majority of active hours, and nobody else participates more than the individual.
3. Personal Participation for More Than 100 hours – the individual participates for at least 100 hours within the tax year, with no one having logged higher participation hours.
4. Significant Participation Activities (SPAs) – the individual participates in one or more activities with more than 100 hours logged on each, totaling at least 500 active hours.
5. Material Participation for any of the 5 prior 10 years – the individual materially participated in the activity for any five of the ten years immediately preceding the current tax year.
6. Material Participation in a Personal Service Activity – Participating in a personal service activity for any three prior tax years.
7. Based on Facts and Circumstances - Even if the individual does not meet any of the above criteria, they may still qualify as materially participating based on the facts and circumstances. This generally requires significant participation in the activity regularly, continuously, and substantially.

Importance of Self-Managing Your Short-Term Rental

As you may have noticed by now, it’s critical that you self-manage the rental property to benefit from using the STR tax loophole. You must show that you are actively involved within the business to qualify, and that’s a small price to pay if you’re generating a high income from your STR and want to save on taxes.

It’s Now or Never: The Decline of Depreciation for Short-Term Rentals

If you’ve been teetering between starting an Airbnb or any form of short-term rental, you might want to decide quickly.

Time and trends aren’t in your favor because, since 2018, the bonus depreciation rate for STRs has been on the decline. It used to be 100% between 2018 to 2022. However, 2023 decreased that to 80%, while 2024 brought it even lower at 60%.

At the current rate, 2025 means that it’ll drop down to 40%, 2026 is 20%, while 2027 removes the bonus depreciation rate entirely. While nothing’s set in stone yet, the current trajectory isn’t exactly promising. So, we recommend acting now to take advantage of higher depreciation rates while they’re still here.

How to Use Depreciation in The Short-Term Rental Tax Loophole Strategy

Standard properties often start to depreciate in 39 years. That’s a long time to wait for savings. However, certain portions of your property won’t last for 39 years; they’ll only be there for 5 or 15. The IRS basically allows you to say, “These parts won’t last for 39 years, they’ll only last for 5.” This way, you can spread the cost for those specific parts between 5 to 15 instead of the original 39 years, allowing you to save money on taxes sooner.

Here are the two steps you need to do:

1. Cost Segregation Study – it’s usually done by a team of tax experts and will require some upfront costs, but it can allow you to save in deductions for several years. It’s a long process, but the gist of it is listing down every part of your rental to see which parts would wear out sooner.
2. Reclassifying Property Parts – Once the study is finished, you can now find each part that wears out faster. So, you can count their costs over a shorter period of time, changing them from 39 years down to 5 and 15. It usually includes things you can touch or improvements you’ve made to the land.

This strategy works mainly because the 5 and 15-year parts are usually worth around 20 to 30% of the initial purchase price. Your losses on these parts are considered non-passive, which means you can count it towards a tax loss and use it to offset your W2 income. Pretty neat, right?

Despite this guide helping you through the process, we still recommend consulting with an expert to tailor the STR tax loophole strategy specifically to your situation.

Conclusion

That’s our entire guide on how you can qualify and benefit from the STR tax loophole if you’re a W2 high-income earner. Hopefully, we were able to help you save up on taxes for your short-term rental business.

FAQs

What Parts Can Be Reclassified for a Shorter Depreciation Life?

Typically, it involves parts you can touch, such as appliances, flooring, lighting, carpeting, landscaping, and land improvements.

How Much Is a Cost Segregation Study?

The cost will depend on your property’s size, type, and physical characteristics. It usually falls within the $1,000 to $3,000 range.

Do I Need To Self-Manage My Rental To Take Advantage of the STR Tax Loophole?

Not necessarily, but it’ll make meeting requirements for the IRS Material Participation Test easier. It’s going to be tough to be the one with the highest participation hours if you aren’t self-managing your rental.