Additional Short-Term Rental Loophole Considerations

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Here are some additional things to consider as dream of all the possibilities, opportunities and arbitrage.

Grab Yourself a Partner

This is an abbreviated repeat of our rental properties owned by partnerships section. WCG CPAs & Advisors encourages short-term rentals to be owned by partnerships such as a multi-member LLC Why?

First, the historical audit rate of partnerships (Form 1065) is 0.4%. Super low compared to individual tax returns (Form 1040) which might be 4% to 12% depending on your income levels. Why does this matter? When you have a big cost segregation depreciation plus your big startup expenses such as furniture and supplies, and you then have a big tax deduction against your big W-2 income because your passive losses are no longer limited with your big material participation, it raises some eyebrows.

Second, with a partnership tax return, we can mechanically show your capital contribution (at-risk money) including recourse loan debt. Why does this matter? Let’s say you invest $250,000 into a new business, and that business loses money. The IRS sees your “partner basis,” the $250,000, within your 1040 tax return, and suddenly the $100,000 first-year loss doesn’t seem so out-of-whack.

Conversely, a rental property reported on Schedule E of your 1040 tax return does not present the same way. The mathematical support relative to the allowed rental loss and tax deduction is simply not presented but rather assumed.

Third, all rental activities, including short-term rental (STR) activities, within a partnership tax return are reported on Form 8825. This is another layer of cloaking within the Form 1065 tax return and allows your rental income and deductions to fly just a little closer to the ground as compared to Schedule E page 1 of your Form 1040 tax return. There are three degrees of separation… the 1040 to the K-1 to the 1065 to the 8825, all wrapped with nice basis information. Wow, we really geeked out there.

Also, there is an additional reduction in audit rate risk and tax footprint with states. If you have an income-producing asset in a taxing jurisdiction, such as a rental property, then you have a tax return filing obligation even if the rental activity yields a tax loss. Why? A taxing jurisdiction, and in this case, a state department of revenue, has the right to inspect your books and records to ensure your loss is truly a loss. However, if you file a partnership tax return for the taxing jurisdiction, and that results in a tax loss, it is unlikely you need to file an income tax return as a person in that jurisdiction as well. This reduces your personal tax footprint among multiple states.

Other minor benefits of having your rental property reported as a partnership include anonymity of the enterprise, orderly transfer of ownership within the LLC’s Operating Agreement (versus a trust or will), discounted gifting of interests to others such as your kids, and some enhanced protection with charging orders (super flimsy, but they still exist).

Downsides on partnerships include the additional tax return preparation fees and perhaps unnecessary state taxes such as California’s franchise tax and LLC fee which can be summarized as money-grabs or “pleasure to do business in our state” fees. You need to consider your exposure versus the cost of reducing your exposure and therefore subsequent risk.

Short-Term Rental Cost Segregation Study

We mention cost segregation sporadically in this section. Keep in mind that the primary benefit of the short-term rental loophole is the ability to deduct your rental property losses. Next, keep in mind that you can turbo-charge your losses with a hefty depreciation deduction usually because of a cost segregation study.

The basics of a cost segregation study is the identification of certain personal property such as counters, cabinets, ceiling fans, closet shelving, appliances, floor coverings, decorative light fixtures, among many other things. In aggregate, these items would be depreciated over 39.0 years with the short-term rental property building (recall that it is considered nonresidential property). However, when parsed out, depreciation can accelerate to 0 years with bonus depreciation or Section 179 expense, or 5, 7 or 15 years with typical depreciation.

Since we are real estate CPAs, we have an entire section on cost segregation on page xx including accelerated depreciation on page xx.

Schedule C versus Schedule E

If your rental property is a short-term rental and has commercial or business-esque qualities, does this mean you report the activities on Schedule C of your 1040 tax return? The short answer is No. However, if you provide hotel like services such as daily linen changes, concierge, day tours (think hunting lodge), etc. then your rental activity is considered a straight-up business. Yes, you can deduct losses mostly without limitation, but your income is likely also subject to self-employment taxes (Social Security and Medicare at 15.3% combined).

Gaming the STR System

What we are about to say is not a recommendation, but an observation worthy of mentioning. Your rental property could easily qualify as a short-term rental allowing you to deduct a bunch of expenses including your big fat cost segregation depreciation expense today. Then convert it to a long-term rental or even a 30-day vacation rental next year to lower your hourly requirements and material participation.

At that moment in time, usually a tax year, if your rental activity is a short-term rental, and you later convert it, you do not have to amend or restate your prior tax returns. Each year stands on its own. Having said this, you better have your record keeping ducks lined up. Quack-quack.

Why Care If You Have Rental Profits

A lot of rental property owners fall all over themselves trying to qualify for the short-term rental loophole. They struggle with the required time and the required guest stay average, and all that stuff. If you have other rental activities that earn a profit, and your short-term rental is short-term but doesn’t qualify for the loophole, if the losses are absorbed by other rentals, then why do you care? The result is the same. So, if you are beating yourself up to leverage the short-term rental loophole, ensure it is purposeful where taxable income beyond your rental properties is reduced.

Reasonable Gross Rent

We recently had a client who lost $76,000, $74,000 and then $77,000 over three years on a short-term rental in Joshua Tree, California. Given the amount of rental income as compared to the expenses, we were concerned. We were also concerned since the household earned about $300,000 in pre-tax salary, and after paying for normal living expenses, it didn’t seem reasonable that the taxpayers could afford to throw $60,000 after-tax cash into a business venture each year (the difference being depreciation). Sure, one down year, we get it, but three in a row? Sounds like a habit at this point.

One of our duties at WCG CPAs & Advisors is to inform the real estate investor and rental property owner of risk. We are not the tax police, but we need to remind taxpayers that the tax police exist. After we get over our professional hurdles as paid tax return preparers and real estate CPAs, it is ultimately your tax return. We are facilitators, and a part of that process is to discuss tax positions and risk.

We chatted with our client and outlined the feasibility of what she was expressing on her tax returns. We also used AirDNA data to look at other rental properties in Joshua Tree of similar size, qualities and amenities. We carefully and respectfully asked how do other short-term rentals seem to earn $70,000 to $80,000 in gross rent and you are continuously earning $20,000 to $25,000? Is this a business venture with a profit motive? Or a hobby? Is this more of a vacation home for you and your friends? Or are there some discrepancies in your tax records that you cannot easily defend?

We are not the IRS, but we still need to raise these issues and make the taxpayer aware of how this looks simply based on math.