Short-Term Rental (STR) Loophole

By Jason Watson, CPA
Posted Saturday, August 10, 2024

Everyone loves loopholes, right? The Hummer loophole was recently popular again with 100% bonus depreciation. The older kid on the block is the short-term rental (STR) tax loophole. What is a loophole anyway? Is it a close cousin to donut holes? Yum!

Common convention suggests that a loophole allows you to get around some inherent rule or limitation by finding an escape. According to some historians and BackThenHistory.com,

The word loophole dates to the mid-1500s. It comes from a combination of the word hole and the Middle English word loupe, which refers to the “narrow window” or “slit-opening in a wall” that archers used for protection while shooting. The figurative sense of the word loophole meaning “outlet” or “means of escape” didn’t come into usage until the 1660s.

Today, the word loophole is mostly used in legal applications, and to identify the inconsistency between parents when raising children where a child at the early age of 4 learns how to naturally manipulate. We digress.

With respects to short-term rentals, people in the real estate CPA community consider it a loophole since the tax code was written with hotel operators in mind, and not the average real estate investor operating a single-family home as a hotel. Here is the short-term rental loophole elevator spiel-

• If your average guest stay is 7 days or fewer, and

• You materially participate in the rental activity, then

• Your activity is non-passive, and as such your rental property losses are not limited by passive activity loss limitations (please see our discussion on passive activity losses on page xx).

Let’s review where this 7-day rule comes from. Treasury Regulations Section 1.469-1T(e)(3)(ii)(A) reads-

(3) Rental activity—(i) In general. Except as otherwise provided in this paragraph (e)(3), an activity is a rental activity for a taxable year if—

(A) During such taxable year, tangible property held in connection with the activity is used by customers or held for use by customers; and

(B) The gross income attributable to the conduct of the activity during such taxable year represents (or, in the case of an activity in which property is held for use by customers, the expected gross income from the conduct of the activity will represent) amounts paid or to be paid principally for the use of such tangible property (without regard to whether the use of the property by customers is pursuant to a lease or pursuant to a service contract or other arrangement that is not denominated a lease).

(ii) Exceptions. For purposes of this paragraph (e)(3), an activity involving the use of tangible property is not a rental activity for a taxable year if for such taxable year—

(A) The average period of customer use for such property is seven days or less;

(B) The average period of customer use for such property is 30 days or less, and significant personal services (within the meaning of paragraph (e)(3)(iv) of this section) are provided by or on behalf of the owner of the property in connection with making the property available for use by customers;

(C) Extraordinary personal services (within the meaning of paragraph (e)(3)(v) of this section) are provided by or on behalf of the owner of the property in connection with making such property available for use by customers (without regard to the average period of customer use);

(D) The rental of such property is treated as incidental to a nonrental activity of the taxpayer under paragraph (e)(3)(vi) of this section;

(E) The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers; or

(F) The provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not a rental activity under paragraph (e)(3)(vii) of this section.

As such, the very first exception is “the average period of customer use for such property is seven days or less.” However, there is a 30-day consideration outside of the second exception as well. Since some readers enter into our book at different places, we repeat ourselves at times. This is one of those times.

The 30-day thing is a bit nuanced and takes a bit of time to sort through. IRC Section 168(e)(2) reads-

(2) Residential rental or nonresidential real property
(A) Residential rental property
(i) Residential rental property
The term “residential rental property” means any building or structure if 80 percent or more of the gross rental income from such building or structure for the taxable year is rental income from dwelling units.

Ok. What is a dwelling unit? IRC Section 168(e)(2)(a)(ii)(I) reads-

(ii) Definitions. For purposes of clause (i)-
(I) the term “dwelling unit” means a house or apartment used to provide living accommodations in a building or structure, but does not include a unit in a hotel, motel, or other establishment more than one-half of the units in which are used on a transient basis

Great. What is transient basis? In Private Letter Ruling 139827-07, the IRS stated-

“Lodging facility” is defined in section 856(d)(9)(D)(ii) as a (l) hotel, (ll) motel, or (lll) other establishment more than one-half of the dwelling units in which are used on a transient basis. The term “transient” is not defined in section 856 or the regulations thereunder. However, for other purposes of the Code, a renter has generally been treated as “transient” if the rental period is less than 30 days. See section 1.48-1(h)(2)(ii) (which concerned definitions under old section 48 for purposes of the investment credit under former section 38); Shirley v. Commissioner, T.C. Memo 2004-188.

