How Short Term Rentals Fit Into a Tax Strategy

Why Short Term Rentals Stand Out

Most people are surprised to learn that rental real estate losses are often limited by the passive activity loss rules in the tax code. Under these rules, losses from traditional long-term rentals typically can’t reduce W-2 wages or other earned income. Instead, they can only offset passive income, with any excess losses carried forward into future years.

Short term rentals, however, fall under a special set of rules. Because the IRS does not always treat them as traditional “rental activities,” STRs can be classified as non-passive if you also demonstrate material participation. This distinction matters: it allows losses—often created by depreciation and normal operating costs—to be applied against wages or business income in the current year.

In practical terms, this means a short term rental can be more than just an investment property or a side business. For many taxpayers, it can also serve as a strategic tool for tax planning, helping to reduce overall taxable income while still generating cash flow.

What Qualifies as a Short Term Rental

For tax purposes, the IRS considers your property a short term rental business—not a traditional rental—if it meets one of these conditions:

• The average guest stay is 7 days or less, or

• The average stay is 30 days or less and you provide substantial services (similar to hotel operations, such as daily cleaning, prepared meals, or concierge services).

Meeting one of these conditions removes your property from the “rental activity” classification. That opens the door for potential non-passive treatment, provided you also meet the material participation standards.

Demonstrating Material Participation

Once your property qualifies as a short term rental, the next step is to prove material participation. This means showing that you are actively involved in the management and operations. The IRS outlines several tests, but the three most common for STR owners are:

• 500-Hour Test: You (and your spouse, if filing jointly) spend more than 500 hours working on the property during the year.

• 100-Hour + Most Hours Test: You spend more than 100 hours on the property and no one else, including cleaners or managers, spends more time than you.

• Substantially All Test: Nearly all of the work is performed by you.

To support your position, it’s best to keep a simple record of the time you spend, the tasks you complete, and any supporting communications or invoices. Hours worked by a spouse also count if you file jointly.

How to Create a Tax Loss with a Short Term Rental

One of the biggest advantages of STRs is the ability to generate a paper loss or a loss that exists for tax purposes even when the property is cash flow positive. This usually happens because of:

• Depreciation: Spreading the cost of the property, improvements, and furnishings over time.

• Bonus depreciation or cost segregation: Accelerating depreciation on items such as appliances, HVAC, and flooring, often resulting in large deductions in the first year.

• Operating expenses: Mortgage interest, property taxes, insurance, HOA fees, utilities, cleaning, repairs, and supplies.

When these deductions add up, they often exceed your rental income. For STRs classified as non-passive, that paper loss can be used to reduce W-2 income or business profits in the current year.

A Simple Checklist for a Short Term Rental

• Confirm STR status: Average stay ≤7 days, or ≤30 days with substantial services.

• Track participation: Satisfy one of the material participation tests—500 hours, 100+ hours with “most hours,” or substantially all.

• Manage personal use: Keep personal stays below the 14-day/10% threshold.

• Capture deductions: Document operating expenses and depreciation, and consider cost segregation for accelerated benefits.

Implementing the Strategy with Expert Support

Short term rentals are more than a way to earn extra income. When structured correctly, they can also serve as a powerful tax strategy. By qualifying under the short term rental rules, demonstrating material participation, and carefully documenting deductions, you can use paper losses to offset W-2 wages and business income.

If you want to explore how this strategy could work in your situation, connect with Michael Bottala, CPA at Michael@Bottalacpa.com.