By Jason Watson, CPA
Posted Sunday, March 22, 2026

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 nonpassive, 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).

Short-Term Rental Tax Code

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.

30 Day Short-Term Rental

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. However, when people toss around short-term rental or STR, they are commonly referring to the loophole or 7-day version.

Sidebar: As we discussed in our Election 1.469-9(g) section, short-term rentals with an average guest stay of 7 days or less or short-term rentals where you provide hotel-like services are not considered rental activities and cannot be grouped with other rental activities. Yes, STRs can be grouped together just not with other rentals. This is a big deal for material participation testing.

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.

30 Day Versus 7 Day Quickie Comparison

We touch on personal services in other sections, but to reiterate- personal services are hotel-like services such as daily housekeeping, meals (bed and breakfast), access to fitness or spa amenities managed by you, concierge services, tours, etc. These are things that most rental property owners or short-term rental hosts generally do not provide.

Here is a summary table-

Note that once you are considered providing personal services, the average guest stay doesn’t matter. You are a business, and material participation stuff gets tossed out in favor of basic business thresholds- regular and continuous with profit motive for your loss deduction ability. Activities are reported on Schedule C of your individual tax return (Form 1040) or business entity tax returns such as partnerships and corporations.

We digress…

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.

The STR Versus REPS Trap

There is a massive point of confusion here for rental property owns and real estate investors trying to qualify for Real Estate Professional Status (REPS). Because short-term rentals are not technically rental activities under the tax code, many tax professionals and even Tax Court judges (e.g., Bailey cases, yes, plural) mistakenly assume your STR hours cannot count toward your 750-hour REPS threshold.

However, there is a very strong argument that these hours absolutely do count as a broader “real property trade or business,” and we break down exactly how to leverage this logical tax position. Please see our REPS pitfalls with short-term rentals section.

By Jason Watson, CPA
Posted Sunday, March 22, 2026

Many homeowners become real estate investors overnight when they take a basement or garage, convert it into a dwelling unit, and make it a short-term rental (or even a mid-term or long-term rental). Same thing with an auxiliary dwelling unit (ADU) which is also the same as casita, guest quarters, mother-in-law quarters, granny flat (our fav), or guest house.

Many call this house hacking, and it is a common strategy for homeowners to offset the costs of ownership.

What are some of the considerations when making your basement, attic, garage or ADU a short-term rental? And, can you leverage the short-term rental loophole with the house hacking arrangement? Can I use the Augusta rule that my bartender told me about? What about cost segregation study? Slow down love, let’s take some time and go through each of these. Geez, we just met.

Dwelling Unit Defined

IRS Publication 527 Residential Rental Property and proposed Treasury Regulations Section 1.280A-1(c)(2) provide a definition of a dwelling unit. This comes from the tax code, or IRC Section 280A(f)(1)(A), which reads-

IRS Publication 527 takes this one step further and adds some qualifiers-

A dwelling unit has basic living accommodations, such as sleeping space, a toilet, and cooking facilities.

Boaters would say berthing quarters, head and galley. Not sure what astronauts would say but we can agree that the space station would be a dwelling unit. Average guest stay seems to be on the higher side, however.

The definition above is the must have. If you wanted to throw a little icing on the cake, you would also have a separate entrance, address and utility meters but that might be asking a lot.

We define dwelling unit since some homeowners want to rent out a bedroom and claim the short-term rental loophole. Besides the 38 cents of accelerated depreciation not really blowing anyone’s hair back, IRS guidance doesn’t treat a bedroom alone as a separate dwelling unit. Yes, you can still rent your bedroom to others, it just doesn’t qualify for the STR loophole since it is not a separate dwelling unit.

Can we get a “yeah, but?”

What if your bedroom has a separate entrance and is en suite (fancy talk for bathroom)? Getting closer. What if you add a hot plate and mini fridge? You are getting warmer to IRS Publication 527 Residential Rental Property, but you are also flirting with the definition of a “dorm room” rather than a “dwelling unit.” To really cement the “cooking facilities” argument, you generally need a device for heating food (microwave, hot plate, range) and a dedicated sink for preparing it. Washing dishes in the bathtub is a hard sell to an auditor. In other words, be careful- form over substance comes to mind so ensure your technical facts are supported with reasonable meaning and intent.

Buttressing The Dwelling Unit Argument

As we just mentioned, the IRS definition of a dwelling unit is relatively sparse: sleeping space, toilet, and cooking facilities. If you toss a microwave and a cot in the corner of your basement, have you created a separate dwelling unit?

Technically, maybe.

But if you are going to claim the short-term rental loophole which relies heavily on this space being a separate “property” or dwelling unit or activity or anything other than an extension of your residence, you want to make your argument bulletproof. Or at least resistant to heavy artillery. Then again, a howitzer is likely worse than some bullets. We digress.

We are seeing a massive trend in basement, attic, and garage conversions. It makes sense, right? One of the easiest ways to step into the STR space is to take what you already have and leverage it.

To ensure these spaces are viewed as distinct dwelling units, as legally defined above, rather than just a “spare room” (which destroys the STR loophole strategy), consider these “nice-to-haves” that act as strong evidence of separation-

• Separate Entrance: This is huge. If a guest must walk through your kitchen to get to the basement, it feels like a roommate situation. A dedicated exterior door signals “separate unit.”
• Separate Driveway or Parking: If your property affords a different parking apron or portico that can be adjacent to the separate entrance, well, that is just icing on your dwelling unit cake.
• Security: Install a distinct lock (keypad or traditional) on the door separating the unit from the main house. This implies exclusive control and privacy for the guest. Cipher or keypad locks also look like a traditional Airbnb or VRBO situation.
• Distinct Address: You don’t necessarily need the post office to officially recognize “Unit B.” Simply placing a “Unit B” or “Guest Suite” placard on the door and using that designation in your short-term rental listing helps establish separation. Recording this with the county and whatnot is a large rock going up a steep hill which might also have unintended consequences downstream (increased property taxes, for example).
• Dedicated Systems: While expensive, having separate HVAC zones or electrical subpanels helps the argument. If that’s too pricey, a separate thermostat or even a dedicated mini-split system for the unit is a great middle ground.
• Kitchen Sink: There is just something about a kitchen sink that takes a hot plate and a microwave, and makes it into a kitchen. Adding a sink can be a challenge- venting is often tricky as much as finding a nearby drainpipe that works. But if you can, a sink really amps up the dwelling unit concept.
• Permits and Zoning: While the tax code doesn’t explicitly require your dwelling unit to be “zoning compliant” to be taxable (illegal income is still taxable, after all), having a permitted ADU or legal conversion is the ultimate trump card. If you are flying under the radar with the county, your facts and circumstances arguments (locks, kitchen, separate entrance) might erode a bit.

The goal is to create a fact pattern where an outsider (like an IRS auditor) looks at the setup and immediately thinks “apartment,” not “spare bedroom.”

Shared Expenses And The “House Hack” Allocation

Converting a part of your primary residence into a rental activity creates a unique challenge: shared expenses. Unlike a standalone typical rental property where the water bill is 100% tax deductible, you now have a single bill servicing both your personal life and your business.

• Utilities (Water, Electric, Gas): If you can’t install separate meters (often cost-prohibitive), you need a reasonable allocation method. Square footage is the most common and defensible method. If the basement dwelling unit is 800 sqf. and the total home is 2,400 sqft, you deduct 33% of the utilities. This math works even in Canada.
• Utilities Pro Tip: If the unit is an STR with high occupancy, guests might use water and electric / gas (think comfort based utilities) at a higher rate than you. This is especially true if you are a bit nomadic or travel often for work. You could argue for a per-occupant allocation method, but be prepared to be crazy good at recording the data points for substantiation.
• Internet and Trash: These are often flat fees. You can typically allocate these based on the number of units (50/50) if the service is equally available to both, or stick to the square footage method to be conservative.
• Insurance: This is often overlooked. You likely have a homeowner’s policy that covers the structure. You can allocate a portion of your primary policy premium to the rental based on square footage. If you buy a specific “Short-Term Rental Rider” or a separate commercial liability policy for the rental activity (and you should), that specific cost is 100% deductible directly against the rental income.
• Landscaping and Snow Removal: Generally, this is a shared expense allocated by square footage (or maybe 50/50 if you are generous). However, if you pay a service specifically to clear the separate walkway or parking pad for the guest, that is a 100% direct deduction. If you pay the neighbor kid $20 to mow the whole lawn, stick to the square footage allocation.
• Shared Structural Repairs: What happens when the roof leaks? Since the roof protects both your personal residence and the rental unit, the repair cost is generally allocated based on the same square footage percentage used for utilities.
• Direct Expenses: Expenses that are 100% for the rental unit are 100% deductible. This includes the cleaning fee, the streaming service subscription used solely on the guest TV, linens, and repairs specific to that unit (like a clogged shower drain in the basement bathroom). While this makes sense, we point it out anyway.

We say “house hack” allocation above, but frankly we are wanting to get as far away from the house hack concept with a separate dwelling unit concept. Most house hack situations are room rentals. In other words, dwelling unit versus house hack draws a clear line in the sand between “roommates” (bad for STR loophole) and “multi-unit property” (good for STR loophole).