If your rental property has tenants or guests who stay 30 days or less, then they are considered transient. Subsequently, the rental property is nonresidential.

Why did the IRS, Treasury, Congress and everyone define it this way? The original intent was to prevent real estate investors from using 27.5 years of depreciation versus 39.0 years. In other words, by calling a rental property a residential property, they were able to shrink the depreciation schedule (and increase current year depreciation deductions).

As such, if your rental property has tenants who stay 30 days or less, it is considered nonresidential and is depreciated over 39.0 years versus 27.5 years. Many rental property owners are unaware including several tax professionals.

However, we can use this spat to our advantage. How? See our section on qualified improvement property and the additional accelerated depreciation and Section 179 expensing.

Forget 30 Days Let’s Talk 7 Days

Many cities and various municipalities are cracking down on 7-day short-term rentals. Sure, people complain about the additional cars, noise, and shenanigans associated with the inherent turnover of guests at a rental property. The hotel industry seems to enjoy this turnover since it typically means higher rents (short rent periods = higher daily rates), but they don’t like competition. As such, they leverage busy body Betty, take her complaints to local governments and influence code changes.

Some kidding aside, the other reason for these ordinance changes is a deemed housing shortage. Some governments believe that a bunch of typical homes are being pulled out of the market as a residence and re-deployed as a short-term rental (a long-term rental can be viewed as a net-zero or neutral within this argument). However, in glamorous cities such a New York City and San Francisco, short-term rentals help long-term renters with high rent costs by augmenting their household income with sporadic rental income. For example, a NYC long-term renter might sublet his Manhattan pad when they travel overseas for 10 days. Not anymore.

There is a gotcha for real estate professionals and the 750 hours rule who have short-term rentals with an average guest stay of 7 days or less. Temporary Treasury Regulations 1.469-1T(e)(3) reads-

(3) Rental activity—(i) In general. Except as otherwise provided in this paragraph (e)(3), an activity is a rental activity for a taxable year if

(A) During such taxable year, tangible property held in connection with the activity is used by customers or held for use by customers; and

(B) The gross income attributable to the conduct of the activity during such taxable year represents… amounts paid or to be paid principally for the use of such tangible property.

(ii) Exceptions. For purposes of this paragraph (e)(3), an activity involving the use of tangible property is not a rental activity for a taxable year if for such taxable year-

(A) The average period of customer use for such property is seven days or less;

Read those last two sentences again. Are we telling you that a short-term rental with an average guest stay of 7 days or less is not considered a rental activity? Not even a real property trade or business? No, but the regulations are.

Oh, and so are the courts.

In Bailey v. Commissioner, Tax Court Memo. 2001-296, and again in Bailey v. Commissioner, Tax Court Summary Opinion 2011-22, which are different people with different facts but the same problem- the court used a literal interpretation of “the average period of customer use for such property is seven days or less” and stated that the activity was not a rental activity, and therefore those hours did not count as material participation.

If you cannot get enough, here is a contradicting blurb from Chief Counsel Advice 201427016–

whether a taxpayer is a qualifying taxpayer within the meaning of section 469(c)(7)(B) and Treas. Reg. § 1.469-9(b)(6) depends upon the rules for determining a taxpayer’s real property trades or businesses under Treas. Reg. § 1.469-9(d), and is not affected by an election under Treas. Reg. § 1.469-9(g). Instead, the election under Treas. Reg. § 1.469-9(g) is relevant only after the determination of whether the taxpayer is a qualifying taxpayer.

Let’s break this down. IRC Section 469(c)(7)(B) refers to the 750 hours requirement which is a consideration for real estate professional status (REPS). The Treasury Regulations 1.469-9(g) refer to the formal election to group all your rental activities together as a single activity for material participation testing. The IRS’s chief counsel is disagreeing with the Bailey decisions. Nice!

