The Short-Term Tax Loophole
Tax preparers frequently promote the short-term rental tax loophole, especially on platforms like YouTube. Often referred to as the AirBnb tax loophole, it’s popular among aggressive short-term rental hosts eager to minimize their income taxes. Many flashy websites have aggressive tag lines. For instance, “hold your beer” or “live like the one percent do“. Surprisingly, it’s not what you expect!
The phrase “short-term rental tax loophole” frequently comes up in client meetings. Thereby, igniting curiosity. As well as sometimes skepticism. So, it’s essential to clarify that what many label as a “loophole” is not a loophole at all. Rather, it’s a legitimate component of tax law. Most importantly, acknowledges short-term rentals as a trade or business.
The Misconception of a Tax Loophole
A Gap or ambiguity?
The word “loophole” typically implies a gap or ambiguity in the law. A tax loophole which can be exploited. However, the tax benefits available to property owners are not due to any legal oversight. Rather, they arise from clear provisions within the tax code. Furthermore, treat these rentals as a trade or business under specific circumstances.
Learned Hand
Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
A Winning Strategy?
I get it!
The excitement of hiring a tax preparer who promises to help you outsmart the IRS. It’s a great feeling in the moment. Soon or later, the government will soon step in and reverse that great feeling, leading to years of pain.
So, it’s essential to recognize that short-term rentals are classified as a trade or business.
What typically happens
So you think it’s a good idea to casually sign up as an STR (Short term rental) host one evening. You might have had a few drinks, while watching a football game. So, your strategy is to just keep a log of your time. Secondly, you don’t keep books. Consequently, you don’t solicit any STR guests to stay at your property. Additionally, you conduct a cost segregation study to deduct significant losses. It seems like, a winning strategy. After all, you’ve outsmarted the IRS. In fact you say I’ve discovered the best unbeliveable short term rental loophole tax strategy ever invented.
Think again
It’s not a tax loophole in the tax code; it’s tax avoidance. In other words you didn’t just use a “cheat code”. You’ve now increased your risk to pay significant taxes, penalties and interest. Furthermore, many short-term rental hosts go further to add even more risk! As stated above think they believe they only need to keep a log, not adequate books and records. As a consequence, they might only list their property on a medium such as AirBnB for a few days or weeks! If your doing this and don’t agree, call me at 954-686-6250 to find out why this is a risky strategy.
A legitimate loophole recognized by everyone? The 1120S loophole allows business owners to reduce their FICA taxes. As a result, all tax professionals agree that using a 1120S to lower FICA taxes is a tax loophole.
Be like the 1%
Thereby minimize your income taxes. In other words, be like the super rich.
Other aggressive tax preparers write
“hold my beer”.
Well the IRS might just go after all those tax preparers clients. In other words, you just set yourself to be a sitting duck for an IRS audit.
Conversely, the IRS has specific rlues governing how you can allocate expenses.
When using property in a trade or business for a portion of the year, the IRS has specific rules. Specifice rules on how you can allocate expenses such as depreciation, real estate taxes, mortgage interest, and utilities, ensuring that only the business-use portion is deducted
Allocation of Depreciation: Depreciation is limited to the portion of time and space the property is used for business. You calculate the business-use percentage based on the number of days the property is used for business compared to total days in the year.
- For example, if the property is used for business 30 days out of the year, your depreciation deduction is the depreciation amount multiplied by 30/365.
Depreciation for Business Use (IRC Section 167 and Section 168)
Depreciation is only allowed on the portion of the property used for trade or business purposes. Under IRC Section 167, taxpayers are allowed to depreciate property used in a trade or business or held for the production of income (such as rental properties). The Modified Accelerated Cost Recovery System (MACRS) under Section 168 applies to most property.
- Allocation of Depreciation: Depreciation is limited to the portion of time and space the property is used for business. You calculate the business-use percentage based on the number of days the property is used for business compared to total days in the year.
- For example, if the property is used for business 30 days out of the year, your depreciation deduction is the depreciation amount multiplied by 30/365.
Example: Assume the property has a depreciable basis of $100,000, and the yearly depreciation under MACRS would be $3,636. If the property was used for business 30 days of the year, your allowable depreciation would be:
Real Estate Taxes, Mortgage Interest and other expenses
These expenses must also be allocated between personal and business use. According to IRC Section 280A, you can deduct the business-use portion of real estate taxes and mortgage interest as business expenses if the property is partially used for business.
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Allocation of Real Estate Taxes: Real estate taxes can be allocated based on the number of days the property is used for business relative to the total number of days in the year.