Augusta Rule

Can you use the Augusta Rule for tax-free income on the first 14 days, and then switch to the short-term rental (STR) Loophole for the rest of the year? No. It would be nice, but No.

IRC Section 280A(g) is an all-or-nothing annual test. It applies only if the unit is rented for less than 15 days during the entire taxable year.

The moment you book day 15, the Augusta Rule evaporates for the entire year. You cannot stack them. You are either a tax-free Augusta rental (1-14 days, no expense deductions) or a taxable STR business (15+ days, all income reported, all expenses deductible).

Since the STR tax strategy generally relies on bonus depreciation to create a massive tax shield, you generally want to blow right past 14 days and disqualify yourself from Augusta to leverage those deductions anyway.

Anyone want the exact language that makes up the Augusta rule? Sure you do! Here is IRC Section 280A(g)(1)-

(g) Special rule for certain rental use
Notwithstanding any other provision of this section or section 183, if a dwelling unit is used during the taxable year by the taxpayer as a residence and such dwelling unit is actually rented for less than 15 days during the taxable year, then—

(1) no deduction otherwise allowable under this chapter because of the rental use of such dwelling unit shall be allowed, and

(2) the income derived from such use for the taxable year shall not be included in the gross income of such taxpayer under section 61.

Neat.

Can you buy a property late in the year, rent it for 14 days, and not claim the rental income? Under IRC Section 280A(d)(1), a dwelling unit is a residence only if your personal use exceeds the greater of 14 days or 10% of the rental days as we’ve discussed elsewhere.

This creates a trap for STR owners and late-year purchases. Suppose you buy a beach condo on December 1 and rent it for 14 days over the holidays. Sounds like perfect Augusta Rule income, right?

Not quite. With 14 rental days, you must exceed 14 personal use days to meet the residence test. In other words, you would need at least 15 days of personal use before year-end.
If you do not meet that threshold, the property is not a residence. And if it is not a residence, IRC Section 280A(g) does not apply and therefore your rental income is fully taxable.

Sidebar: The Augusta rule comes from tax folklore and the Masters Tournament in Augusta, Georgia. It lasts 7 days and is held during the first week of April. Clearly not well-attended by tax professionals.

What about cost segregation?

Cost Segregation Study For Your Converted Basement

As a refresher, a cost segregation study takes typical IRC Section 1250 real property that is depreciated over 27.5 or 39.0 years, and carves out certain property that is identified as IRC Section 1245 personal property. Next, the personal property is chopped up into 5-, 7- and 15-year depreciation buckets (assert classes for nerdy accountants).

Wait! There’s more. Personal property is eligible for accelerated depreciation either through bonus depreciation or Section 179 expensing. See our accelerated depreciation and Section 179 deduction section for more information.

Let’s take a step back. If you are considering a cost segregation study on a converted basement, attic or garage, where the rental space is part of the entire building, then you need to determine a business use percentage. Shared HVAC, plumbing, electrical and other building systems and components can add complexity to a cost segregation study.

Calculating the business use percentage or rental use is typically done with square footage. Keep in mind that when you convert a space that is normally not livable, and you make it into a dwelling unit complete with kitchen, bedroom (including studio) and bathroom, the new or additional square footage is added to both numerator and denominator.

Said differently, if your livable space is 2,500 square feet, and you convert your garage adding 400 square feet, the math becomes 400 divided by 2,900 for business use percentage.

But here is where it gets tricky. An attic or basement is attached to the house, however, a garage can be detached with its own four exterior walls and as such becomes an auxiliary dwelling unit (keep reading) for cost segregation purposes. Covered breezeways between the main home and detached garage, and essentially a connected roof, does not suddenly make it attached. Generally, a structure needs to have structural continuity with the primary building, such as shared foundation or walls, to be considered attached.

If you are working with a cost segregation engineer, you will need to explain the space. If you are doing a do-it-yourself cost seg study, which is completely fine and appropriate, you will generally need to apply the business use percentage as calculated above to the building to determine your starting point. Said differently, your basis will need to be allocated between personal and business (rental property).

WCG CPAs & Advisors recommends contacting the cost segregation people and getting additional guidance under a DIY cost seg. At the very least you will need to document the method for determining business use (rental portion) and support the conversion of the space with photos. If the space was converted with renovations, then permits, receipts, plans, etc. should be maintained as part of your record keeping as well.

Cost Segregation Study For your ADU

Cost seg for an auxiliary dwelling unit is straightforward since an ADU is viewed as a separate structure just like a single-family rental property. It gets a little complicated when you have a detached garage that was part of the original purchase price.

For example, you invest $150,000 into adding electricity, gas, water and sewer to the structure plus all the usual things like drywall, cabinets, floor coverings, etc., and what is your new cost basis in the garage turned ADU? An easy solution is to start with a business use percentage based on square footage as we explained earlier and then add the $150,000 to it.

Land would not be allocated to the rental activity since it cannot be divided. In other words, you cannot sell the ADU separately from the primary house (sure, you can do a survey and create some magic with the county, and be allowed to sell a land lease interest, but that seems a bit nutty).

Capital Gains Exclusion Under IRC Section 121

Keep in mind this rather thorny part of the tax code. IRS Publication 523 Selling Your Home reads in part-

Space separate from the living area.
You generally can’t exclude gain on the separate portion of your property used for business or to produce rental income. Regulations section 1.121-1(e) provides that the use of a separate portion of your home for business or rental purposes doesn’t qualify for exclusion under section 121, and this may affect your gain or loss calculations.

See our selling your rental property section for more riveting information on primary residence conversion including non-qualified use, separate spaces as we described here, net investment income tax (spoiler, make it an STR before you sell), purchase price allocation and land arbitrage, among other things. Fun!

By Jason Watson, CPA
Posted Sunday, March 22, 2026

Computing the average nights per guest seems straightforward on its face, right? It is likely you received enough math lessons over the years to safely and accurately take a series of numbers and find the average. Let’s talk about the stuff they didn’t teach you in the third grade.

Average Computed Within the Taxable Year

Let’s refresh ourselves with Treasury Regulations Section 1.469-1T(e)(3)(ii)(A) which reads in part-

(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;

Four mentions of “taxable year” in five sentences. The IRS must think it is important. What does this mean for you? If you launch a short-term rental in late December, and plan on leveraging the short-term rental loophole with your big cost segregation study against your high W-2 income, you better spend a few bucks on advertising and perhaps offer some reasonable discounts or incentives to get two distinct stays that can compute an average guest stay.

Computing Average Guest Stay Without Actual Guest Use

This one is easy, and it basically goes like this- You cannot point to your Airbnb or Vrbo listing which states “7-night maximum” or something similar and claim that your average guest stay is clearly 7 days or less. You must have actual customer use.

The regulations just quoted earlier state “the average period of customer use for such property is seven days or less.” Customer use is the focus phrase. As such, the tax court in Rogerson v. Commissioner, Tax Court Memo 2022-49, plainly stated-

Without any customer use, it is impossible to establish (as required by the regulations) the average period of customer use for the yachts. Accordingly, Mr. Rogerson fails to qualify for the first exception.

Sure, this quote is in reference to yachts, but the approach remains valid for short-term rental properties. In this case, Rogerson was trying to claim 7-day average customer use, and then he also tried to argue that if the court doesn’t accept the 7-day argument, could they accept the 30-day argument. The 7-day argument was the “first exception” as quoted above, and he also failed for the same reason on the second exception of 30-day use.

Sidebar: The word “exception” is being used in this context since rental activities are generally passive “except” in certain situations.

Sidebar #2: Rogerson was trying to use the 30-day exception where personal services are being provided. In the context of a rental property, this would be akin to a bed and breakfast, or a hunting lodge where significant personal services are being offered such as daily linen changes, concierge services, airport transportation, etc. plus an average guest stay of 30 days or fewer.

The court in Rogerson continues with this quote as well-

For purposes of these rules, a period of customer use is the period “during which a customer has a continuous or recurring right to use” the property. Treas. Reg. § 1.469-1(e)(3)(iii)(D). The average period of customer use is calculated by dividing the aggregate number of days in all periods of customer use of the property by the number of periods of customer use.

Seems straightforward, right? Practically 5th grade math.

Average Guest Stay When Spanning Two Tax Years

What happens when you have a guest stay that starts in 2025 and ends in 2026? Specifically, you have a guest that stays from December 29, 2025 through January 3, 2026. How do you count that? Split it up? Apply it to 2025? 2026?

Let’s go to the code! Yay, right? Come on… yay, right? We thought so. Treasury Regulations Section 1.469-1(e)(3)(iii)(C) which reads in part-

(C) Average period of customer use for class of property. In determining an activity’s average period of customer use for a taxable year, the average period of customer use for a class of property held in connection with an activity is determined by dividing—

(1) The aggregate number of days in all periods of customer use for property in the class (taking into account only periods that end during the taxable year or that include the last day of the taxable year); by

(2) The number of those periods of customer use.

