Understanding Short-Term Rental Tax: Is There a Loophole?

The advent of modern short-term rental properties, or STR, opened up a world of possibilities and choices that the typical traveler had not experienced before. Popular short-term rental platforms like Airbnb and VRBO have led the way, helping to solidify a new type of vacation rental. While this has provided a new revenue stream for short-term rental property owners, it can complicate their tax situation with unanticipated complexities.

Short-term rental taxes can be confusing, especially when you factor in its intersection with hospitality. Use this article as your guide to understand short-term rental taxes and whether a loophole exists to help you reduce your tax liability.

Short-term rental tax loophole key takeaways: 

• Learn about what is considered the short-term rental tax loophole

• Understand the difference between active and passive income 

• Review property and state tax considerations and deductions 

What Is the Short-Term Rental Tax Loophole?

Collecting rent for short- and long-term rentals is usually considered passive income for tax purposes. However, there are exceptions written initially to benefit hotels and motels that short-term rental property owners can use to classify rental income as active instead of passive. This conversion allows owners to take advantage of tax deductions they otherwise would be ineligible for. Because these exceptions weren't intended for modern short-term rentals, it's common for them to be viewed as loopholes among some real estate professionals.

Short-term rental property exceptions include: 

1. The average period of customer use for such property is seven days or less.

2. The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers.

3. Extraordinary personal services are provided by or on behalf of the property owner in connection with making such property available for use by customers (without regard to the average period of customer use).

4. The rental of such property is treated as incidental to a nonrental activity of the taxpayer.

5. The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers.

6. Or, providing 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

Tax Categorization of Short-Term Rental Income: Active vs. Passive Rental Income

How your income is categorized will impact your tax burden. The IRS typically considers rental income passive, but loopholes exist. Unlike active income, which primarily includes wages, salaries, or business income from your active participation, passive income typically includes sources like interest, dividends, and, of course, your rental income from real estate investments. 

Substantial service

While the typical landlord isn't expected to provide substantial services to tenants, it's more common among short-term rental property hosts. Substantial services you provide to short-term rental guests include: 

• Regular cleaning of the rental unit 

• Changing linens and sheets

• Ongoing maid service

If you provide substantial services to guests as part of their bookings, report these expenses and your rental income on Schedule C. It's important to note that not everything you provide is considered a substantial service. Examples of services not considered to be "substantial" include: 

• Trash and recycling collection 

• The furnishing of lighting and heating

• Cleaning of public areas

Material participation

If you were involved in your short-term rental business's operations continuously, regularly, and substantially throughout the year, that activity is usually considered material participation. Generally, a business activity isn't considered passive if you've materially participated.

The IRS created a series of material participation tests (you must satisfy one or more) to determine if you materially participated. 

• You participated in the activity for more than 500 hours.

• Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.

• You participated in the activity for more than 100 hours during the tax year and at least as much as any other individual, including those who didn’t have any interest in the activity, for the year.

• The activity is a significant participation activity, and you participated in all significant participation activities combined for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and didn’t materially participate under any material participation tests other than this. 

• Other than by meeting this test, you materially participated in the activity for any 5 of the 10 immediately preceding tax years, whether consecutive or not.

• The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves personal services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.

• Based on all the facts and circumstances, you participated in the activity regularly, continuously, and substantially during the year.

Note that you didn’t materially participate in the activity under the final test if you participated in the activity for 100 hours or less. Your participation in managing the activity doesn’t count in determining whether you materially participated under this test if:

• Any person other than you received compensation for managing the activity. 

• Or if any individual spent more hours managing the activity during the tax year than you did, regardless of compensation. 

Tax Filing (and Deductions) for Active Business Income

Qualifying active income includes salaries paid from an employer to an employee and tips, commissions, and other income you participated in. If you are eligible for the short-term rental tax loophole, you can change the status of your rental income from passive to active. This change allows you to take numerous tax deductions for which you would be ineligible if your rental income were classified as passive. Tax deductions reduce your taxable income.

