Written by Randall Weaver, CPA and Geoffrey Kaufman, CPA, MBA
Real estate investors seek to maximize their tax advantages while maintaining profitable investments. One area with significant opportunities is the short-term rental (STR) "loophole". This blog post will explore a case study demonstrating how proper planning around STR can benefit real estate investors, particularly those who are not real estate professionals.
Understanding the Short-Term Rental "Loophole"
Typically, rental activities are considered passive under IRS Section 469, unless a taxpayer qualifies as a real estate professional. However, an STR can bypass these passive activity rules if the average rental period per guest is seven days or less. When structured correctly, STR owners can claim nonpassive losses that offset other income sources, leading to significant tax savings.
Case Study: How One Investor Benefited from STR Tax Advantages
Scenario
A taxpayer, who is a full-time employee, purchased a vacation rental in a southern state and listed it on Airbnb. Since their full-time job prevented them from qualifying for the real estate professional tax status, they used the STR "loophole" to unlock tax savings.
Key Strategy 1: Meeting Material Participation Requirements
To claim nonpassive losses, taxpayers must meet one of seven material participation tests. The most relevant test for STR investors is spending at least 100 hours managing the property while ensuring no one else spends more time on it.
Critical Considerations:
- The investor actively managed bookings, handled maintenance, and interacted with guests, surpassing the 100-hour requirement.
- They avoided hiring a property manager, which would have automatically disqualified them.
- If a cleaner worked more hours at the rental than the owner, the taxpayer would not have qualified.
Key Strategy 2: Utilizing a Cost Segregation Study
A cost segregation study was conducted to classify portions of the property under different depreciation schedules, allowing for accelerated depreciation:
- Some components were assigned to 39-year depreciation.
- Others were categorized as 5-year bonus-eligible depreciation, unlocking immediate deductions.
Even after adjusting for limited personal use, the taxpayer generated a $255,000 nonpassive tax loss, significantly reducing their taxable income.
Tax Impact: Significant Savings on W-2 Income
By applying the STR tax strategy, the taxpayer saved approximately $78,000 in federal income taxes. Although this reduced their Qualified Business Income (QBI) deduction, the net financial benefit remained substantial.
In future years, any additional improvements to the property may be eligible for treatment as Qualified Improvement Property (QIP), qualifying for bonus and a faster depreciation period of 15 years. This is because STR property is considered commercial. This greatly accelerates the realization of depreciation on improvements against STR income, compared to the 27.5-year life associated with improvements to a traditional long-term rental property. Refer to our January Blog on QIP for more details on residential versus commercial rental improvements.
Qualified Improvement Property: A Case Study on Real Estate Savings >
Lessons for Real Estate Investors
1. Understand Material Participation Rules
To claim nonpassive STR losses:
- Actively manage your property and track hours meticulously.
- Avoid hiring a property manager or outsourcing significant tasks.
Purchasing an STR late in the year can be advantageous, as fewer hours may be needed to meet the material participation test.
2. Consider a Cost Segregation Study
Cost segregation can accelerate depreciation and provide immediate tax deductions. This strategy is especially beneficial when bonus depreciation is high:
- 2023: 80% bonus depreciation
- 2024: 60% bonus depreciation
- 2025: 40% bonus depreciation
3. Properly Account for Personal Use
Personal use of an STR—including by family members who pay below market rates—must be carefully tracked. Misreporting personal use can trigger IRS scrutiny and penalties.
4. Plan for QBI Deduction Impacts
While STR income may qualify for Qualified Business Income (QBI) deductions, generating nonpassive losses can reduce the deduction amount. Taxpayers should weigh these trade-offs when implementing STR tax strategies.
5. Maintain Records for Ongoing Improvements
Once an STR property is placed into service, additional improvements to the property may qualify as QIP. This allows real estate investors to deduct costs at a much quicker rate compared to improvements made to traditional long-term rental properties.
Conclusion
Short-term rentals offer real estate investors a unique opportunity to unlock substantial tax savings — even without real estate professional status. By strategically managing an STR, ensuring material participation, and leveraging cost segregation, investors can maximize deductions and reduce their taxable income. Planning to improve the property during years with higher ordinary income from other sources can also help maximize tax savings. If you’re considering an STR investment, consult a tax professional to ensure you comply with IRS regulations while optimizing tax benefits.
How Trout CPA Can Help
At Trout CPA, we specialize in helping real estate investors navigate complex tax regulations and implement strategies that enhance profitability. Our expertise includes:
- STR tax planning & compliance
- Cost segregation studies
- Real estate tax classifications
- Entity structuring for tax efficiency
Contact Trout CPA today to explore how strategic tax planning can benefit your real estate portfolio.
About the Authors
Randall Weaver, CPA
Randall joined Trout CPA in 2011. He graduated from Millersville University with a Bachelor of Science degree in Business Administration (magna cum laude) in 2006. Randall has over 19 years of accounting experience. He currently serves on the firm's Construction and Real Estate, Manufacturing, and Estate & Trust Practice Groups. As a Partner, Randall manages all aspects of tax planning and preparation and business consulting for some of the firm's significant clients. Randall enjoys activities with his family, being involved with his church, and rooting for Philadelphia sports teams. He lives in Lancaster County with his wife and two children.
Geoffrey Kaufman, CPA, MBA
Geoff joined Trout CPA in August 2020. He graduated Summa Cum Laude from Lebanon Valley College's 3+1 Accelerated Bachelor of Science in Accounting and MBA Program. He currently serves on the firm's Construction & Real Estate, Manufacturing & Distribution, and Estate & Trust Practice Groups. As a Senior Associate, Geoff assists with attest services, including financial statement preparation, and provides tax planning and preparation support for individuals and corporations. Additionally, Geoff specializes in helping real estate investors navigate the complexities of their financial and tax obligations. In his free time, Geoff enjoys spending time with family and friends, hiking, going to the beach at Wildwood Crest, and volunteering in the community. He lives in Lancaster County with his wife and daughter.