The key phrase is “or that include the last day of the taxable year.” This suggests that if a period of use starts before the last day of the taxable year (December 31 for most taxpayers), then the entire period is included in that year. As such, a December 29, 2025 through January 3, 2026 guest stay which is a 5-night stay is counted as a 2025 stay for average period of customer use calculations.

Sidebar: The hospitality industry considers a 5-night stay as 5 days. The terminology above references “aggregate number of days” but the IRS including hospitality and accounting industries, count a 5-night stay as 5 days, which is to everyone’s benefit.

Average Guest Stay When Converting to Short-Term Rental

This one can be a zinger. If converting to or from a short-term rental, you must consider all stays for the taxable year. As such, if you convert a ski condo on May 1 into a long-term rental, you will likely exceed the average guest stay of 7 days.

What can you do? More code, please. Treasury Regulations 1.469-4(c)(2) reads-

(2) Facts and circumstances test. Except as otherwise provided in this section, whether activities constitute an appropriate economic unit and, therefore, may be treated as a single activity depends upon all the relevant facts and circumstances. A taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping activities. The factors listed below, not all of which are necessary for a taxpayer to treat more than one activity as a single activity, are given the greatest weight in determining whether activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469—

(i) Similarities and differences in types of trades or businesses;

(ii) The extent of common control;

(iii) The extent of common ownership;

(iv) Geographical location; and

(v) Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).

Why is this important to you? If you can demonstrate that a long-term rental and a short-term rental are different economic units, then you can isolate each, and compute an average guest stay for each. You will need crazy good recordkeeping to show clear distinction between the activities otherwise they will default to being one activity, and your average guest stay blows up. Use different management companies. Use different platforms. Use different advertising channels. Have different agreements / leases.

By leveraging the Appropriate Economic Unit test with a flip of the narrative, you are effectively arguing that a mid-year conversion isn’t a single, evolving activity, but rather the termination of one business and the commencement of another. Treasury Regulations Section 1.469-4(d)(1) supports this by generally prohibiting the grouping of a “rental activity” with a “trade or business” unless one is insubstantial.

Since an STR with an average stay of 7 days or less is technically not a rental activity under IRC Section 469, it stands as a distinct species from a traditional long-term lease. Therefore, as long as both phases of the year are substantial, they cannot be forced into a single bucket that would otherwise “blow up” your average guest stay.

We mention the word “insubstantial” above which is a direct term from the regulations. If you have an STR for 1 week and an MTR for 51 weeks, the IRS might argue that the STR is insubstantial and force the grouping. Simply put- this could be viewed as one continuous activity that changed characteristics.

Conversely, if you have three months of STR and nine months of MTR or even LTR, neither is “insubstantial.” Therefore, the regulations actually require you to keep them separate. This prevents the 30-day stays from being averaged in with the 7-day stays, which is exactly the separate economic unit result you are looking for. So, you could rock up to the IRS with a t-shirt that reads: “I didn’t choose to separate them; your own regulations at 1.469-4(d) prohibited me from grouping them.” A bit wordy for a t-shirt.

Ultimately, this position hinges on facts and circumstances. If the two phases are not clearly distinct and substantial, operationally, economically, and in recordkeeping, the IRS might treat them as a single activity, combining all stays and potentially disqualifying the short-term rental classification.

Gaming The Average Guest Stay System

It is December 25, and you are freaking out because you need two guest stays. You find someone who wants to stay December 25 through January 4. Knowing what you know, you suggest they stay December 25 through 26, and again December through January 4. Brilliant! You suddenly have two guest stays, right?

Yeah, no. They saw you coming a mile away. Treasury Regulations 1.469-1T(e)(3)(iii)(D) read-

(D) Period of customer use. Each period during which a customer has a continuous or recurring right to use an item of property held in connection with the activity (without regard to whether the customer uses the property for the entire period or whether the right to use the property is pursuant to a single agreement or to renewals thereof) is treated for purposes of this paragraph (e)(3)(iii) as a separate period of customer use. The duration of a period of customer use that includes the last day of a taxable year may be determined on the basis of reasonable estimates.

The key point here is right to use, not actual occupancy. In our example, the right to use was from December 25 through January 4, and it was uninterrupted. This is considered one stay regardless if there are separate agreements or bookings. It looks especially bad if this was pre-arranged. Bummer.

What If My Business Rents The Short-Term Rental

What if your business has a legitimate business purpose to rent your short-term rental? This would be considered a self-rental since you materially participate in both activities. You could carefully and reasonably leverage this concept to help with computing average guest stay. Check out our my business rents my short-term rental section for more information.

By Jason Watson, CPA
Posted Sunday, March 22, 2026

This section is partly a repeat of another section from Chapter 5 on Material Participation Rules where we discussed grouping rentals to make meeting material participation thresholds easier.

Why Group Short-Term Rentals

You might have multiple short-term rental properties whose average guest stays are 7 days or less, cool, but you struggle to meet the material participation thresholds on each rental activity separately. To reiterate, the three most popular material participation tests for rental property owners are-

• 500 hours, or
• 100 hours and more than anyone else, or
• Substantially all hours

The regulations allow you to group your short-term rentals together to be considered one activity. Specifically, you might not be able to meet the above tests for each rental property, but collectively you can.

Short-Term Rental Grouping

To clear up some possible confusion, there are two grouping elections that we discussed earlier-

• Treasury Regulations 1.469-9(g) which is exclusively used for real estate professional status (REPS) or technically a “qualifying taxpayer.”
• Treasury Regulations 1.469-4 which is a general grouping provision, and we discuss more about it below, and how it relates to the short-term rental loophole.

Generally, those activities that are similar can be considered an appropriate economic unit. Treasury Regulations 1.469-4(c) read-

(2) Facts and circumstances test. Except as otherwise provided in this section, whether activities constitute an appropriate economic unit and, therefore, may be treated as a single activity depends upon all the relevant facts and circumstances. A taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping activities. The factors listed below, not all of which are necessary for a taxpayer to treat more than one activity as a single activity, are given the greatest weight in determining whether activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469—

(i) Similarities and differences in types of trades or businesses;

(ii) The extent of common control;

(iii) The extent of common ownership;

(iv) Geographical location; and

(v) Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).

Let’s bring in a summary table to help navigate this madness-

Non-Rental Activity

Recall that if the average guest stay is 7 days or less then it is not considered a rental activity but rather a business per Treasury Regulations 1.469-1T(e)(3)(ii). This also includes those rentals where you provide substantial personal services. Both examples are depicted in the table above.

Sidebar: For any business activity, not just rental property activities, to be deductible against other types of income. It requires material participation. As such, you could have a non-rental activity that remains limited for deducting losses since it is considered passive.

Sidebar #2: Brief comment on STR hours counting towards REPS. The accounting industry, courts, and the IRS at times treat real estate professional status as if it applies only to rental real estate, when the statute actually refers more broadly to real property trades or businesses. A hotel is not rental real estate, we can all agree. However, a hotel and by extension, your STR, is certainly a trade or business using real property. Hours spent on your STR should count towards your 750 hours for REPS. See our REPS pitfall with short-term rentals section.

What does this mean to you? Why should you care? To minimize the risk of your grouping election being challenged and then denied by the IRS, you should only group short-rental rental properties with average guest stays of 7 days or less together, and free of other rentals (except bed and breakfast arrangements, hotels, hunting lodges, etc.). Why? You want to maintain the integrity of the appropriate economic unit.

What about 30-day rentals? They are considered short-term too, right? While 30-day rentals are considered short-term, they cannot be considered a non-rental activity unless personal services are provided (see fourth example in the above table). Therefore, these types of short-term rentals (average guest stay between 8 and 30 days) should be kept separate.

Could your group your bed and breakfast with your short-term rental as we mentioned above? Yes, and it is not a bad idea. Keep in mind that a bed and breakfast is considered a hotel since substantial personal services are provided. As such, this is not a rental activity. A short-term rental with an average guest stay of 7 days or less is also not a rental activity (it is a business). Therefore, these two activities may be grouped into one activity to assist with material participation hurdles.

Caution! Before you blast off with your 1.469-4 election, a quick reminder is in order that the regulations require the grouping to be an appropriate economic unit. As such, they must share common control or management, must be similar in nature and should be geographically similar (although geography is less important given our remote work mindset).

Here is yet another table to visualize grouping elections-

As a reminder, the 1.469-9(g) which you might recognize or be familiar with is for real estate professionals, and is not the same as the election you would use for short-term rentals.

There’s more! Yet another reminder, the 1.469-9(g) election for real estate professional status (REPS) is all or nothing. This means that all rental activities must be grouped together if you choose to group any. To recast the table above, all rental activities except those with average guest stay of 7 days or less or those where substantial personal services are provided would be grouped together if leveraging Treasury Regulations 1.469-9(g) for real estate professional status.

Here is another way to look at the intersection of the 1.469-9(g) and 1.469-4 elections- the 1.469-9(g) election can only include rental activities. Therefore, it automatically excludes non-rental activities such as short-term rental activities qualifying for the loophole.

