Short-Term Rental Material Participation Tests

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

As mentioned earlier, to qualify the rental property as a non-passive short-term rental, you need average guest stays of 7 days or less and you need to materially participate in the rental activity.

According to Temporary Treasury Regulations 1.1469-5T(a), there are seven tests, but we only list the first three since 99% of the rental property owners out there will use one of these-

(a) In general. Except as provided in paragraphs (e) and (h)(2) of this section, an individual shall be treated, for purposes of section 469 and the regulations thereunder, as materially participating in an activity for the taxable year if and only if—

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

For a complete list and in-depth discussion, please see our material participation section.

500 Hours

This is the material participation hammer, but it is challenging. 500 hours is nearly 10 hours a week, every week. Many short-term rentals are seasonal, such as a ski condo or a hunting cabin, or rely on periodic local events. Even a beach house has ups and downs in terms of participation intensity. As such, be careful.

Substantially All Participation

This one is usually used when a short-term rental property is purchased near the end of the year, and you do all the work. We discuss prorations for a short-year in a little bit (spoiler alert- there aren’t any prorations). Let’s say you purchased a rental property in October, and got it online in November. For those next two months you need at least two guest stays (so you can compute an average) and you will need to do all the cleaning and maintenance. Next year, you hire a property manager and move to the 100 hours and more than anyone else test.

Having said all this, you could very easily have a full-year short-term rental property where you do all the work. This is common with ADUs, converted garages, casitas and separate structures.

100 Hours and More Than Anyone Else

This is a very popular material participation test for short-term rental property owners. 2 hours per week doesn’t seem too shabby. However, let’s throw some numbers at this. Let’s say you have 26 guest stays total for the year, and each time about 2.5 hours is spent cleaning the unit after guests depart. That is 65 hours, and with your 100 hours, you satisfy this material participation test.

Having said this, don’t forget the time spent by the property manager and maintenance personnel. These hours count against you, if you will. Said differently, your hours need to eclipse the individual cleaners, managers and contractors, and exceed 100. However, you don’t combine these people- the regulation reads “more than anyone else” and this is taken literally such that three cleaners are considered three separate people for the test. Therefore, ensure you deploy multiple people cleaning your rental property. Try to have at least five or six people mow the grass. Why not?

Track Others Time

In Pohoski v. Commissioner, Tax Court Memo 1998-17, the Tax Court noted that the taxpayer did not introduce evidence of the hours spent by a property management company. The Tax Court implied that they would entertain proof that the taxpayer substantially participated as compared to the participation of a third party (in this case a property management company). The Tax court also stated the second test was not satisfied when taxpayers failed “to put forth some indication of the actual time spent by” third-party non-owners in activities on the property.

Prorations for Short-Year

What about buying a rental on December 1 and placing it immediately into service as a short-term rental, pick up a couple of reservations, and take a nice tax deduction? Not so fast. In Gregg v. U.S. 186 F.Supp.2d 1123, the court stated:

Defendant argues, however, that neither Section 469 nor the regulations promulgated thereunder provide for such proration in the event of a short year. The defendant states that the plain language “if and only if” contained in § 1.469-5T(a), denotes a requirement of strict compliance. In addition, if proration is allowed, 500 hours per year equates to less than 10 hours per week. Such a deminimis standard of “material participation” acts against the Secretary of the Treasury’s strong interest in preventing taxpayers from initiating or acquiring passive activities at the close of a taxable year, and then characterizing those losses as non-passive, and deducting the losses against ordinary income. Although, as plaintiffs argue, no regulation or case law prohibits annualizing the participation hours in the event of a short year, I defer to the defendant’s explanation on how the first test should be applied.

I appreciate plaintiff’s frustration regarding the application of this test, since timing of the formation of a business entity ironically affects the determination of the nature or level of a taxpayer’s participation in the business activity under the first test. However, plaintiff chose to form Cadaja as an LLC over other organizational forms in November of tax year 1994 for various business reasons, which may or may not include tax considerations. Application of this test without strict compliance will open the floodgates defeating the regulations’ purposes. Therefore, I find that plaintiff fails to meet the 500-hour-per-year threshold requirement under the first test.

Regulations 1.469-9(g) Election for Short-Term Rental Loophole

We discussed this in a previous section on when reviewing material participation. Here is a brief summary again-

You can elect to group all your rental properties into one activity so the material participation test is less onerous. If you had three rentals and were needing to use the 500 hours test for material participation (test #1), you would need to spend 3 x 500 or 1,500 hours total at a minimum. The Treasury Regulations 1.469-9(g) election is a formal election on the tax return that endures each year unless revoked.

However, and this is a big deal, you cannot group your short-term rentals with an average guest stay of less than 30 days with your mid-term and long-term rentals. Wait, what? Short-term rentals, as defined just now, are not considered rental activities under Treasury Regulations 1.469-1T(e)(3)(ii). In other words, you cannot mix apples and oranges with this grouping election. Group short-term rentals for STR loophole, and group other rentals for real estate professional status.

Are there other downsides to the election? Yes, there are. Again, please check out the material participation section referenced above. There is a ton more to it than what we listed here.