Short-term rentals are more than a growing trend in real estate investing. They can also be a powerful tool for reducing taxes when used correctly. The short-term rental (STR) tax strategy allows investors to treat their rental losses as nonpassive, opening the door to offsetting W-2 wages, business income, and other earnings.
The key is understanding how the IRS defines STRs, how material participation works, and what steps you need to take to position yourself for these tax advantages.
What Makes STRs Different From Regular Rentals
Most real estate investors are familiar with the rules of passive activities. By default, rental income and losses fall into the passive bucket. That means losses from long-term rentals typically cannot offset nonpassive income like wages or business profits. Instead, those losses often carry forward to future years until there is passive income to offset them.
Short-term rentals work differently. If your property qualifies as an STR, the IRS does not consider it a rental activity. Instead, it is defined as an active business, similar to a hotel. This distinction allows investors to unlock tax benefits that are not available with long-term rentals.
IRS Rules You Need to Know
Before you can use the STR tax strategy, it is crucial to understand the criteria that make a property eligible:
- Average Stay Requirement: Your property qualifies if the average guest stay is seven days or less. You can also qualify if the average stay is 30 days or less and you provide substantial services, such as daily cleaning during the stay, concierge support, or meals.
- Personal Use Threshold: You must not use the property for personal enjoyment for more than the greater of 14 days or 10% of the days you rented the property at fair market value. Days spent working on the property do not count as personal use, and days the property is vacant do not count as rental days, even if it was available to be booked.
- Material Participation: To treat your STR activity as nonpassive, you must materially participate. This means you are actively involved in the day-to-day operations of running the property, including marketing, guest communication, check-ins, maintenance and cleaning coordination, and other management activities.
The IRS has seven tests for material participation; however, the two to focus on are (1) 500+ hours spent on the STR during the year or (2) 100+ hours spent on the STR and more than anyone else. These two tests are quantifiable and provide a time goal to hit. An additional benefit if you are married is that both spouses’ hours can be combined to reach the target.
Accurate time tracking is critical.
Benefits of the STR Tax Strategy
The primary advantage of the STR tax strategy is that losses may be used to offset nonpassive income. This can result in significant tax savings, especially in the early years of ownership when depreciation and make-ready costs are high.
Other benefits include:
- Accelerated Depreciation: Through a cost segregation study, you can identify building components with shorter depreciable lives, allowing for faster deductions. Bonus depreciation can further amplify this benefit.
- Broad Expense Deductions: STR owners can deduct expenses such as cleaning fees, furnishings, interior design, supplies, repairs, software costs, utilities, and insurance.
- Flexibility with Portfolio Planning: Unlike long-term rentals, STRs offer more flexibility to convert to mid-term or long-term rentals, given their higher turnover frequency, which aligns with your overall investment strategy and timeline.
How to Put the Strategy into Practice
If you are considering the STR tax strategy, follow these steps to maximize your savings:
- Confirm Your Property Qualifies: Review average length of guest stays and the services you provide to ensure IRS rules are met.
- Track Material Participation: Maintain a detailed log of hours and activities related to your STR. Documentation can make or break your case if audited.
- Explore Cost Segregation: Engage professionals to conduct a study and identify opportunities for accelerated depreciation.
- Deduct Strategically: Keep accurate books and records of all expenses tied to your property. Even small items can add up to meaningful deductions. Messy books and unorganized records can tank your chances of winning an audit.
- Work With a CPA: STR tax rules are complex. A CPA who specializes in real estate can help you apply the rules correctly and avoid common pitfalls.
Common Mistakes to Avoid
Even though STRs can be powerful tax tools, many investors encounter problems due to misunderstandings or inadequate preparation. Avoid these common mistakes:
- Assuming all STRs automatically qualify without reviewing IRS requirements and qualifying criteria.
- Failing to track hours of participation throughout the year.
- Not taking accounting seriously. Reconcile your books monthly or hire a pro to do so for you!
- Confusing STR rules with long-term rental rules can result in incorrect filings.
Is the STR Tax Strategy Right for You?
The STR strategy is not for everyone. It requires active management, accurate recordkeeping, and a willingness to stay involved in the day-to-day operations of your rental. However, if you are committed to building wealth through real estate and want to maximize your tax position, it can be one of the most effective strategies available.
Final Thoughts
Short-term rentals offer more than just cash flow opportunities. They also present a powerful way to reduce taxes when the rules are applied correctly. By understanding the IRS requirements, documenting material participation, and working with a qualified tax professional, investors can unlock significant savings and create a stronger financial foundation.
Want to maximize your short-term rental tax benefits? Contact Aiola CPA to learn how we help investors plan, document, and execute this strategy effectively.