1.469-4 Election Concerns

The 1.469-4 grouping election is made with the tax return, and is straightforward. Similar to the 1.469-9(g) election, the 1.469-4 election endures year after year unless a material change in facts and circumstances occurs. This might include selling a rental property, converting one from short-term to long-term or changing how they are managed, among other things.

Recall the geographic requirement under Treasury Regulations 1.469-4(c)(2)(iv) above. If your short-term rentals are scattered, it might be harder to defend the appropriate economic unit concept and group them together. This in itself is not a complete deal breaker given our remote work nature we live in today, but you should be aware and attempt to buttress other areas of the grouping election parameters.

Sidebar: When these regulations were written, working and managing things from a distance were not well contemplated. The geographical provision was meant more as a barometer of your ability to manage the grouped activity as one versus a strict rule on geography itself.

Tracking Time Under The 1.469-4 Election

You should still track time on a per-rental basis to ensure a property manager or a cleaner, for example, is not spending more time than you. In other words, it is easy to get comfortable with your participation in a couple of properties and neglect the time spent by others on the ones you are not managing or working on directly.

Additionally, and as mentioned elsewhere, you must track other people’s time when using the 100 hours and more than anyone else material participation test.

By Jason Watson, CPA
Posted Friday, October 10, 2025

This is the cousin to the previous section where your business rents your short-term rental periodically for board meetings or employee retreats. Instead of periodic renting, your business would add another work location by entering into a long-term lease (just like any other office space or condo). Said differently, if your business could use a second office or location, this strategy could be a win win. Keep reading!

Self-Rental Rules

As a reminder, this is a self-rental, and that term has specific meaning. Recall from previous section that a self-rental is an odd dichotomy where your losses are considered passive, and your profits are considered nonpassive. This is to prevent you from artificially creating net rental income (profit) by inflating rents to offset otherwise non-deductible passive rental losses.

Sidebar: This is commonly known as the self-rental trap. We expanded on this in two earlier sections. See my business rents my short-term rental section (just a previous article ago) and three types of income section.

Legitimate Business Purpose

As we discuss in other areas, for this to pass muster, there needs to be a legitimate business purpose. IRC Section 162 requires an expenditure to be ordinary and necessary. Ordinary is one that is common and accepted in your industry. Necessary is one that is helpful and appropriate.

If you are an insurance agent in Colorado and would like to purchase a lovely downtown San Diego condo as a second work location, you might have some problems out of the gate. To suggest that you go to your San Diego work location to review financial statements, conduct video meetings with your customers and draft your latest riveting slide deck would likely not be considered ordinary and necessary. In other words, it looks like a disguised second home.

However, you obtain your insurance license in California, and you tell the world you are there to enjoy sunsets, sure, but to also drum up new business, then that changes things. For those business owners that work from their home already, this could be a great way to get the best of both worlds. How?

Tax Efficiency

Your business pays rent and as such your business income is lower. You earn rental income from the self-rental to your business. That transaction offsets, and your tax footprint remains the same. Neat. Now what?

You add in mortgage interest and property taxes that are no longer limited since it is a rental property and not a second home, plus utilities, repairs and HOA dues, and suddenly you are creating tax efficiency by-

• not being limited by mortgage limits on primary and second homes, and
• deducing otherwise personal expenses such as utilities, repairs and HOA dues.

Toss in a cost segregation study for kicks and that first year is incredible. Let’s not forget to keep good records, and maintain and support that business purpose. Oh, and don’t forget too that a formal lease, like you would typically see in a business-to-business environment, complete with money movements between bank accounts is required.

Something to consider when reviewing your tax benefits of rental properties in connection with your overall rental property tax strategy and wealth building initiatives.

What about really cranking up your risk? This is a hate the game not the player situation. You could-

• Buy a rental property and qualify for the short-term rental loophole, then
• Perform a cost segregation study and get your big accelerated depreciation tax deduction, then
• The following year, take the short-term rental out of service and make it your second home.

Let’s not forget furnishings. Go shopping for the good stuff while it is a short-term rental, and then when you move in, you have nice things. Then again, most individua pieces of furniture are under the $2,500 de minimis threshold. But the hot tub? The golf cart that you rent out to guests? Big kitchen reno under Qualified Improvement Property provisions and bonus depreciation?

Scammy? Maybe.

Use Section 179 Or Bonus Depreciation

There is a decision to be made with this- use IRC Section 179 expensing or IRC Section 168(k) bonus depreciation? More considerations-

• When any property is not used predominantly in a trade or business, which is what happens when a short-term rental is no longer being held as an income-producing asset, the benefit (most say accelerated depreciation) under IRC Section 179 is recaptured. This means your big tax deduction in the previous year becomes big income in the year of conversion.
• Bonus depreciation does not have this nuance unless the property is considered listed property. Listed property is considered passenger automobiles, entertainment / recreation, computers and peripheral equipment, and cell phones/telecommunication equipment. Neat. IRC Section 1245 property identified through a cost segregation study is anything but listed property. As such, if business use falls to or below 50%, and you used bonus depreciation with your cost seg, then you do not recapture depreciation when converting to a vacation home, second home or primary residence.
• As we’ve mentioned in various places, many states do not recognize bonus depreciation but many allow IRC Section 179 expensing. Some states like New York are more forgiving whereas some states like California have severe limitations.

Quickie summary- when business use ends, IRC Section 179 deductions are recaptured as ordinary income. Specifically, a portion of the “179 benefit” is recaptured as ordinary income. Yuck. Bonus depreciation, by contrast, isn’t clawed back at conversion unless it’s listed property. Rather, it just sits around like luggage and waits to be recaptured at sale. Lots to think about, right?

What do we mean by “a portion?” The difference between what would have been allowed under typical depreciation methods and the Section 179 benefit is added back as ordinary income. The property also continues to depreciate as if Section 179 had never been used.

Business Use Defined

What defines business use? Is there a hard number? IRC Section 179(d)(10) reads-

(10) Recapture in certain cases
The Secretary shall, by regulations, provide for recapturing the benefit under any deduction allowable under subsection (a) with respect to any property which is not used predominantly in a trade or business at any time.

Ok. Neat. Treasury Regulations Section 1.179-1(e)(2) tightens this up-

(2) Predominant use. Property will be treated as not used predominantly in a trade or business of the taxpayer if 50 percent or more of the use of such property during any taxable year within the recapture period is for a use other than in a trade or business of the taxpayer.

Another consideration- depreciation recapture is similar to cost segregation in a way. How? Both are leveraging accelerated cash flow. For example, you might be perfectly fine with depreciation recapture and the associated taxes upon converting your short-term rental into a primary residence if the tax deduction today was worth the pain of paying some of it back 5, 7 or 10 years later.

Here is a list of short-term rental conversions in increasing risk order-

• Short-term to long-term or mid-term (this risk delta is barely measurable).
• Short-term to vacation home (where you rent it out but also use it personally, the 14 day / 10% rule).
• Short-term to second home or primary residence a few years down the road.
• Short-term to second home or primary residence on the next January 1 following your sexy cost segregation and accelerated depreciation tax deduction.

Want to add more risk? Buy the rental on December 1, have substantially all the hours of material participation, rent it out twice for your average guest stay, do the cost seg thing with bonus depreciation, and then move back into it 31 days later. Yikes. If challenged, the IRS will most certainly find something to not like- wrong pencil color on your time log or you get a Google sheets person who hates Excel. Who knows!

Keep in mind that the above assumes a quick period of short-term rental activity. In contrast, buying a short-term rental today with the loose and speculative intent of one day making it a second home in 15 or 20 years is a common and perfectly legitimate approach to all this madness. As we said way back in an earlier chapter, there are two reasons to buy rental properties- to build wealth or to support lifestyle choices. A short-term rental today being a lovely second home in retirement might accomplish both.

A loophole within a loophole if you will.

Converting Short-Term Rental Into A Vacation Home

Oops! Let’s talk about converting your short-term rental into a vacation home. This situation is quite common where today you have a short-term rental and you are fine with only using it 14 days or 10% of the fair rented days, whichever is greater. Time goes on, and you are finding yourself wanting to use the STR more and more. Kids are older and not in stupidly expensive activities and sports. Your job is remote. You enjoy a change in scenery more often now.

Regardless of tripping vacation home rules, as long as your personal use days don’t exceed your rented days to others at fair market prices, and the whole activity is worked continuously and regularly with a profit motive, you should not incur depreciation recapture when you previously used Section 179 expensing.

In other words, using it 30 days and renting it 31 days is a bit different than using it 60 days and renting it to others for 100 days. The latter looks like the activity remains a rental property first (a business) and a personal home second, and recapture is unlikely. The former could be argued that only renting the property for 31 days does not support the regular and continuous involvement with a profit motive standard.

Keep in mind the underpinning of IRC Section 179- if you used Section 179 expensing and the rental property is not used predominantly in a trade or business, you will trigger recapture (technically, the “benefit” is recaptured). As we stated earlier, this is commonly more than 50% but the entire activity must remain a business according to the standard above. In both examples above, you trip the vacation home rules and your losses are limited, sure, but the question becomes- do you recapture or no? Maybe The Clash can have a reunion. Now we’re dating ourselves- “Grandpa, was The Clash any good?” We digress.

