One of the great tax advantages of real estate is that rentals often generate a loss on paper, mostly thanks to depreciation. And that negative income can help offset your other income to reduce your tax bill. But you can’t always use the real estate rental loss to offset your other income unless you meet the conditions for one of the ways to deduct your real estate losses. One of those four ways is the so-called “short-term rental loophole”.
What It Gets You
If your short-term rental meets all the qualifications that we’ll explain in this article, the STR loophole lets you deduct all your rental losses from your ordinary income (such as your W-2 job or your business income).
If your net taxable rental income (after subtracting all expenses and the depreciation of the property) is not negative, then there is less reason for you to try to qualify for the STR Loophole if you don’t have negative taxable rental income. If you have taxable rental profit, you may instead want to go in the other direction and see if you can avoid paying self-employment tax on the profit.
How to Qualify for the STR Loophole
There are two qualifications you must meet for your rental property to qualify for this loophole, a short-term average stay, and material participation. You must meet both tests.
- Short-term average stay: The average length of stay of your guests must be less than 7 days. Alternatively, you can also qualify if the average stay is less than 30 days and you provide “significant personal services.” Significant personal services exclude activities that are typical of a rental, like cleaning between guest stays, so that option isn’t relevant to most short-term rentals.
- Materially participate: There are three primary ways most often used to meet the qualification for material participation. You need to qualify for any one of these tests:
- You or your spouse do substantially all the work to manage the rental. That means you do all the management, cleaning, etc. yourself.
- Or if other people also help with the rental, you have to spend at least 100 hours per year on it, and that must be more time than anyone else. So if you use a cleaner who is going to spend more hours working on the property than you, one solution to that is to use multiple cleaners to keep them under your number of hours. You need to keep a log of the hours you spend on it and the time that other people spend on it as well.
- Or if anyone else spends more time on it, then you have to spend at least 500 hours per year. (There is a way to optionally group multiple rental properties together to meet this test.) You need to keep a log of the hours you spend on it and the time that other people spend on it as well.
You must meet this material participation requirement for each property that has losses that you want to deduct from your other income (unless you elect to group multiple properties together). For more detailed information, see our article on material participation.
Additionally, it’s important to be aware that the STR loophole also won’t work if you go over the limit of personal use days of the property, because that would prevent you from being allowed to take a tax loss on the property. So your personal use days (which is your personal use of the property, or family members, or any days you rent it at less than fair market rent value) can’t be more than 10% of the number of days it was actually rented out (or 14 days is the limit if that calculates to less than 14 days).
Properties with Multiple Units
The calculation for the average stay gets a little complicated if you have multiple units (or multiple rooms rented out separately, etc). The actual calculation to determine the average stay with multiple units is a weighted average based on the amount of rent revenue each portion of the property is generating (see Regs 1.469–1(e)(3)(iii)(b)). But in practice, we rarely have to make that computation because usually it’s clear if you’re above or below the 7 day threshold. But if it’s not clear, it may be necessary to make that computation to calculate the exact average stay.
If you have multiple units and you live in part of the property as an owner-occupied unit, you can still qualify for the STR loophole using the average stay of the rental portion.
When to Avoid Qualifying for the STR Loophole
There are some scenarios when you would be better off not qualifying for this strategy, most notably if your short-term rental is operating at a taxable profit rather than a loss. If you have a particularly profitable short-term rental, it may be generating a taxable profit even after subtracting expenses and depreciation. In that case, this strategy would be either not be useful to you, or could actually increase your tax bill.
Consider this example. If you have two rental properties, one that is long-term and generating a tax loss, and the other that is short-term and generating a taxable profit. The long-term rental is considered passive income (assuming you don’t qualify for real estate professional status). If the short-term rental profit is also considered passive income, then you can net income and loss of the two rentals together. So the short-term rental’s profit can offset the other rental’s gain. But if you use this STR loophole strategy to make the short-term rental non-passive, then the other rental’s losses can no longer be netted against the short-term rental’s gains, because passive losses can’t offset non-passive gains.
Tax Code Reference
Real estate rental activities are considered to be passive income even if you are actively participating in the activity, and most passive loss can’t offset other types of income from activities that are non-passive. But there are some exceptions, including an exception that allows for the STR loophole. This is also explained in the instructions for form 8582 (Passive Activity Loss Limitations).
