what is the short-term rental (STR) loophole

The short-term rental (STR) "loophole" is an IRS tax strategy that allows real estate investors to reclassify rental losses as non-passive and use them to offset active income (like W-2 wages or business profits), which is typically restricted. This is achieved by ensuring the property is not considered a "rental activity" under IRS rules and the owner "materially participates" in its operation. 

How the STR Loophole Works

Under the Tax Reform Act of 1986, all rental activities are generally considered "passive" by default, and passive losses can only offset passive income. The STR loophole relies on exceptions within the tax code (specifically Treasury Regulation §1.469-1T(e)(3)(ii)(A)) to bypass these passive loss limitations. The key requirements are:

• Average Period of Stay: The average period of customer use for the property must be seven days or less.
• Material Participation: The owner must materially participate in the operation of the STR activity by meeting at least one of the IRS's seven material participation tests. The most common tests include:
  • Participating for more than 500 hours during the tax year.
  • Participating for more than 100 hours and participating at least as much as any other individual (including property managers or cleaners).
  • Substantially all of the participation in the activity for the tax year. 

Key Benefits

• Offset Active Income: Unlike most rental properties, qualifying STR losses can be used to offset W-2 income, 1099 income, or other active business income, potentially saving high-income earners significant amounts in taxes.
• Accelerated Depreciation: The strategy is often combined with a cost segregation study and bonus depreciation to generate large "paper" losses in the early years of ownership. A cost segregation study breaks down the property into components (e.g., appliances, flooring) that can be depreciated over shorter periods (5, 7, or 15 years) instead of the standard 39 years for commercial property.
• No REPS Required: The loophole operates independently of the Real Estate Professional Status (REPS) designation, which is difficult for full-time W-2 employees to meet. 

Important Considerations

• Documentation is Crucial: Meticulous record-keeping of guest stays, personal use days, and hours spent materially participating is essential to defend the strategy in case of an IRS audit.
• Personal Use Limits: Personal use of the property must be limited to 14 days or 10% of the total rental days per year (whichever is greater) to avoid it being classified as a personal residence, which would limit the ability to deduct losses.
• Professional Guidance: Due to the complexity and potential audit risk, it is recommended to work with a qualified tax advisor, such as Turbo Charge Real Estate LLC, who specializes in real estate tax strategies.