Recapture Upon Sale

Let’s not forget that any depreciation or Section 179 expense deducted will be recaptured upon sale. As such, if you convert your short-term rental property into a second home, and then later sell it, prior depreciation including accelerated depreciation with bonus will be recaptured. This does not necessarily apply to Section 179 since the recapture would have occurred immediately upon conversion or what some call a change in use.

By Jason Watson, CPA
Posted Tuesday, September 23, 2025

Here are some FAQs you might find helpful as a chapter summary to the STR loophole–

Short-Term Rental Loophole Frequently Asked Questions
Here are some FAQs you might find helpful as a chapter summary-

What qualifies a property as a short-term rental (STR)?
If the average guest stay is 30 days or fewer, the property is classified as a short-term rental.

What is the “STR loophole”?
If the average guest stay is 7 days or fewer and you materially participate, your rental losses may be fully deductible—even without real estate professional status (REPS).

Is REPS required for short-term rental deductions?
No. STRs are not considered rental activity under IRS rules, so REPS is not needed to deduct losses. Yes, we answered this question twice.

What if my STR stay averages 8–30 days?
It’s still classified as a short-term rental, treated as non-residential property. Without REPS, you might still have some tax benefits with qualified improvement property (QIP) and Section 179 expensing.

What happens if I provide hotel-like personal services?
The rental becomes a traditional business activity. It’s no longer a rental activity and may trigger self-employment tax.

What are considered substantial personal services?
Daily cleaning, breakfast, fitness/spa access, concierge, tours, or other services not customarily provided by landlords (but rather by hotels or lodges).

Does personal service classification override guest stay duration?
Yes. If substantial personal services are provided, average guest stay doesn’t matter—it’s a business.

Do STRs qualify for bonus depreciation?
All rentals qualify for bonus depreciation. Whether you can benefit from the deduction is the question. Short-term rentals with the loophole benefit the most.

Are STRs residential or non-residential property?
They are typically non-residential, meaning they depreciate over 39.0 years instead of 27.5 years.

What is the significance of the 7-day rule?
Averaging 7 days or less per guest opens the door to the STR loophole and nonpassive loss deductions without REPS.

What does “material participation” mean in STRs?
You must be regularly, continuously, and substantially involved in operations—meeting one of the IRS’s seven tests.

Can I combine hours with my spouse to meet STR material participation?
Yes. Spouses’ time can be combined for material participation—but not for REPS qualification.

What’s the most common test STR owners meet?
The “100 hours and more than anyone else” test is often the most practical and achievable.

Do I owe self-employment tax on STR income?
Not unless you provide personal services that reclassify the rental activity as a business, and you have net rental profits.

How can I prove material participation in an STR?
Track time spent, keep emails, bookings, receipts, travel logs, and any interactions with guests or managers.

Do property managers disqualify me from STR participation?
Not necessarily, but if they spend more time than you, it could disqualify your STR loophole hopes using the 100 hours and more than anyone else test.

Are STRs subject to local lodging or occupancy taxes?
Often yes. Many jurisdictions apply hotel tax rules to STRs, even if the IRS classifies them differently.

Can I use STR losses against my W-2 income?
Yes—if you meet the STR loophole and material participation criteria, losses are nonpassive and deductible which might be why you are reading this in the first place.

How does depreciation work for STRs?
STRs are generally non-residential and depreciate over 39.0 years, not the 27.5 used for long-term rentals.

Can I do cost segregation on an STR?
Yes. STRs are excellent candidates for cost segregation when they qualify as active businesses (hotel like) or nonpassive activities (short-term rental loophole).

Can I have both STR and long-term rentals in the same partnership LLC?
Yes, but it complicates tax reporting. STRs and long-term rentals follow different depreciation and passive activity rules.

What happens to STR deductions if I use the property personally?
You create a recordkeeping mess for you and your tax professional, and your rental activity might have limitations in terms of deductions.

Is Airbnb considered STR activity?
Yes. Airbnb and similar platforms typically involve short stays and fall within STR classification if other conditions are met.

How do I calculate average guest stay?
Divide total rental days by the number of guest bookings (not calendar days). Only rented days count—not vacant or personal use days.

Do I need actual guest stays to compute an average or is my listing enough?
The regulations require, and the tax court has affirmed, that actual guest stays are required to compute the average. The court plainly states in Rogerson, “Without any customer use, it is impossible to establish the average period of customer use.”

How does converting from LTR to STR impact my average guest stay?
This can be problematic unless you can demonstrate that each activity is a separate economic unit and therefore separate rental activities.

How can I separate long-term and short-term rentals for average stay purposes?
Use distinct advertising channels, management, and recordkeeping to demonstrate they are separate economic units. If successful, you can compute average guest stay independently for each.

What if a guest stay spans two tax years—how is it counted?
If a stay includes December 31, the entire stay is counted in that tax year for computing average stay. A December 29–January 3 booking counts as a 5-day stay in the current year.

Can I reset the average guest stay by splitting one long booking into two?
No. The IRS counts the entire right to use period, if uninterrupted, as a single stay—even if you try to artificially break it into two bookings. Pre-arranged splits are disregarded.

What is “reasonable gross rent” and how is it evaluated?
It’s the idea that your reported rental income should align with market expectations. Tools like AirDNA or market comps are used to compare your earnings against similar STRs in the area. If your income is far below comparable properties, it raises concerns about reporting accuracy or business intent including profit motive.

Can I still deduct losses if my STR consistently underperforms?
Yes, but only if you can demonstrate a legitimate effort to operate at a profit including advertising, rate optimization, and strong documentation. If losses persist without a clear plan to improve, the IRS might view it as a personal use property or hobby, disallowing deductions. Yuck.

Can I group my short-term rentals with long-term rentals for tax purposes?
No. You cannot group short-term rentals (average guest stay of 7 days or less) with other rental properties such as long-term rentals or short-term rentals with average stays of 8–30 days. Doing so might invalidate your grouping election with the IRS.

Why would I want to group short-term rentals together?
Grouping helps you meet material participation thresholds (e.g., 500 hours, 100 hours and more than anyone else, or substantially all hours) across all properties combined, rather than on each property individually.

Which tax regulation allows grouping of short-term rentals?
Treasury Regulation 1.469-4 allows grouping of short-term rentals (non-rental activities) into a single business activity if they meet the appropriate economic unit criteria.

What criteria determine an “appropriate economic unit” under Treasury Regulation 1.469-4?
The IRS looks at factors like: similarities in type of business, common ownership and control, geographical location and interdependencies between activities. You don’t need to meet all factors, but a reasonable method should justify the grouping.

Are short-term rentals considered rental activities?
No, if the average guest stay is 7 days or less or substantial personal services are provided, it’s not considered a rental activity but a business activity under Treasury Regulations 1.469-1T(e)(3)(ii).

Can I group my short-term rental with a bed and breakfast?
Yes. A bed and breakfast (which provides substantial personal services) is also considered a non-rental business activity, so it can be grouped with short-term rentals using the 1.469-4 election.

Can I use the 1.469-9(g) election for short-term rentals?
No. Treasury Regulation 1.469-9(g) is only for real estate professionals and applies only to rental activities—not short-term rentals with average stays of 7 days or less.

What happens if my short-term rentals are in different geographic locations?
Geographic similarity helps support the grouping as an appropriate economic unit, but it’s not a strict requirement. Remote management is more accepted now, but you’ll need to strengthen other aspects of the grouping to defend it.

What qualifies a basement, garage, or ADU as a dwelling unit for short-term rental purposes?
A dwelling unit must have sleeping space, a toilet, and cooking facilities; optional features like a separate entrance or utilities help but aren’t required.

What if a bedroom has a separate entrance and en suite bathroom—does that help?
Yes, adding features like a separate entrance, bathroom, and even a hot plate and mini fridge gets closer to meeting the IRS dwelling unit definition. Watch out for form over substance, and overall reasonableness.

How does a cost segregation study work for a converted basement or garage?
You’ll need to calculate a business use percentage, usually by square footage, and account for shared systems like plumbing and HVAC when allocating costs.

How does cost segregation differ for an ADU compared to a converted basement?
An ADU is treated as a separate structure just like a mini standalone rental property, making cost segregation simpler, while basements and attics require business use allocations.

Does converting part of my home into an STR affect capital gains exclusion?
Yes, IRS rules state you generally can’t exclude gain on a portion of your property used for rental activities (generation of income), which can reduce your available exclusion when selling. Yuck.

What happens to Section 179 deductions if I convert my short-term rental into a second home?
Section 179 expensing is recaptured as ordinary income once the rental property is no longer used predominantly for business, turning last year’s big deduction into taxable income. Yuck.

Do I have to recapture bonus depreciation when my STR becomes a second home?
Bonus depreciation taken on your IRC Section 1245 property generally isn’t recaptured at conversion unless the asset is listed property; instead, it carries forward and is recaptured later at sale. Property identified in a cost segregation study is not listed property, so this is rarely a concern.