- Example: If real estate taxes are $5,000 for the year, and you use the property for business 30 days, you allocate the deduction as:
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Allocation of Mortgage Interest: Similar to real estate taxes, mortgage interest under IRC Section 163(h) can be allocated based on business-use days. If total mortgage interest for the year is $10,000 and business use is 30 days, the calculation is:
3. Utilities and Other Operating Expenses
Operating expenses, such as utilities, insurance, and maintenance, must also be prorated based on business usage. These costs are generally allocated between personal and business use by comparing the days of business use to total days in the year.
- Utilities Allocation: If utility bills for the year are $1,200, and the property was used for business for 30 days, you calculate:
Mixed-Use Property (IRC Section 280A)
IRC Section 280A limits deductions for expenses related to property used for both personal and business purposes (mixed-use property). If the property is not used exclusively for business, you cannot claim deductions for the personal-use portion. The portion of expenses that apply to the personal use of the property (e.g., real estate taxes and mortgage interest) may still be deductible on Schedule A (Itemized Deductions).
Example of Allocation:
Suppose you have a property where total expenses are as follows:
- Depreciation: $3,636 (business use: 30 days)
- Real Estate Taxes: $5,000 (business use: 30 days)
- Mortgage Interest: $10,000 (business use: 30 days)
- Utilities: $1,200 (business use: 30 days)
You allocate these expenses for business use by calculating the business-use percentage (30/365):
| Expense | Total Amount | Business Use (30 days) |
|---|---|---|
| Depreciation | $3,636 | $298.63 |
| Real Estate Taxes | $5,000 | $410.96 |
| Mortgage Interest | $10,000 | $821.92 |
| Utilities | $1,200 | $98.63 |
These allocated amounts can be deducted as business expenses.
Key Takeaways
- Allocate based on usage: Expenses such as depreciation, real estate taxes, mortgage interest, and utilities must be prorated based on the days the property was used for business.
- IRC Sections 167, 168, 163(h), and 280A: These sections guide the treatment of depreciation, mortgage interest, and business/personal use allocation rules.
- Keep accurate records: Proper documentation of days used for business is essential for compliance with IRS regulations.
I recommend setting up a bookkeeping system such as QuickBooks. Lucky for me, I’m a certified ProAdvisor in QuickBooks
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What would Judge Learned Hand think?
Understanding the provisions of the tax code is essential for taxpayers.
Therefore, classifying certain activities like short-term rentals as a legitimate trade or business. This classification is not merely an oversight or a gray area in the law. Most importantly, it represents a thoughtful recognition by Congress of the economic realities that taxpayers encounter. Judge Hand would assert leveraging the tax code to one’s benefit, especially regarding short-term rentals, is lawful. In other words, setting up a trade or business which is not misconstrued as exploitation. In other words, not a short-term rental tax loophole. The problem is that many short-term rental hosts misconstrue the law. Furthermore, they believe its ok to list the vacation rental for a few days or weeks. Then take full depreciation deductions for the year. 
Tax Professionals or Journeyman?
A journeyman travels to wherever he can find the greatest interest and opportunity. In contrast, a tax professional is dedicated to understanding and prioritizing what is truly best for their clients. Therefore, ensuring their financial well-being and peace of mind.
- Short-Term Rentals as a Trade or Business
- The Tax Implications
- The Short-Term rental tax loophole is not technically a loophole
- IRS Publication 925: Key Points on Trade or Business, Rental Activity, and the 100-Hour Rule "Key Take Aways"
- What is a short-term rental activity
- Short term rental tax benefits
For a property to qualify as a trade or business, it typically needs to meet certain criteria. Most importantly, active involvement by the owner in the operation and management of the property. This can include activities like marketing the property, managing reservations, maintaining the property, and more. Emphatically, an active trade or business. In contrast to being a passive activity.
As a trade or business, short-term rentals can unlock several tax advantages. For instance, rental income is offset by various business expenses, including mortgage interest, property taxes, repairs, and depreciation. Moreover, the income from short-term rentals can be subject to self-employment tax. However, it also opens the door to potential deductions and even the ability to shelter other income streams, depending on the owner’s overall tax situation.
The key takeaway is that the so-called “short-term rental tax loophole” isn’t a loophole at all. Moreover, a legitimate recognition of the economic activity. Furthermore, the owner’s active participation in running this business. By understanding and correctly applying the tax rules, property owners can maximize their tax benefits. Most importantly, within the bounds of the law. Lastly, without resorting to any questionable or unethical practices.
Trade or Business:
- According to IRS Publication 925, a “trade or business” generally involves continuous and regular activity. Additionally, with the primary purpose of earning income or profit. This includes significant participation in the operations, management, and decision-making aspects of the activity.