Why do you care? If you want to qualify as a real estate professional as defined by the IRS, there are two hurdles related to hours. The first is the 750 hours test which some call REPS hours. You cannot use the time spent on your short-term rentals where the average guest stay is 7 days or less for the REPS hours hurdle. That’s why you might care.

What Time Counts for STRs

We exhaustively discussed what time counts for participation in an earlier section as well. Investor and research times do not count. Travel time might count depending on your facts (the window is small). Acquisition time might count if you complete the purchase (convert investor hours to acquisition hours).

Obvious activities that count include repairs and maintenance, scheduling or managing contractors, showing the rental property to prospective guests, managing your advertising and rental platforms, collecting rent, and shopping for supplies.

IRS Publication 925 Passive Activity and At-Risk Rules states the following-

Work not usually performed by owners. You don’t treat the work you do in connection with an activity as participation in the activity if both of the following are true.

1. The work isn’t work that’s customarily done by the owner of that type of activity.

2. One of your main reasons for doing the work is to avoid the disallowance of any loss or credit from the activity under the passive activity rules.

Participation as an investor. You don’t treat the work you do in your capacity as an investor in an activity as participation unless you’re directly involved in the day-to-day management or operations of the activity. Work you do as an investor includes:

1. Studying and reviewing financial statements or reports on operations of the activity,

2. Preparing or compiling summaries or analyses of the finances or operations of the activity for your own use, and

3. Monitoring the finances or operations of the activity in a non-managerial capacity.

Therefore, talking to your wonderful short-term rental experts and real estate CPAs at WCG CPAs & Advisors about tax returns might not count. However, if we chat about contracts, problems with renters, reviewing tenant agreements, then yes!

Short-Term Rental Material Participation

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.

Short-Term Rental (STR) Time Logs

We discuss time logs in our what time counts for material participation section. There is a ton of chatter about time logs. Spreadsheets with dropdowns, conditional formatting, and built-in pivot tables. Neat. So much effort is spent on the right data that people lose sight of four fundamentals-

Your time log must be done in real-time, or what the IRS considers contemporaneous. This is usually not a huge deal, but it is surprising how many court cases mention that the records were not kept in real-time.

Next, your time log must highlight not just your time, what you did and the location, it must also contain the time spent by others on your rental activities. This demonstrates your exhaustiveness or completeness in recording all time spent, not just yours. This is critical on material participation test #3 given the Pohoski tax court case.

Next, your time log must appear credible. To support credibility, you will likely need to recall details surrounding the time or moments spent. You will also need to be reasonable. In Escalante v. Commissioner, Tax Court Summary Opinion 2015-47, the rental property owner listed hundreds of hours for writing checks and reviewing mortgage statements. The Tax Court considered how long it would take them to write their own checks based on their own experience of daily life.

Finally, your time log must be corroborated with other transactions or by disinterested third parties. You claim that you spent 6 hours replacing a toilet, and you also demonstrate two separate trips to Lowe’s with receipts. The first is the toilet. The second has all the crud that you forget to get the first time. Perfect!

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.

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.

Short-Term Rental (STR) Loophole Summary

Here is a recap of what we just discussed-

• Short-term rentals officially have an average guest stay of 30 days or less. When this occurs, the rental is considered nonresidential which opens up additional accelerated depreciation and Section 179 expensing. However, depreciation is now 39.0 years versus 27.5 years. The activity remains passive.

• Short-term rentals with average guest stay of 7 days or less where you materially participate as defined by Temporary Treasury Regulations 1.1469-5T(a) changes the color of money and your rental property activity is non-passive (and not limited by passive activity loss limitations).

• You can still consider your short-term rental property with an average guest stay of 30 days or less as non-passive, and therefore not limited by passive activity loss limitations. To do this, you need to provide additional services such as daily cleanings, tours (think hunting lodge), concierge services and other hotel-like services.

• The top three material participation tests are a) 500 hours, b) substantially all the hours, and c) 100 hours and more than anyone else.

• Short-term rentals, the 7-day average stay variety, do not count towards the 750 hours test (REPS hours) for real estate professional status. Then again, you do not need to be considered a real estate professional to leverage the tax benefits of a short-term rental property.

• Reporting your rental property activities, and not just your short-term rentals, in a partnership such as multi-member LLC significantly lowers your audit rate risk and reduces your tax footprint.