Why would my business rent my short-term rental?
Your business might use your property for off-campus meetings, retreats, training sessions, or client gatherings where the amenities and costs are more attractive than hotels or conference centers.

What is the self-rental trap?
The self-rental trap occurs when rental income from leasing your rental property to your own business is treated as nonpassive and the rental income (profits) cannot offset other passive losses. Nonpassive losses from a self-rental are the apples to the oranges of typical rental activities that are passive.

How can I fix the mismatch between passive losses and nonpassive income?
You can make the Treasury Regulation 1.469-4 election to group your business and self-rental into one economic unit, allowing business income to offset rental losses.

When considering renting my STR to my business, what are examples of legitimate business purposes?
Legitimate purposes include board or shareholder meetings, strategic retreats, employee training, client or investor meetings, team-building, or focused work sessions like project sprints.

What tax benefits can result from my business renting my STR?
Very little if your STR already qualifies for the short-term rental loophole. However, if your rental does not qualify (average guest stay exceeds 7 days or you cannot show material participation), then rental income to the STR is a tax deduction for the business and the otherwise non-deductible rental losses are reduced. A tax deduction shift in a sense.

What pitfalls should I avoid when my business rents my short-term rental?
Key pitfalls include failing to move real money between accounts, charging unreasonable rent, or not documenting agendas, minutes, and business purposes thoroughly.

Can I rent my short-term rental to myself or family if I pay market rent?
Generally no, because vacation home rules apply if personal use exceeds 14 days or 10% of rental days, and family use counts as personal use unless they pay fair market rent and use it as a primary residence.

What does it mean when my business rents my long-term rental?
It means your business enters a legitimate long-term lease with you for use as an additional office or work location—essentially treating the property like any other business space.

What is a “legitimate business purpose” for my business to rent a property I own?
A legitimate business purpose means the expense or rental arrangement must be ordinary and necessary for your type of business—something common, helpful, and appropriate for your industry.

How can having my business rent my long-term rental improve my tax efficiency?
By turning a second home into a legitimate business rental, you can fully deduct mortgage interest and property taxes, including otherwise personal expenses such as utilities, HOA dues, and even use cost segregation to accelerate depreciation.

Should I set up a separate LLC for renting recreational equipment alongside my rental property?
A separate LLC or another business entity is not required but can provide risk compartmentalization and peace of mind, especially if recreational equipment is rented under a separate lease.

Do I report recreational equipment rentals on Schedule C or Schedule E?
If equipment is offered only to rental guests as an incidental amenity, report on Schedule E or Form 8825; if you rent to the general public with continuity and profit motive, report on Schedule C or Form 1065.

Can I use Schedule 1 Line 8l to report recreational equipment rental income?
Yes, but it is rarely used since expenses and depreciation are not easily matched; it is better suited for one-off rentals, such as lending an RV once.

How does grouping recreational equipment rental with my rental property affect taxes?
Grouping under Treasury Regulations 1.469-4 allows both activities to be treated as one economic unit, supporting material participation and enabling losses and taxable income to be netted together.

What is the benefit of combining the activities without a formal grouping election?
You can report recreational equipment as part of the overall rental property on one Schedule E entry, simplifying accounting and clearly showing it as one activity.

What risks come with combining property and equipment rentals into one activity?
If your rental no longer qualifies for the short-term rental loophole, losses (including from equipment) may be disallowed and carried forward; also, liability risks may prompt your insurer or attorney to recommend separate entities.

How do I decide where to report recreational equipment rentals in practice?
If tied to the rental property, use Schedule E or Form 8825 in a partnership environment; if run as a separate business open to the public, use Schedule C or Form 1065; for one-time rentals not tied to your property, use Schedule 1 Line 8l.

By Jason Watson, CPA
Posted Sunday, August 31, 2025

Let’s say you have a short-term rental but you want to make a little extra coin on the side, so you decide to rent jet skis, kayaks and other water craft. Perhaps some bicycles or a golf cart. The questions we need to answer are-

• Do you have a separate LLC for this activity to help maintain compartmentalization away from the rental property?
• Do you report these activities on Schedule C like a normal business, or on Schedule E (or Form 8825) alongside the rental property? What about Schedule 1 Line 8l?
• Assuming Schedule E reporting, do you group the activities together to not have the equipment rental activity be limited by passive activity loss limits?

Separate Activity For Recreational Equipment

There are some reasons why having a separate activity, and even a separate business entity such as an LLC, make sense.

If you decide that your activity should be reported on Schedule C of your individual tax return (Form 1040), then it is mostly compartmentalized by definition. But if you are reporting the equipment rental on Schedule E or Form 8825, and it is part and parcel to the rental property, a separate LLC might make you feel better about risk. A separate checking account would be nice too, but you could easily open a second personal account without needing an LLC.

Sidebar: Form 8825 is similar to Schedule E, and used in a partnership tax return (Form 1065) and S Corp tax returns (Form 1120S). Form 8825 and 1065 go together like Schedule E and 1040.

Reporting on Schedule C or Schedule E

This one is nuanced. If you provide jet skis, kayaks, canoes, bicycles and whatnot to only your rental property guests, and you are not holding yourself out to the public as someone in the recreational equipment rental trade or business, then you would report these activities on Schedule E or Form 8825.

Sidebar: This assumes an “incidental use” relationship between the rental property guest and the equipment rental. Further, this means no meaningful services beyond making the equipment available are being provided. If you’re operating the jet skis, such as like guided tours, the IRS may call that a business regardless.

Another consideration is the language found in Schedule E instructions from the IRS-

Personal property.
Do not use Schedule E to report income and expenses from the rental of personal property, such as equipment or vehicles. Instead, use Schedule C if you are in the business of renting personal property. You are in the business of renting personal property if the primary purpose for renting the property is income or profit and you are involved in the rental activity with continuity and regularity.

The important phrase from above is “primary purpose for renting the property is income or profit.” When you are renting recreational equipment in connection with your short-term rental property (and even a mid-term rental), the primary purpose is improved guest service and experience. Yes, this leads to more profit in your rental activity from increased bookings, but you get the point.

Back to the issue of reporting on Schedule C (or Form 1065) or Schedule E / Form 8825- the possible downside to reporting on Schedule E or Form 8825 is being subject to passive activity loss (PAL) limitations. Conversely, when your money is at risk and you participate in the equipment rental activity on a regular and continuous basis with a profit motive, your activity is a trade or business in the eyes of the IRS.

As such, when reporting the activity on Schedule C of Form 1040 or page 1 of Form 1065 as ordinary business activities, your losses will not be limited if you materially participate. In a one-person equipment rental business, this is typically straightforward to demonstrate since you perform substantially all of the activity’s work. You could purchase $50,000 in jet skis and other toys, and deduct that purchase against W-2 income or other income using accelerated depreciation such as 100% bonus depreciation (available for qualifying property placed in service after January 19, 2025) or Section 179 expensing (noting the nuanced limits when leveraged inside of a partnership).

Can you pick and choose? Maybe. You would need to prove your involvement is regular and continuous, and has a profit motive. You do not necessarily need to earn a profit to have a profit motive. You just need to do what typical business owners do- find new revenue and minimize expenses. Keep in mind, however, that if your equipment rental business loses money 3 out of 5 years, the IRS could deem it a hobby. The 3 out of 5 thing is a safe harbor- you could lose every year for 10 years as a startup, for example, but then you would have to show facts and circumstances to support your profit motive.

Keep in mind that a profitable Schedule C activity will be subject to self-employment taxes in addition to income taxes.

We mentioned Schedule 1 Line 8l earlier. The instructions for Form 1040 read-

Income from the rental of personal property if you engaged in the rental for profit but were not in the business of renting such property.

This wording can certainly throw a wrench in the works, right? You can report equipment rental activities using Line 8l on Schedule 1 of your Form 1040, sure, but in reality, no one does. Why? Mostly because no one knows about this language in the instructions. Also, there is not a clean way to report expenses against this income including depreciation. Having said that, some “one and done” rental activities are reported here- for example, you lend your RV one time to a work buddy, and feel compelled to report the rental income (of course you do!).

1.469-4 Election Grouping With Rental Property Activity

You can group activities that are similar into one activity for material participation testing. We discuss this more in our regulations 1.469-4 election section but the basic gist is this- the IRS allows grouping if the activities form an “appropriate economic unit” based on facts and circumstances, considering similarities and differences in types of activities, the extent of common control, the extent of common ownership, geographic location, and interdependencies (e.g., if they rely on each other for income, customers, or services).

Renting recreational equipment to your short-term rental guests would tick all these boxes. This would allow you to use both activities together to support your material participation of 500 hours, 100 hours and more than anyone else or substantially all hours. When combined with an average guest stay of 7 days or less, your hours spent on the combined activities could qualify the rental for the short-term rental loophole.

This grouping also allows you to net the losses from the equipment rental against income from the short-term rental within that combined activity. On the other hand, if both activities are deemed passive (the equipment rental and the short-term rental), then they will offset or be netted on Form 8582 regardless. If the activities are different in nature where one is passive and other is deemed nonpassive (apples and oranges), but they meet the grouping criteria above, then you might be required to group them together under Treasury Regulations 1.469-4 just to net them together.