- To qualify as a trade or business, the activity must be more than a mere investment. Furthermore, it requires material participation from the owner. This distinction is crucial. Notably, it affects how income and losses are reported. Thus, they can be offset against other income.
2. Rental Activity:
- The IRS defines rental activity as the leasing or renting of property for a set period. Rental activities are typically considered passive, meaning they are not actively engaged in by the taxpayer.
- However, there are exceptions where rental activities can be classified as non-passive if the taxpayer materially participates in the operation. Short-term rentals, particularly those involving active management and significant involvement, qualify for non-passive treatment. Henceforth, aligning them more closely with a trade or business.
3. The 100-Hour Rule:
- The 100-hour rule is a guideline used to determine material participation in an activity. If a taxpayer spends more than 100 hours actively participating in the activity and no other individual spends more time than the taxpayer, the activity may be considered non-passive.
- This rule is particularly relevant for short-term rental activities, as meeting the 100-hour threshold can shift the classification from passive to non-passive, impacting how income and losses are treated for tax purposes.
Disputing the Idea of Short-Term Rental Activities as a Loophole:
- The classification of short-term rental activities as a trade or business under IRS rules is not a loophole but a legitimate application of tax law. The tax treatment of these activities is based on clear criteria set forth by the IRS, particularly regarding material participation and the nature of the rental activity. So, there is not short-term rental tax loophole.
- Calling it a loophole is misleading because it suggests an unintended exploitation of the tax code, whereas the benefits associated with short-term rentals are intentional and grounded in the principles of business taxation
Short-term rental activities are defined by specific time frames. Furthermore, determine how the rental income and related expenses are treated for tax purposes. Here are the key rules that define short-term rental activity:
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7-Day Rule: A rental property is considered a short-term rental if the average period of customer use is seven days or less. This rule is crucial. Henceforth, if your average rental period is seven days or less, the activity is often classified as a business. In contrast to a passive rental activity. In other words, affect how income and losses are reported.
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30-Day Rule: If the average period of customer use is more than seven days but less than 30 days, and you provide substantial services (such as daily cleaning, concierge services, or meals), the activity may still be considered a business. Instead of a passive rental.
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100-Hour Rule: This rule is related to material participation in the rental activity. If you spend more than 100 hours on the activity and no one else spends more time than you do on managing the rental, you can claim to materially participate in the rental. This is important for determining whether the income from the rental is active or passive, which affects your ability to deduct losses.
These rules help determine how the IRS classifies the rental activity, which impacts tax obligations and the treatment of rental income and expenses.
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Starting a short term rental activity can be highly advantageous for property owners, especially those actively engaged in managing their rentals. Here are some key benefits:
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Depreciation Deduction: One of the most significant short term rental tax benefits is the ability to deduct property depreciation over time. Even though your property might be appreciating in value, you can still deduct depreciation, reducing your taxable income.
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Expense Deductions: As a short term rental owner, you can deduct various expenses associated with managing your property. These include mortgage interest, property taxes, maintenance costs, utilities, insurance, and even marketing expenses.
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Qualified Business Income Deduction: If your short term rental qualifies as a trade or business, you might be eligible for a 20% deduction on your qualified business income under the IRS Section 199A.
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1031 Exchange: Short term rental tax benefits also include the possibility of deferring capital gains taxes when you sell your property and reinvest the proceeds in a similar property through a 1031 exchange.
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Home Office Deduction: If you manage your short term rental business from a dedicated space in your home, you may qualify for the home office deduction, further reducing your taxable income.
- Travel Expenses: If you need to travel to your property for management or maintenance purposes, those travel costs can be deductible as part of your short term rental tax benefits.
Understanding these short term rental tax benefits can significantly enhance your profitability and ensure you’re maximizing the financial returns on your investment. Always consult with a tax professional to ensure you’re taking full advantage of these opportunities while staying compliant with IRS regulations.
Get a 2nd opinion
Nobody has a monopoly on all the information. Certainly, not the Internal Revenue Code.
Most importantly, there are both pitfalls as well as opportunities. Hire an short term rental tax CPA. Stay away from the “journey man”. A journey man is someone who journeys to what you want to hear.
Short Term Rental Tax Advice!
Wow! David is an absolute master of numbers and helped me get my airbnb business started, quickbooks setup, and even advised me on every aspect of accounting and taxes for my new business. This is the first time i’ve worked with a CPA who I can actually call and get a quick answer from or categorize a charge as “ask my accountant” and he will categorize it properly. David has spent over 3 hours cumulatively on video calls with me to ensure I know how to properly run my new business and how to connect my bank accounts, run payroll, and properly book-keep. 10/10 recommend!!!
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For inquiries or requests which require a more personal response, I will make every attempt to respond.