Examples of short-term rental tax deductions related to rental expenses include: 

• Depreciation

• Cost segregation

• Furniture and furnishings

• Maintenance and cleaning

• Commissions and fees

• Insurance

• Mortgage interest

• Taxes

• Advertising and marketing

• Legal and accounting fees

Learn more about your self-employment tax responsibilities in our blog, Taxes for Freelancers: What the Self-Employed Need to Know. 

Tax Filing for Passive Rental Income

If you received income from something you didn't actively participate in, such as dividends, interest, and rent collection, it's typically considered passive. Passive rental income is ineligible for many of the tax deductions it would if it were classified as active income via the short-term rental tax loophole.

However, whether passive or active, your rental income will usually be subject to the same tax rate.  

State Taxes for Short-Term Rentals

Your short-term rental is usually subject to some state and local taxes. However, these taxes can differ by state, such as California and Texas, and be called different names depending on region–tourist, stay, or occupancy tax, to name a few–and can be taxed at different rates.

You may also have additional responsibilities regarding direct tax collection from guests, especially if you operate outside mainstream short-term rental marketplaces that will collect these taxes on your behalf.

If you have questions about the tax laws in your jurisdiction, including the hotel occupancy tax, lodging tax, or other rental tax issues, contact state and local authorities or a qualified real estate CPA.

Property Taxes for Short-Term Rentals

Short-term rental property owners will pay property taxes as they operate their businesses. Property taxes for your rental property can be written off entirely if the property is used exclusively as a rental or for the portion used throughout the year by guests. 

You must be eligible for the short-term rental loophole in order to take advantage of applicable tax deductions. 

Tax Time: When to File Taxes If You Have Short-Term Rental Income

Use the records you've retained throughout the year and other supporting documentation to prepare and file your business tax return by tax day, April 15. Forms you may use to file your taxes and claim tax deductions include: 

IRS Form 1040

Individual taxpayers file IRS Form 1040, U.S. Individual Income Tax Return. Form 1040 calculates your federal taxable income and tax liability.

You should also file schedules to report self-employment income: Form 1040 Schedules C and E.

Form 1040, Schedule C

To report business income and expenses, file IRS Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship). Schedule C calculates your business income or loss and is typically used when you provide substantial services (regular cleaning, laundry, etc.) for your short-term rental property. 

Form 1040, Schedule E

Report income or losses from rental real estate, royalties, partnerships, S corporations, estates, trusts, and residual interests in real estate mortgage investment conduits by using Schedule E (Form 1040), Supplemental Income and Loss.

Form 1040, Schedule SE

You must also pay the 15.3% self-employment tax on your self-employed income. Sole proprietors must calculate self-employment tax liability using IRS Schedule SE (Form 1040), Self-Employment Tax. You can claim half of what you paid in self-employment taxes as a deduction.  

Quarterly Estimated Taxes

Self-employed individuals must also estimate and pay quarterly estimated taxes throughout the year. Quarterly estimated tax payment due dates for the 2025 tax year include the following: 

• April 15

• June 16

• September 15

• January 15, 2026

Form 1040, Schedule ES

Use IRS Form 1040-ES, Estimated Taxes for Individuals, to calculate and pay your quarterly estimated taxes. The form includes tax information such as payment vouchers and instructions for filing online.

Estimating and submitting quarterly tax payments while running your short-term rental business can be challenging without 1-800Accountant's full-service quarterly estimated tax solution. 

Classify Right and Stay Compliant: Get the Best Tax Deal

Ensuring your short-term rental business has an optimal tax classification while remaining IRS-compliant can be difficult. That's why many hosts and other short-term real estate investors trust the CPAs and tax professionals at 1-800Accountant, America’s leading virtual accounting firm, for their real estate accounting needs.

Save time and achieve your annual short-term real estate financial goals with our suite of affordable, tax-deductible financial services. Schedule a quick consultation–usually 30 minutes or less—to learn how tax advisory and business tax preparation and filing will help your short-term real estate business maintain full compliance with maximum tax savings.