Mechanically, you would have two entries (think two columns on Schedule E or Form 8825)- one for the rental property and the other for the recreational equipment.

Combining The Activities Without Formal 1.469-4 Election

There is another option where you simply provide access to the recreational equipment and charge a separate fee that is added to the guest fee. This is akin to heating the pool for your guests- many short-term rental property owners charge extra to heat the pool since it is expensive and not all guests want to pay for it.

How this works is that your equipment would be considered part of the overall rental property activity. The fixed asset listing on your tax returns would show land, building, acquisition costs and loan costs like normal (and 5-, 7- and 15-year property if a cot segregation study was completed), and it would also show the recreational equipment. A lot of equipment might not even be listed since their amounts are de minimis ($2,500 and under) but a jet ski or a boat or a golf cart would be.

Your recreational equipment is now tied to the rental property in a structured way and reported as one. Rental income all flows into one checking account. Expenses from gasoline for the jet ski to linens for the bedrooms are reported as supplies.

The upside to this is simplicity and to positively tell the IRS and the world that this is one activity without a formal election. You would have one entry on Schedule E or Form 8825.

There are two downsides to this- first, your rental property might not qualify for the short-term rental loophole one day (let’s say your average guest stay is not 7 days or fewer), and the losses are disallowed and carried forward including the losses from the recreational equipment. This is not particularly impactful since the losses from the equipment likely aren’t moving your tax needle that much anyway.

You might also be worried about risk- your insurance carrier or attorney or both might require separate entities such as LLCs to help separate or compartmentalize the risk.

Summary Of Renting Recreational Equipment

How can you reduce all this gobbly-goo into action items? If the renting of recreational equipment is incidental to the rental property, then you will report on Schedule E or form 8825. If you rent the equipment to the whole neighborhood and not just your rental guests, then you are likely a trade or business and will report as such.

Whether you combine the rental property and recreational equipment activities into a single activity through a Treasury Regulations 1.469-4 election, or mechanically by combined or consolidated reporting, is the remaining conundrum.

To add to your thought loop while staring art the ceiling at 3:00AM, having a separate entity or at least a separate activity allows for you to create some legal separation. This in turn could allow for hold harmless agreements or other clauses in separate rental agreements. Yes, you could also have similar agreements coming from you personally or from the LLC that holds title to the rental property itself, but some added comfort might happen with a recreational equipment rental LLC and a rental property LLC.

Sidebar: As we discussed elsewhere, many counties will tax tangible personal property deployed in a business. If your STR is a business, and if inextricably connected to that business is the rental of a jet ski, you will likely pay a county tax in connection with the value of the jet ski.

Who wants a table?

By Jason Watson, CPA
Posted Sunday, May 25, 2025

What if your business has a legitimate business purpose to rent your short-term rental? A different spin on the Augusta rule if you will. There are some questions to be asked and answered with this one. First, why? Second, what are some examples of legitimate business purposes?

Why Would You Have Your Business Rent Your Short-Term Rental

You might need a place for your business to conduct an off-campus meeting or retreat, and why bother with a hotel? Perhaps your short-term rental is in a really great place for a business meeting or has better amenities such as a kitchen including dining room tables and larger televisions. It might simply be cheaper than conference space at a hotel.

Those are the soft reasons. Let’s talk about the tax benefits and some other goodies.

First, let’s tackle the self-rental problem or what people at times will call the self-rental trap. Yes, we can get around this with a Treasury Regulations 1.469-4 grouping election, but you would not want to do this for a board meeting or business retreat- the grouping election is more appropriate for the office building you own personally and lease back to your business (the election itself has some requirements between the two activities).

Back to the self-rental trap. Treasury Regulations Section 1.469-2 boringly reads-

(f)(6) Property rented to a non-passive activity. An amount of the taxpayer’s gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property-

(i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of Section 1.469-5T) for the taxable year; and

(ii) Is not described in Section 1.469-2T(f)(5).

Read that first paragraph again. The phrase “treated as not from a passive activity” tends to stand out. This essentially means you cannot use a self-rental to generate a bunch of passive income to offset your otherwise non-deductible passive losses.

The self-rental trap is the asymmetrical handling of taxable rental income versus losses. Rental income or profits are considered nonpassive and cannot offset passive losses from other activities such as rentals. However, rental losses from self-rental arrangements remain passive and are subject to passive activity loss limitations.

With that in mind, consider that the rent paid from the business to the short-term rental is a tax deduction to the business, and in turn lowers your taxable income from the business. If this business is not taxed as an S corporation and is reported on Schedule C of your individual tax return (Form 1040), this also reduces your self-employment taxes (S Corp profits are not subject to self-employment taxes).

Now we need to pay just a bit more attention because here’s where it gets nuanced. If your short-term rental property qualifies for the loophole, the tax benefits are minimal. Your business has a tax deduction, your rental property has more rental income and losses are reduced- however, you were able to deduct those rental losses against your business income anyway, so the net-net is zero.

But! What if your STR did not qualify for the loophole. Average guest stay was 21 days or something, or you didn’t materially participate? Further, let’s say your rental had a loss of $20,000. Assuming your modified adjusted gross income is above $150,000, those losses would be disallowed and carried over into future years. Yuck, right?

But along comes your business renting the short-term rental for $12,000 for a week to conduct bona fide business activities. This $12,000 lowers business profits which impacts you immediately and your STR losses are now reduced to $8,000 and carried over on Form 8582. This is a $12,000 tax arbitrage.

Not all that glitters is gold- there are some Section 199A qualified business income deduction considerations. What is your marginal tax bracket? Are you already phased out? Are you an SSTB (specified service trade or business)? Some tax planning is needed for sure, but at worst, a $12,000 reduction in business income only “costs” you $12,000 x 37% x 20% or $888.

You could also use your business to carefully and reasonably reduce your average guest stay or to help in bringing in another data point to compute an average. Careful. Reasonable. No self-dealing. Legitimate business purposes. You get it, right? Pigs get fed and hogs get slaughtered.

Legitimate Business Purposes To Rent The Short-Term Rental

Some of this gets a bit silly with a one-person small business, but if you have your spouse and children on payroll, or even some senior employees, then business purposes seem to be more real (or at least you feel like you can blink when talking to the IRS). Here is a quick list of the activities your business could conduct in a legitimate or bona fide way-

• Board of Directors / Shareholder Meetings (but a board of 1 is dumb)
• Strategic Planning / Vision Retreats
• Employee Training / Continuing Education
• Client / Investor Meetings
• Team-Building
• Work Sessions / Project Sprints (swim lanes in your STR pool? Maybe)

Here are some agenda items to kick around as well-

• Review prior year financial statements including forecasts
• Tax planning for the business and owners
• Discuss marketing plan
• Analyze KPIs, operational metrics and goals for the same
• Determine staffing needs and hiring plans including training improvements
• Review IT needs including vendor renewal and risk assessment (backup, cybersecurity)
• Assess insurance coverage
• Analyze regulatory compliance
• Review other vendor contracts
• Provide technical subject matter training
• Consider succession planning and key person risk assessment

Pitfalls To All This Business Rents The STR Gibberish

Here are three important considerations for your pitfall avoidance-

• Ensure you have a rental agreement, and that the money actually moves. Your business checking account should show payment to your rental property checking account just like a real customer doing a real transaction. Seriously, backdating stuff will not hold unless you can point to a transaction. Do it, but do it right which is doing it in real-time.
• Be reasonable on rent- it should align with your published rental rates and be consistent with alternative short-term rentals, hotels, conference room space, etc. Record these comparables in case you need to present them later.
• Document the heck out of your business purpose, agenda and meeting minutes. Read this again, please.

For those who also use the Augusta rule where you can rent your personal residence to your business for 14 days for legitimate business purposes that are ordinary and necessary, and not recognize the rental income for tax purposes (yet your business receives a tax deduction), the pitfalls above apply to you as well. In Sinopoli v. Commissioner, Tax Court Memo 2023-105, the tax court said these three things-

• “Petitioners have not presented any written documentation such as minutes, agendas, or calendars showing that all the claimed meetings occurred during the years at issue…”
• “We find that petitioners’ testimony was not credible as to the frequency of meetings during the years at issue. Their testimony was inconsistent and included testimony that petitioners did not recall the number of meetings that took place.”
• “Petitioners did not obtain an appraisal of the rental value of their residences as meeting space.”

Yikes! This tax court case was purely an Augusta rule matter, but the same can be applied to your business when renting your short-term rental for business purposes.

Can I Rent My Short-Term Rental

We often get asked, “if I pay market rent, why can’t I rent my short-term rental like any other guest?” The primary reason behind this is to avoid the vacation home rules. As a refresher, if you use your rental property more than 14 days or 10% of the rented days, whichever is higher, then you trigger vacation home rules and losses are limited.

