The Short Term Rental Loophole Explained

All I hear about in tax circles these days is the short term rental loophole for real estate investors. 

First of all, it bears mentioning that taxpayers normally can’t use passive losses from real estate to offset active gains from employment. There are only a couple of exceptions to this rule: 1) Qualifying as a Real Estate Professional in the eyes of the IRS (which essentially means real estate is your full time profession – not really an option if you already have career in medicine, accounting, or whatever), or 2) Taking advantage of the short term rental loophole. short term rental loophole

But what is the short term rental loophole?

In a nutshell, we’re talking about two different types of activities:

  • Passive Activities (in terms of real estate, defined by the IRS under Section 469 of the tax code as a long term rental, or any rental property with an average stay of more than seven nights), which can create passive gains and losses on your tax return, and
  • Non-Passive Business Activities (such as owning a Subway restaurant, working as a freelance photographer, or operating a bed and breakfast*), which can create active gains and losses on your tax return.

*Of note here is that the IRS carves out short term rentals with an average stay of less than seven nights as a non-passive activity in Section 469.

Then, when it comes to non-passive activities, we’re also talking about two different types of owners: An owner can be passive (such as a silent investor in that Subway store or B&B who lets the onsite store manager handle the dirty work), or an owner can materially participate in the business activity (in other words, actually manning the counter and making the sandwiches, or the beds). 

So the underlying theme of the short term rental loophole is an active owner (who materially participates) in a non-passive activity (such as operating a short term rental) can use their non-passive losses from this activity to offset their active (W-2) income in that tax year. 

Of course, no one wants to operate their business at a loss (at least not for long), but when it comes to real estate, it can actually be easier to generate a loss in the first year or two by fixing up a property, furnishing it, and taking advantage of more advanced tax strategies such as cost segregation and accelerated depreciation. These strategies can result in significant tax savings for high wage earners!

Below is a clip of Kenji Asakura of Semi-Retired MD explaining the STR Loophole, and here is a more in-depth guide to the short term rental loophole from a CPA’s perspective. 

Speaking of advanced tax strategies – We are not CPAs and the above information may not apply to you and should not be taken as professional tax advice. I firmly believe that hiring a CPA with advanced knowledge of real estate investing is the best investment you’ll ever make. Hire one!