The relevant tax code is section 469, with guidance provided by Treasury Regulations section 1.469. Regs 1.469-1T(e)(3) provides the definition of “passive activity” as it relates to “rental activity”. Regs 1.469-1T(e)(3)(ii)(A) provides an exception if “the average period of customer use for such property is seven days or less. ” And then Regs 1.469-1T(e)(3)(ii)(B) additionally provides an exception if “the average period of customer use for such property is 30 days or less, and significant personal services … are provided.” So that establishes that such properties are exempt from the definition of “rental activity”, and therefore they aren’t automatically considered passive.
While that makes such properties not a “rental activity”, the activity still must meet the qualifications to determine if a business activity is passive or not. In order to meet that standard, material participation must still be met, as defined in Regs 1.469-5T(a).
FAQ
Can this offset my capital gains from the sale of stock? Yes, it can offset any type of income including W-2 income, business income, other rental income, or investment income such as stocks.
How long does it need to be a short-term rental to qualify? If it’s a new rental that you just put on the rental market that year, you need to have at least two stays to establish the average stay length, but most tax professionals recommend having at least three stays. A basis for this is tax court case Rogerson v. Commissioner (T.C. Memo 2022-49) in which the court’s findings state that “without any customer use, it is impossible to establish (as required by the regulations) the average period of customer use.” And that also means the calculations have to be based on actual customer use, so just making the rental available as a short-term rental isn’t enough. You have to have actual stays.
What if I later change it to a long-term rental in a later tax year? You aren’t required to continue using it as a short-term rental in later tax years, so you just wouldn’t qualify in those later tax years to deduct more losses. But it’s generally not advisable to try to game the system by doing a few short-term rentals on a new property at the end of the year and take the tax deduction and then immediately switch it to long-term. That may be technically allowed if you can make a reasonable claim that you did that for legitimate business reasons, but you may be opening yourself up to scrutiny by the IRS.
Is there an income limit to be able to use this? No.
Is there a limit on how much I can deduct using this method? The Excess Business Loss limits (section 461) apply, which limits the amount of regular income you can offset for 2024 to $305,000 ($610,000 for joint returns). These amount adjust each year for inflation. Additional losses above that limit are carried forward to apply to future tax years.
Can qualifying for the STR loophole unlock suspended losses from past years to offset my ordinary income? No. This strategy only lets you deduct losses for the current year when you qualify and make use of it. Past losses remain suspended until you have other passive income that it can offset. One exception to that, if the same property becomes more profitable and it now produces a taxable income, you can still use the past suspended losses to offset any current taxable profit for that same property (or grouped properties under a grouping election). This is based on tax code section 479(f).
What if the average number of days is slightly over 7 days, like 7.1 days? Can we round down? No. Based on the summary judgement case of James V. and Judith M. Patterson vs. Commissioner, the courts have stated that the average stay for this calculation must be exactly 7 days or less. If the average is even slightly over 7, you don’t qualify.
What if the same guest has multiple stays? If the same guest has multiple bookings during the year, they’re counted as separate stays as long as there is gap between the bookings when they are not staying at the property and it’s available to be booked by other guests between the stays.
How do you calculate the length of stays that go beyond the last day of the year? For example, how do you calculate the length of a stay that starts in December of one year and ends in January of the next year? The answer is in Regs 1.469-1(e)(3)(iii)(C)(1) which states “the aggregate number of days in all periods of customer use for property in the class (taking into account only periods that end during the taxable year or that include the last day of the taxable year)”. What that means is you have to include in your calculations all stays that either end that year, or that run through the last day of the year (December 31st). So for a stay that runs from December to January, you have to include the entire length of that stay in your calculations for both tax years!
Do stays by family member count? No, not if they are siblings (whole or half blood), spouse, ancestors, and lineal descendants of an owner (see tax code section 267(c)(4)). And their stay is considered personal use of the property (it may reduce the expenses you can deduct).
Finding a Tax Preparer to Help
The majority of professional tax preparers are completely unaware of this special exception in the tax code for short-term rentals. So don’t be surprised if your CPA or EA tells you that you can’t offset your other income with your short-term rental income in this way. There just isn’t a lot of awareness of this loophole in the tax code among tax preparers. You can share articles like this to help let them know, or contact us if you would like us to review your taxes or prepare your return. We specialize in real estate taxes, and this loophole is just one of the real estate tax strategies that you could be missing out on.