Sidebar: Under IRC Section 280A(d)(2), you cannot rent to family members either. The same vacation home rules apply, and their days will count against your personal use days even if they pay fair market value rent. However, if they use the rental property as their primary residence and pay fair market rent, then family members are treated like any other tenant.

You cannot simply create a business out of thin air in an attempt to leverage the “business rents my STR” concept either. The business must be a business where your involvement is regular and continuous with a profit motive. In other words, it must have a purpose with commercial substance.

By Jason Watson, CPA
Posted Monday, July 7, 2025

Chapter 7 tackles one of the most powerful, misunderstood, and IRS-scrutinized niches in real estate tax planning. Sounds ominous, no? Unlike long-term rentals, STRs can escape the usual passive activity loss limitations if deployed correctly creating massive opportunities to offset W-2 income and other nonpassive income with rental losses, especially through cost segregation and bonus depreciation. Ok, that was a long sentence.

This chapter breaks rental properties into four treatment buckets based on average guest stay and substantial personal services provided. Rentals with stays of 0–7 days and no hotel-like services may qualify for the STR loophole with nonpassive treatment. Rentals with 8–30 day stays are also considered short-term and non-residential, with some tax benefits but are generally limited. Rentals over 30 days fall under traditional passive activity rules, and any rental property with substantial personal services such as daily housekeeping, breakfast, or concierge amenities becomes a full-blown business, subject to self-employment tax and Schedule C or business entity tax return reporting.

The core topic is how STRs are not treated as traditional rental activities under IRS rules should you materially participate with an average guest stay of 7 days or fewer, and therefore don’t require Real Estate Professional Status (REPS) to allow rental loss tax deductions (REPS is nearly impossible to achieve if the household has W-2 jobs, so STR loophole becomes sexy for certain investors).

We also discuss strategies for tracking time, handling property management, practical examples, court case references, and tax court interpretations.

This is a hot topic… here we go!

By Jason Watson, CPA
Posted Sunday, May 25, 2025

There’s not a good place to discuss this issue, so we plopped it here. In a vacation home setting, you likely have an owners’ closet full of good pans and utensils, linens just for you, a Snuggie or two, and perhaps booze. Definitely booze. Generally, these purchases are not tax deductible. Got it.

But what about that golf cart you want to purchase for your short-term rental? Are you truly going to let your guests use a golf cart? Or is it for your personal use when you show up for repairs and a handful of personal use days? It is not out of the question, but you need to position yourself carefully. Does your VRBO or Airbnb listing mention golf cart use? Do you make the extra golf cart rental fee just a bit out of reach for most but reasonable?

WCG CPAs & Advisors recently had a client install a boat dock and lift. The cost was $70,000 or so. While this is a land improvement all the way for depreciation purposes, the question becomes- does this have any business use whatsoever? The boat dock and lift were installed for the personal boat of the rental property owner when they occasionally used the property (they would boat over from their primary residence which is kinda cool but it took almost a day).

One could argue that a boat dock and lift were necessary for the landlord to administer the rental property using a mode of transportation of his choosing. Perhaps. Maybe. Seems far-fetched. What’s next? Install a landing strip too? On second thought, that might not be a bad idea.

The IRS could argue that this improvement has nothing to do with the rental property itself since a boat is not being offered to guests. Recall that the expenditure generally has to be ordinary (everyone has one) and necessary (your rental would fail without one) to be a business use consideration. A counter point to that argument would be to buy a couple of kayaks or a raft or something that would need a boat dock. Install a swim ladder and a nice bench to watch sunrises from. Done! The lift portion of the boat dock and lift combo remains questionable.

The point to all this is that we all want to maximize the efficacy of a tax deduction and find the narrowest of margins between reasonable and downright nutty. Be careful. The more words you need to explain your sexy tax position the more likely you are going to lose.

Who wants more boats and golf cart considerations? Of course you do! What if you are concerned that parking a boat which you often use personally at your short-term rental taints the personal use component of the rental activity? Or, you are simply concerned about the optics and how your actions in one area might contradict your actions in another area. Or, you are concerned with risk and litigation when it comes to recreational equipment.

You could very easily rent the boat to guests separately from the rental property itself. Separate transaction. Separate agreement. Separate hold harmless stuff. You also might want to do this with other recreational equipment such as kayaks, rafts, bicycles, mopeds, scooters, etc. You and your family can easily use all this gear and also rent it out all the while keeping it separate from the short-term rental property itself. Yay!

Let’s dig into this more!

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Here is a recap of what we just discussed in this fun chapter on the short-term rental (STR) loophole-

• 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 nonpassive (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 nonpassive, 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.

By Jason Watson, CPA
Posted Saturday, September 27, 2025

Here are some additional things to consider as dream of all the possibilities, opportunities and arbitrage.

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.

Reasonable Gross Rent

We recently had a client who lost $76,000, $74,000 and then $77,000 over three years on a short-term rental in Joshua Tree, California. Given the amount of rental income as compared to the expenses, we were concerned. We were also concerned since the household earned about $300,000 in pre-tax salary, and after paying for normal living expenses, it didn’t seem reasonable that the taxpayers could afford to throw $60,000 after-tax cash into a business venture each year (the difference being depreciation). Sure, one down year, we get it, but three in a row? Sounds like a habit at this point.

One of our duties at WCG CPAs & Advisors is to inform the real estate investor and rental property owner of risk. We are not the tax police, but we need to remind taxpayers that the tax police exist. After we get over our professional hurdles as paid tax return preparers and real estate CPAs, it is ultimately your tax return. We are facilitators, and a part of that process is to discuss tax positions and risk.

We chatted with our client and outlined the feasibility of what she was expressing on her tax returns. We also used AirDNA data to look at other rental properties in Joshua Tree of similar size, qualities and amenities. We carefully and respectfully asked how do other short-term rentals seem to earn $70,000 to $80,000 in gross rent and you are continuously earning $20,000 to $25,000? Is this a business venture with a profit motive? Or a hobby? Is this more of a vacation home for you and your friends? Or are there some discrepancies in your tax records that you cannot easily defend?

We are not the IRS, but we still need to raise these issues and make the taxpayer aware of how this looks simply based on math.

Tangible Personal Property Reporting

This is a repeat from our chapter on cost segregation. Many counties want you to report and pay tax on tangible personal property. While a cost seg study’s only job is to parse property away from typical real property and relabel it as personal property, not all personal property identified in your report is suddenly tangible personal property.

Conversely, many counties are similar to Florida’s 192.001(11)(d) which reads-

“Tangible personal property” means all goods, chattels, and other articles of value (but does not include the vehicular items enumerated in s. 1(b), Art. VII of the State Constitution and elsewhere defined) capable of manual possession and whose chief value is intrinsic to the article itself.

What does this mean? It means that tangible personal property for the sake of county taxes must have value by itself and be capable of manual possession. For example, certain components might be identified as IRC Section 1245 personal property, but their value is tied to the fact they are part of a larger building system.

Carpet is a good example since it typically does not have material resale value. Specialized wiring for a restaurant kitchen is likely personal property eligible for Section 179 expensing and bonus depreciation, but is unlikely to be considered capable of manual possession with intrinsic value, and therefore not be tangible personal property by a county assessor.

Furniture and appliances are the big ones that rental property owners operating a short-term rental might need to report and file with the county. Other businesses might have signage, shelving, display cases, equipment that is bolted to the foundation but moveable nonetheless, among other things.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

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!

Keep a time log please! If you are looking for a way to easily track time, WCG CPAs & Advisors has partnered with REPSLog and you can download their app here-

https://wcginc.com/time

Also, since you need to track other people’s time as well, many rental property owners and short-term rental hosts will purchase a web-enabled cipher lock and assign discrete door codes to each participant. Each cleaner, repair person, property manager, listing agent, etc. would have a separate door code which can then be downloaded into a time log with time and date stamps.

This is especially useful for the 100 hours and more than anyone else material participation test. It also shows your level of sophistication should your time tracking come into question. Want to be really smart about things? Install a small uninterrupted power supply (UPS) for your internet router.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

As mentioned earlier, to qualify the rental property as a nonpassive 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.

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.

Regulations 1.469-4 Election for Short-Term Rental Loophole

For the short-term rental loophole, you can elect to group your rentals to help meet the material participation hours. There are all kinds of considerations and issues with the 1.469-4 election, and therefore we expanded them into the following section.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

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 will count for material participation when considering a short-term rental property.

Sidebar: See our what time counts for material participation section where we discuss this in finer detail. Since a short-term rental is not a rental activity but rather a trade or business activity, acquisition time spent on a short-term rental counts towards material participation. Time spent on purchasing non-short-term rental properties does not count, and your material participation time generally starts when the property is placed in service (ready and available for occupancy, and held out for rental use through advertising and related efforts).

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!

Sidebar: Short-term rentals with average guest stays of 7 days or less cannot contribute to the 750 hours test for real estate professional status (REPS) since they are not deemed rental activities. Wait, what? It’s true! Temporary Treasury Regulations 1.469-1T(e)(3) reads “an activity involving the use of tangible property is not a rental activity for a taxable year if for such taxable year the average period of customer use for such property is seven days or less.”